Mortgage-backed Securities

by Obaidullah Jan, ACA, CFA

Mortgage-backed securities (MBS) are bonds (specifically asset-backed securities) backed by a pool of residential or commercial mortgages and issued by a special purpose entity (SPE) specifically created to obtain ownership of and receive cash flows from the mortgages. MBS are classified into residential MBS and commercial MBS.

Mortgages are loans made by commercial banks to individuals and companies for purchase or construction of real estate which are backed by the real estate. Obtaining exposure to mortgages by depositing cash with banks is not efficient because bank reserves are pooled and then loaned out and there is no segregation of return by loan types. MBS solves this problem by enabling the banks to carve out mortgages as a separate asset class and raise cash by selling them to third-party investors. They allow investors to obtain exposure to mortgages as an asset class and at the same time creates liquidity for banks.

Structure and parties

The following chart illustrates the parties involved and the process of creation of mortgage-backed securities:

Mortgage-backed Securities

The commercial bank (the originator) transfers the mortgages (called securitized assets) to the special purpose entity (SPE), which is a bankruptcy remote entity specifically incorporated for this purpose. The SPE’s only assets are the mortgages and it is immune to any weakness in the financial position of the commercial bank which gives it enhanced credit status. The SPE issues mortgage-backed securities to the investors. The MBS may have different classes securities each having different credit risk and prepayment risk exposure, or it may issue just a single class of MBS. The servicer of the mortgages which was originally obligated to the pay the commercial bank now pays the periodic payments to the SPE which distribute it to investors. The commercial bank receives the cash proceeds that SPV generated by issuing those securities to the commercial bank which can use them to make more loans.

Residential MBS vs commercial MBS

Residential mortgage-backed securities are securities which are backed by residential mortgages.

Residential mortgages have a range of different structures such as fixed rate mortgages, adjustable rate mortgages, index-mortgages, etc. which determine their cash flows and prepayments if any. There are two further categories of residential MBS: agency MBS and non-agency MBS

Agency MBS

Agency mortgage-backed securities are MBS issued by US government agencies of quasi-government agencies and non-agency MBS are mortgage-backed securities issued by private lenders. Agency MBS issued by federal government agencies have virtually zero credit risk while agency MBS issued by quasi-government agencies have limited credit risk. Non-agency MBS have significant credit risk which must be addressed through credit enhancement such as credit tranching, overcollateralization, etc. Mortgages must meet certain requirements to be placed in the agency MBS, such mortgages are called conforming mortgages.

Non-agency MBS

Non-agency MBS are further classified into prime mortgages (i.e. mortgages with good credit quality) and subprime mortgages i.e. mortgages with high credit risk.

Commercial mortgage-backed securities are securities backed by commercial mortgages. Commercial mortgages differ from residential mortgages significantly in two ways: (a) commercial mortgages have low prepayment risk and (b) they have balloon payment structure (instead of the amortizing structure).