MBS: Mortgage Backed Security

By: EconomyWatch Content   Date: 29 January 2010

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A Mortgage Backed Security (MBS) represents claims on cash flows from mortgage loans generally related to residential property and is usually issued by a government backed agency. Mortgage backed securities are issued by government agencies or government sponsored organizations and also private agencies. These agencies purchase mortgage loans from various sources, guarantee them against the risk of default and sell bonds or securities representing claims on principal and interest pertaining to these loans. Investment in mortgage backed securities must be done, keeping in mind its inherent risks.

When to Invest in MBS: Mortgage Backed Security

Since the performance of an MBS depends on the performance of loans backing it, investment in such securities makes sense only if the housing market performance is bright. The 2008 housing crisis and the subsequent economic meltdown in the US and the rest of the world was a result of crisis in the mortgage industry and massive investments in mortgage backed securities by big firms including Bear Stearns.

In times of low interest rates and good conditions in the housing market, investment in MBS is a safe bet. As long as home owners make their payments regularly, the interest of MBS owners also remains safe. However, in a scenario of high interest rates and high default by homeowners, the performance of MBS is threatened. This is because defaults reduce fund availability with the securities issuer, and triggers problems.

The most important risk of investing in an MBS is that of prepayment by a homeowner. Homeowners may also get their loan refinanced when the interest rates fall.

Structure of an MBS: Mortgage Backed Security

An MBS can be of various types, the most common being the pass through participation certificates. This entitles the holder to a pro rata share of all principal and interest payments made on the pool of loan assets. These securities can be based on residential mortgages or commercial mortgages.

However, several other options, known as collateralized mortgage obligations or derivatives, are structured to protect investors from various risks inherent in MBS investment. In this category, mortgages are categorized according to the risk involved and repayment time.


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