Mortgage-Backed Securities

Answer 1

Homeownership, the American dream shared by many, would hardly be possible without mortgages. So if we assume that most people in the U.S. will own a home at one point or another there’s a lot of money to be lent and a lot of money to be made by the banks and institutions that write and service these mortgages. As an investor, you may wish to tap into this market as well. The good news is that you can do just that through the use of mortgage-backed securities.

Mortgage-Backed Securities (MBS for short) are essentially bonds that are created by pooling together a lot of home mortgages, securitizing them, and selling them to individual and institutional investors. When you invest in MBS you’re essentially buying an interest in a pool of residential mortgages. When homeowners make their mortgage payments every month a portion of their payments are returned to you, as an investor in the MBS, in the form of interest and principal.

One of the main risks associated with MBS investment is that of prepayment. You anticipate the maturity of the securities based on the maturity of the underlying mortgages. If it’s a brand new security built around brand new 30-year mortgages, for instance, you’d assume a maturity of 30 years. The problem is that many homeowners do not pay down their mortgages exactly according to the amortization schedule assumed at the time of underwriting. People pay off early, whether due to selling the house, a refinancing, or simply the desire to own the home outright. These prepayments can be very difficult to predict and the extent to which they’ll affect your investment is unsure to say the least.

There have been many attempts made to try to quantify and gauge the amount of prepayment risk at any given time, based on the current economic and interest rate environments. But these variables remain very unpredictable over the long run. In my next post, I’ll discuss three different types of MBS investments and tell you a way that you can at least mitigate some of that prepayment risk.