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Mortgage Backed Securities and Mortgage Derivatives

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mbsMortgage backed securities (MBS) are also known as mortgage derivatives and mortgage-backed bonds.  They are a form of investment that is based upon the mortgages of home buyers. As such, they affect the mortgage interest rate and can also have a significant effect on the economy if they go wrong (more on that later.)

What Are Mortgage Backed Securities?

Also known as MBS, such securities are a form of mortgage investment. When a lender such as a bank or building society grants you a mortgage to buy your home, the lender has to wait a long time to make profit from the interest you pay. This is particularly the case for 30 year mortgage loans.

If that lender wants to profit sooner, then it can bundle a bunch of loans with similar mortgage amounts, interest rates and repayment periods. Investors can purchase a portion of this bundle to profit from the interest paid on it. The lender receives an immediate income from the individual mortgages in that particular part of the bundle, and the investor waits for the longer term benefit.

Example of MBS in Action

As a simple example, take 1,000 people with $200,000 mortgages at 4% interest over 30 years. We shall calculate this at simple interest since compound interest only occurs in the event of negative amortization. That is where the payment you make is less than the interest charged on the loan.

The interest for a fully amortized mortgage over 30 years for a $200,000 mortgage is $143,739. Yes, that is correct – you pay that much interest for your home. That is why mortgage backed securities are popular with many investors.  They are also known as mortgage-backed bonds and mortgage derivatives.

The 1,000 people in our example would therefore be paying out almost $144 million in interest over the 30 years. The bank involved will take its cut immediately by offering this $144 million for sale on the market. If you purchase a mortgage backed security you are promised a return on your investment that your proportion of these 1,000 mortgages would make. You do not purchase the mortgage itself.

Mortgage Derivatives

Mortgage-backed bonds belong to a class of securities known as derivatives whose value lies in an underlying asset. In this case, that asset is the mortgage bundle. The risk of such mortgage derivatives is spread over the whole bundle of loans – in this case 100,000 (this a simple figure used for example only.)

This term has become a dirty word to the layman due to the sub-prime mortgage derivative crash of the mid to late 2000s. This will be discussed in a later post.  It certainly proved that the derivatives market, at least where it involved mortgage derivatives or securities, can be very risky without the high rewards for taking such risks.

Risk Tranches

When investing in mortgage securities, you can purchase your investment from certain subdivisions of thee bundle, known as “tranches.” The lower the perceived risk, the lower your potential return. A tranche comprising income from the first 3 years of a mortgage will be less risky than a 5-7 year tranche.

People are more likely to maintain their mortgage repayment in the first three years than later. Where borrowers have taken adjustable rate mortgages, the return in the later years will be higher- though the risk will be greater. The choice is yours, but if you intend investing in mortgage backed securities, you should take the advice of a financial or mortgage advisor that is independent of a bank or building society.

Finally. . .

In most cases mortgage backed securities (MBS) or mortgage derivatives are fairly safe investments. People usually pay their mortgages, and you have a safeguard against non-payment in the size of the bunch of mortgages included in your tranche.  However, when home prices drop so does the yield from such mortgage backed bonds. A declining market for mortgages leads to a decline in your income from such bonds or securities.

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