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You have probably heard the term ‘mortgage-backed security’ and might associate these types of securities with the 2008 financial crisis. But what are they exactly and how do they work?
Firstly, it is important to understand that mortgage-backed securities have long been viewed as some of the most stable and reliable financial instruments on the market. People buy homes all the time and a vast majority of them need a mortgage to finance the purchase of the property of their choice.
Mortgage-backed securities, or MBS for short, are financial instruments that are created by pooling together a large number of individual home mortgages and then selling interests in the pool to investors. Typically, these investors are major financial institutions, such as banks, pension funds, and asset management companies. However, individual investors can also invest in them.
"What the mortgage bubble was all about was big banks like Goldman Sachs taking big bundles of subprime mortgages that were lent out largely to low-income, highly risky borrowers, and applying this kind of magic-pixie-dust math to these bundles of securities and slapping AAA ratings on them." - Matt Taibbi
The way mortgage-backed securities generate cash flows is by the interest and principal paid by the home buyers.
If you are a somewhat conservative investor and would like to invest some of your money in mortgage-backed securities - look no further than this investfox guide on MBS-s.
Before we dive into some more details, we must first understand the basic principles behind mortgage-backed securities - what they are and how they work. The way MBS-s are created and marketed can be broken down into five key steps:
There are a few types of mortgage-backed securities on the market, which differ in terms of structure and government involvement:
Much like any other financial security, investors can buy mortgage-backed securities using a few different methods, such as:
Before investing in mortgage-backed securities, investors should consider the yield on these investments, as well as the creditworthiness of the underlying mortgage, to decide whether the risk/reward ratio is the right fit for them.
It is crucial for investors to first understand the inherent risks and rewards associated with investing in MBS-s - before putting their capital at risk.
No. As with any financial instrument, mortgage-backed securities also come with a fair amount of risk. Credit risk is the most important one to consider, as homeowners could default on their mortgages, which renders the MBS worthless.
Most mortgage-backed securities are considered to be of low risk. Investors need to conduct thorough due diligence regarding the credit ratings of mortgages within an MBS to decide whether the potential returns are worth the risk.
An agency mortgage-backed security is a type of MBS that is guaranteed by a government-sponsored agency like Fannie Mae or Freddie Mac.