An Introduction to Mortgage Backed Securities

Posted by Nick Niesen on October 29th, 2010

What Are Mortgage Backed Securities?

Mortgage backed securities are securities that are backed by the principle and interest payments on a group of mortgage loans. Lenders group together mortgages and the money that is repaid by the borrowers' pays investors in the mortgage backed securities.

Why Do Mortgage Lenders Issue Mortgage Backed Securities?

There are a variety of reasons that lending institutions issue mortgage backed securities rather than holding the mortgage themselves. Most lenders have a limited amount of liquid assets. By selling mortgages they are able to free up money in the short term to make additional loans.

Another reason that mortgage lenders sell off their loans as mortgage backed securities is to minimize their risk. Although every effort is made to establish the creditworthiness of an individual before a loan is made, circumstances can change. If a borrower defaults on his mortgage, the lender will have unplanned for expenses just in dealing with repossession and selling of the property. Adding in the lost principal and interest, and a small, local lender could find themselves in a financial mess very quickly.

When a lender sells a mortgage as a mortgage backed security, they receive their money up front, both the loaned amount and a percentage of the loan as their fee. The investors in a mortgage backed security then receive income each month, as the borrower pays back the principal plus interest on his loan.

Types of Mortgage Backed Securities

There are a variety of mortgage backed securities. The majority of mortgage backed securities are issued by the Government National Mortgage Association, otherwise known as Ginnie Mae, the Federal National Mortgage Association, or Fannie Mae, and the Federal Loan Mortgage Company, or Freddie Mac. These are all groups sponsored by the federal government. While Ginnie Mae is backed by the full faith and credit of the government, and guarantees its investors that they will receive their payments, both Fannie Mae and Freddie Mac have the authority to borrow from the Treasury, which makes them relatively safe investments as well.

In addition to the government agencies, brokerage firms and banks often offer mortgage backed securities. These are known as private-label securities.

Are Mortgage Backed Securities Risky?

Mortgage backed securities are not generally considered a risky investment. To obtain a mortgage, the borrower must go through a qualification process that assures the bank or lending institution that the loan will be paid back. The group who sets up the mortgage backed security will then group mortgages together in order to sell. By pooling the mortgages together, the risk to the investor is minimized. One borrower, who defaults on a loan, or, conversely, pays the loan off early, depriving the group of years of interest payments, will have less of an effect when he is a member of a large group. The same borrow, particularly one who defaults on a mortgage, can cause a real financial shock to a small lending institution.

Do Mortgage Backed Securities Make a Good Investment?

All investment decisions are extremely personal, and will depend on your personal needs. Decisions on investments are best made with help from a financial advisor. For someone who would like a monthly income, a mortgage backed security can make a good choice. A mortgage backed security, particularly one sold by Freddie Mac, Fannie Mae, or Ginnie Mae, can be excellent investment vehicles. In general, the greater the amount of loans held in a mortgage backed security, the safer the investment, because the risk is spread over more people.

Before investing in a mortgage backed security, you should find out your expected rate of return. While this can vary, it is nice to know what investors have been receiving. Remember, it is not only loan defaults that can affect your income from a mortgage backed security, but also prepayments and principal only payments. The income from the security is figured on full payment of both principal and interest over the life of the mortgage, typically 15 or 30 years. Any action taken by anyone holding a mortgage in the security can affect your income. It is important to be clear about this with the person you purchase the security from.

Mortgage backed securities are an excellent development for borrowers, lenders, and investors. No matter what group you are in, it is important to understand exactly how they work and what you can expect. By doing that, you are better able to make a wise financial decision.