Understanding Mortgage-Backed Securities

Posted by Nick Niesen on October 29th, 2010

The housing boom of the last seven years has been one of the biggest ever. Mortgage-backed securities are one reason for the torrid pace of real estate growth.

Understanding Mortgage-Backed Securities

A mortgage-backed security is essentially a bond. Investors purchase interests in the mortgage security and your monthly mortgage payment is the revenue earned from the security. Unlike a bond, however, the value of a mortgage fluctuates because it can be paid off early. A 10-year bond definitely matures in 10 years, but a similar mortgage may be paid off at any time with a refinance or outright cash payment.

Mortgage-backed securities are issued by retail lenders, i.e., the lender giving you a mortgage. They do this for a number of reasons. The primary reason is to create liquidity so they can use the money for other purposes. If you have a thirty-year mortgage, the lender is going to have to wait thirty years to recover its money and profit. That is a long time in the world of finances. To overcome this, the lender sells securities on the secondary market and your property acts as the collateral for the security. Essentially, the mortgage lender is obtaining a loan from investors by using your mortgage and home as the guarantee of payment.

Lenders will also use mortgage-backed securities to clean up their balance sheet. After the Savings and Loan crisis of the 1980s, new regulations were created that require lenders to maintain certain debt to equity ratios. By issuing mortgage securities, lenders can keep their books safely within the relevant standards set by the regulations.

At first glance, you might think mortgage-backed securities sound a little fishy and speculative. In reality, they have been around for some time and drive the market. Government entities such as Ginnie Mae [Government National Mortgage Association] are active in this secondary mortgage market, guaranteeing many types of mortgages which makes them easier to sell on the secondary market.

As recent as 2004, it was estimated that over 729 billion dollars worth of mortgage-backed securities existed on the secondary market. The size of this investment is what lets lenders keep issuing mortgage loans to you and me.