Securitization and Mortgage-Backed Securities
Securitization is a financial process in which various types of assets, such as loans, are packaged into securities that can be sold to investors. Mortgage-backed securities (MBS) are a type of securitized product that is backed by a pool of mortgage loans. These securities are created by banks and other financial institutions, which pool mortgages together and sell bonds or other securities backed by these mortgages to investors. The income generated from the mortgage payments is then used to pay the returns to the investors. This process allows the originating financial institution to free up capital that was previously tied up in the mortgage loans and make more loans, while providing investors with a regular income stream.
Securitization and MBS
There are a few ways investors could address the unpredictability problem associated with consumer behavior. They could either buy so many mortgages that their average loan lasts for an average amount of time OR the industry could create a standardized product that accomplishes the same goal and offers additional protections.
Enter: Mortgage-Backed-Securities.
Mortgage-Backed Securities (or MBS)
Mortgage-Backed-Securities (or MBS) are what groups of similar loans turn into in order to be sold, bought, and traded.?This process is known as “securitization.”?To understand securitization, let’s consider a hypothetical scenario:
Conclusion: 19 investors made good money. 1 investor lost good money.
In that example, there was no in-between when it came to lender profitability, and no major differences between the 20 underlying loans. It was luck of the draw getting stuck with the one consumer who decided to sell or refinance.
The other 19 investors are glad it didn’t happen to them, and they’d all be willing to give up a fraction of their profits in order to make sure it never happens to them. They’d love to have a way to equally share the risk--to have a 100% chance of small loss as opposed to a small chance of a big loss.
Securitization makes this risk-sharing possible.
Example:
If the average loan amount is $200k, then the same 20 investors could spend the same amount of money and buy the same 20 mortgages, only this time they’ll all share in the loss if 1 out of 20 loans pays off early, and they’ll all benefit from the high likelihood of 19 out of 20 remaining profitable.
Securitization also makes for a more standardized product.?
This standardization means more investors are comfortable buying mortgages without personally evaluating each underlying loan.?After all, those loans have had to pass through the same set of standards from an agency like Fannie Mae, Freddie Mac, The Federal Housing Administration, The Department of Veterans Affairs, etc.
领英推荐
Imagine every tangerine at every grocery store being exactly the same. You’d have a really good idea of what you’d pay and what you could expect to get. You could even grab a whole bag of tangerines without having to check each one.
A bag of tangerines in that example would be like a group of loans underlying a mortgage-backed-security (MBS). The price of tangerines would be like the price of MBS.
If grocery stores had a surplus of tangerines , they might lower the price. Because you know exactly what you want to pay for tangerines, you’d see the good deal and take advantage of it. You’d be less likely to do so if you had to wonder how those tangerines tasted (maybe they’re on sale because they’d sub-par?!).
So How Does Securitization Affect Mortgage Rates?
Understanding securitization and MBS is important in understanding what moves mortgage rates for a few simple reasons.?Securitization turns groups of mortgages into a commodity that can trade on the open market like other bonds.?From an investor standpoint, these mortgage-backed securities (MBS) are very similar to other investment options in the bond market. Thus, whatever causes movement in broader bond markets tends to cause similar movement in MBS.
MBS Price Rises
As MBS prices rise, it means investors are willing to pay more to obtain mortgages. There’s an inverse relationship between price and rate. The more an investor pays, the lower a mortgage rate can be.?If the investor wants more money today than they did yesterday to do your mortgage, it means they’re either charging a higher interest rate, or paying your lender less upfront to buy the rights to the loan.?By that same rationale, instead of paying more to buy the rights to the loan, the lender could instead lower the interest rate. Either way, there would be a decrease in cash flow to the lender.
US Treasuries, Bonds and MBS
Treasuries are bonds issued by the US government to finance its spending and debt obligations. They are considered to be among the safest investments, as they are backed by the full faith and credit of the US government.
The bond market, including US Treasuries, plays a significant role in financing the mortgage industry. When mortgage companies issue mortgage-backed securities, they often turn to the bond market to raise the capital needed to fund the loans. By issuing bonds, mortgage companies can raise the funds they need to originate new mortgages, which in turn can be securitized and sold as mortgage-backed securities.
Additionally, mortgage-backed securities can be used as collateral for Treasuries, providing added stability and liquidity to the mortgage market.?The interplay between Treasuries and mortgage-backed securities helps ensure the ongoing stability and liquidity of the mortgage market and enables it to continue to provide funding for new mortgage loans.
ust like the supply and demand for tangerines could even be affected by the supply and demand for oranges,?MBS prices are influenced by movement in Treasury prices.
This relationship between US Treasuries and MBS is at the heart of interest rate levels and movement. The produce aisle would be like “the bond market.” Investors want to buy a certain amount of bonds for certain reasons just like grocery shoppers tend to buy a certain amount of produce. Sometimes it’s oranges. Sometimes it’s tangerines. Sometimes they’re just not in a citrus mood.
Bringing It All Together
Securitization is a financial process in which various types of assets, such as loans, are packaged into securities that can be sold to investors. Mortgage-backed securities (MBS) are a type of securitized product that is backed by a pool of mortgage loans.
These securities are created by banks and other financial institutions, which pool mortgages together and sell bonds or other securities backed by these mortgages to investors. The income generated from the mortgage payments is then used to pay the returns to the investors.
This process allows the originating financial institution to free up capital that was previously tied up in the mortgage loans and make more loans, while providing investors with a regular income stream.