Getting to Know Mortgage-Backed Securities
Despite helping to lead to the recent financial crisis, mortgage-backed securities paired with tighter regulations can present a unique investment opportunity in the financial markets.
What are mortgage-backed securities and how do they work?
Mortgage-backed securities (MBS) are a type of security that is tied to an asset for collateral – specifically one or many mortgages. The way these investment vehicles are created goes as follows. A group of mortgages are bundled together by a financial institution and is then sold to investors as an MBS. The reason for this is that it allows banks to provide mortgages for homebuyers, who are then reimbursed by the investors purchasing the MBS. Essentially, the bank is the intermediary between the investor and the homebuyer. This structure helps banks to avoid tying up liquid capital in mortgages. The investors on the other hand typically receive monthly coupon payments, otherwise known as the mortgage payments. These are all guaranteed by the US government in that investors will receive their payment on time and in the full amount.
The two different types of MBS.
There are two different types of MBS which go by the names of pass-throughs and collateralized mortgage obligations (CMO). Starting with pass-throughs, these represent a pool of mortgages with similar levels of risk and cash flow timing. On the other hand, you can think of CMOs as being a group of pools each with their own credit rating. These separate pools are called tranches.
Where do MBS trade?
MBS trade on the secondary market. Typically, you can purchase them from full-service brokers, as well as those that are online. The amount of MBS trading that occurs in the secondary market helps to ensure liquidity for its investors.
What are the benefits of MBS?
There are some visible benefits of investing in MBS as seen through their performance in the market as of late. Consider the following advantages.
High returns for fixed-income class. MBS have provided higher returns in recent years compared to other fixed-income assets. One could invest in MBS and maintain a similar risk profile, while reaping greater returns. This is advantageous compared to seeking other investments providing as high a level of return but then taking on more risk.
Lower risk for its level of returns. In addition to providing higher returns compared to similar assets, its risk profile is still low. Therefore, the relative risk-return tradeoff is not compromised by these investments.
Extremely liquid market. As we briefly mentioned before, the secondary market where MBS trade is very active and has lots of traders. Thus, there is an added sense of liquidity when investing in these assets.
With all advantages come challenges too, which we will discuss next.
What are the challenges of MBS?
The main challenge when dealing with mortgage-backed securities is tied to their sometimes unpredictable timing. Despite being guaranteed by the US government for payments that are on time and in full, there are situations where that doesn’t happen. This could occur at the event of a foreclosure or the homeowner paying down the mortgage before it comes due. In either of the situations, the payment schedule may be pushed ahead from what was outlined originally. In these cases, investors will need to do some additional planning so they can reinvest that money immediately.
This provides an introduction to the world of mortgage-backed securities. This is yet another example that today's market is filled with many opportunities for the savvy investor. Our Rich Dad Education trainers will introduce you to proven strategies that can help you launch your career as a successful real estate investor and develop a "Rich Dad Mindset."
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