How does mortage-backed securities (MBS) work?

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Ernest Seow

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Dear all,
As stated, can anyone explains to me?
Thank You.
Cheers,
Ernest
 
Ok, let me try, There is an initial mortgage, the issuer of the mortgage then movess the mortgage to an SPV(Special Purpose Vehicle, which is another entity on its own), the SPV then sells the mortgage to investors in tranches. So when the initial beneficiaries of the mortgage scheme makes payments to the issuer, the issuer passes the payments through to the SPV, which in turn pays its investors. These investors bought a security whose interests is dependent upon a mortgage. And in the case of default, they have a claim on the assets of the mortgage. How’s that?
 
Expanding on adekunle’s explanation, a company (the SPV in his write-up, known as the servicer) buys a bunch of mortgages, then sells bonds to investors; these bonds are the mortgage-backed securities (MBSs). The simplest MBS is a passthrough: all of the bonds are identical; each one gets its proportional share of the monthly payments from the mortgages. Those payments come into the servicer, the servicer skims off their fee, then passes the payments through to the bondholders. So, every month the bondholders get some principle and some interest.
More complicated mortgage-backed securities sell various kinds of bonds and chop up the incoming mortgage payments in various ways amongst those bonds; these are known as collateralized mortgage obligations (CMOs). Conceptually, probably the easiest way to chop up the mortgage payments is into principle payments and interest payments; such a scheme gives rise to principle-only (PO) tranches and interest-only (IO) tranches. (A tranche is just a slice of the incoming mortgage payments.) Another way to chop up the mortgage payments is chronologically: one set of bonds is paid off, then another, then another, in sequence; these are called sequential tranches. There are substantially more complicated ways to chop up the mortgage payments, some of which will be covered in Level II Fixed Income.
 
Thanks both for the explanation. I’m beginning to understand but I’m still quite confused..
Must the issuer of mortgage necessarily be a banking entity?.
Let’s consider a hypothetical example:
A newly-wed couple takes a mortgage from a local bank to finance their new house purchase. From the bank’s perspective, money is being provided to the couple and in return; the bank will receive periodic payments (consisting of partial principals and interest). - am I right so far?
Next, Company A purchase the above mortgage from the bank. Company A then issue bonds backed by this mortgage- Is this how MBS are being created? If so then there will be a few layers from the couple all the way to the MBS investors.
The periodic payments (from the couple) now still go through the bank then to Company A then finally to the holder of the MBS?- am I right for this?
Thanks again guys!
 
I don’t know if it has to be a bank. The couple is just one of the many people who took the mortgage, there would be a pool of the payments from the people who took the mortgage. It is from this pool that interest and repayment to the investors in the MBS are made. The MBS is issued in tranches, like ranking, the higher tranches are less risky, the lower the tranches, the more risky, hence higher return.
I didn’t overcomplicate it did I?
 
It is a kind of securitized bond . In MBS a pool of mortgages is made and securities are issued from this pool . These are called MBS secirities . The interest and principal which is gathered from pool of mortgages are used to pay the principal and intetest to the MBS securities .MBS securities have various tranches lower tranche and higher tranches.
 
Thanks adekunle and edupristine.
Can I bring your attention to my hypothetical example above- are my ways of looking at MBS correct? I recalled from my earlier reading for Equity Investments talking about securitization; am I right to say MBS is just one of the example of securitization?
Thanks again!
 
Sounds like you’ve got the right idea. The key is that the servicer receives the payments though, in most cases, the servicer will be the bank that originated the mortgage (not always though). And for mortgage backed securities, ‘Company A’ is generally Fannie Mae or Freddie Mac in which Fannie or Freddie is the issuer of the securities.
Other MBS are known as Ginnie Mae securities. Ginnie, however, is not the actual issuer, they just provide the guarantee of the principal payments will the full faith and credit of the US Government. Most new MBS these days are either Fannie, Freddie or Ginnie, very few ‘private label issuances’ are taking place at this time.
 
Ernest Seow wrote:Thanks both for the explanation. I’m beginning to understand but I’m still quite confused.
Must the issuer of mortgage necessarily be a banking entity?
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No. For example, in the US two government corporations – FNMA and FHLMC – buy mortgages and issue mortgage-backed securities.
Ernest Seow wrote:Let’s consider a hypothetical example:
A newly-wed couple takes a mortgage from a local bank to finance their new house purchase. From the bank’s perspective, money is being provided to the couple and in return; the bank will receive periodic payments (consisting of partial principals and interest). - am I right so far?
Click to expand...
So far, so good.
Ernest Seow wrote:Next, Company A purchase the above mortgage from the bank. Company A then issue bonds backed by this mortgage- Is this how MBS are being created?
Click to expand...
Yes.
Ernest Seow wrote:If so then there will be a few layers from the couple all the way to the MBS investors.
Click to expand...
Not necessarily: once the bank sells the mortgage, they’re often out of the loop.
This is the reason for all of the furor about sub-prime mortgages: banks were making loans to unqualified borrowers, knowing that they would be selling the loans and avoiding all of the default risk.
Ernest Seow wrote:The periodic payments (from the couple) now still go through the bank then to Company A then finally to the holder of the MBS?- am I right for this?
Click to expand...
Nope: the couple pays Company A, which pays the bondholders.
Ernest Seow wrote:Thanks again guys!
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My pleasure.
 
S2000magician wrote:
Ernest Seow wrote:Let’s consider a hypothetical example:
A newly-wed couple takes a mortgage from a local bank to finance their new house purchase. From the bank’s perspective, money is being provided to the couple and in return; the bank will receive periodic payments (consisting of partial principals and interest). - am I right so far?
Click to expand...
So far, so good.
Click to expand...
S2000magician,
I have a question — let’s say a bank has securitized a mortgage. Isn’t the bank going to lose the cash flow from mortgage because it will be passed through to the investor? $ wise, what’s the advantage to the bank? Can you please explain this ? I understand that a part of the mortgage cash flow will be kept by the bank, and the rest will be passed. However, wouldn’t the bank profit more by keeping all the cash flow — just as a loan lending bank does, as opposed to a securitizer? I believe my question is that from purely $ perspective, what’s the difference between a securitizer and a bank that just loans money and keeps the cash flow?
Thanks in advance.
 
allalongthewatchtower wrote:
S2000magician wrote:
Ernest Seow wrote:Let’s consider a hypothetical example:
A newly-wed couple takes a mortgage from a local bank to finance their new house purchase. From the bank’s perspective, money is being provided to the couple and in return; the bank will receive periodic payments (consisting of partial principals and interest). - am I right so far?
Click to expand...
So far, so good.
Click to expand...
S2000magician,
I have a question — let’s say a bank has securitized a mortgage. Isn’t the bank going to lose the cash flow from mortgage because it will be passed through to the investor? $ wise, what’s the advantage to the bank? Can you please explain this ? I understand that a part of the mortgage cash flow will be kept by the bank, and the rest will be passed. However, wouldn’t the bank profit more by keeping all the cash flow — just as a loan lending bank does, as opposed to a securitizer? I believe my question is that from purely $ perspective, what’s the difference between a securitizer and a bank that just loans money and keeps the cash flow?
Thanks in advance.
Click to expand...
The bank sells the loans and gets cash immediately, which they can then lend to another homeowner. The advantage is that they have eliminated all of the cash flow risk.
 
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