What are Mortgage-Backed Securities?

One way to look at them is like a small business that may be worth many billions of dollars, but it has just one employee, zero investors, and many different outstanding loans and loan officers.

There are zero investors because the people who buy mortgage-backed securities aren’t so much investing in them as much as they are lending them money so that these mortgage-backed securities can further lend money to people who want to buy homes.

There is not a lot of upside to mortgage-backed securities. They are more of just a safe place to park some money for 3% to 5% gains. Nobody is getting these to get rich off them. The mortgage-backed securities don’t act; they just exist.

Market events may make their values fluctuate a little bit, but this isn’t because of anything that the security did. 

Values of the mortgage-backed securities may go up or down based on interest rates, depending on how fast the homeowners pay or don’t repay, refinance, or default on their mortgages.

These mortgage-backed securities are helping people buy houses. These aren’t the investment in the real estate. 

If you have a $300,000 mortgage in one of these securities, and your house doubles in value, that mortgage is still only worth $300,000.

Once these securities are issued and their business starts, they are closed off to any new assets or mortgages. Owners will come and go, but any mortgage that is going to be in that security for the life of it is there on day one.

Why just one employee? Their entire job isn’t to generate new business ideas or to figure out how to grow the firm and it is to sit at their desk all day and wait for payments to come into them and then forward those payments to investors. 

Once that last investor is paid off, the mortgage-backed security closes its door.

There are two important things about mortgage-backed securities that make them more appealing to investors. 

First, they come with the type of insurance that guarantees that the investor will get their money back even if homeowners don’t pay for their mortgages.

This comes from places like Fannie Mae, Freddie Mac, and Ginnie Mae. And second, their security is in numbers. 

So the more loans there are in any one mortgage-backed security, the more likely it is to behave like the average of all loans, making it more predictable for investors. And less likely that it is going to be a uniquely bad investment.

If you have ever applied for a mortgage and been told that you have been qualified for a conforming loan, that means that you met the minimum requirements to be put in the mortgage-backed securities allowing you to benefit from a lower mortgage rate.

The general process for this is; first, you close on your mortgage. Then the lender gives you money to buy your house, and you give the lender the IOU promising to pay off the loan no matter what. And if you don’t, they can take you home.

Next, your lender will sell the IOU to Fannie Mae or Freddie Mac, who will take it, and thousands more like it and throw it into a shiny new mortgage-backed security.

Fannie Mae and Freddie Mac will ensure this mortgage-backed security promising investors that in the event you don’t pay your mortgage payments, they will pay it for you giving investors peace of mind.

Lastly, these mortgage-backed securities are sold to whoever wants to buy them. 

This process is so mechanical at this point that investors are so confident in it that they will buy these mortgage-backed securities in advance even before they are created.