We’ve all heard those words, especially in the past years with the crash of the housing market, Mortgage Backed Securities (MBSs) but how many of us know what Mortgage Backed Securities are. A simple definition, from Wikipedia, MBSs are an asset-backed or debt obligation that represents a claim on the cash flows from mortgage loans, commonly on residential property. Another way of defining MBSs is the bundling of like mortgages, similar interest rates and terms, into a pool of hundreds of mortgages, then formed into a tradable bond backed by the individual mortgages.

Mortgages were generally held as whole individual loan by the initial lender and serviced by a contracted service company, the people who collected the payment. In 1970 MBSs were created to increase capital flows into the mortgage market. The creation of MBSs allowed mortgage originators to replenish their funds, which can then be used for additional origination. This help increase lending and helped in making rates more competitive with in the housing market. It also opened the mortgage markets to investors such as pension funds and life insurance companies, investors with a longer term investment horizon. Most MBSs also carry guaranties from the originator.

MBSs are often called pass-through bonds, this means the payments of principle and interest on all of the pooled mortgages are passed through from the servicer, or collector, of the bond directly to the investor(s) after the servicer subtracts the servicing fee. Since mortgages are broken down and sold into these securities a mortgage may have several investors invested into this mortgage. This leads to the modification problems we are seeing now. All the investors in this loan must agree to the new modified loan amount or interest rate, in some cases both. For a quick example you go to your bank and apply for a home loan. You are approved, you close on it and you make your check payable to that bank each month for your payment. However, what you don’t see is that bank bundled that loan with other loans similar to yours and sold them to investors. The bank you walked into and applied for the loan is now the servicer, collector, for those investors who now own the loan or more accurately these MBSs. Now lets say you can’t continue to make your payments at the current amount and you talk to this bank about a modification, it’s not up to them to agree upon the modifications it’s up to the investors. You can call the bank the middle man.

A few other important points about MBSs. First, tracking MBS markets is critical to mortgage originators because the prices of MBSs are the price changes that are reflected in daily pricing. Second, moment by moment prices of MBSs is the only way to keep completely informed on how pricing changes will occur at the origination level. Keep in mind mortgage markets generally take their lead from how the treasury markets move.

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