What are Mortgage Backed Securities and How do They Work?

If you’ve lived through the 2008 and 2009 financial crisis or if you’ve been paying attention to the news recently, you likely have heard the term “mortgage-backed security.” You likely know that it is loosely related to mortgages, but also, isn’t directly a mortgage. The rest, tends to get a little bit complicated in financial jargon. Mortgage-backed securities, or MBS, and the market that surrounds them are a major underpinning to the US economy, so it’s important to understand them if you want to understand greater economic actions. Let’s explain this market simply, in common terms so everyone can understand.

Ever since mortgage-backed securities were invented in 1981, they have become a larger and larger asset class around the world. Explained simply, MBS are simply shares of mortgages that give you returns based on the payments people make to those mortgages. These securities are basically a bunch of mortgages, say 1000, lumped together into a shell company. Investors can buy stock in this company and make returns on their investment based on how well people who have the mortgages, the homebuyers, make their payments and otherwise honor their loan.

Here’s how that technically works:

You, the loan-seeker, go to your neighborhood bank wanting a mortgage for 100,000 over 30 years at a 5% interest rate. You have a good job and a great credit score. The neighborhood bank takes all of the financial metrics about you, how much you make, your credit score, how much you’re putting down on the house, etc. and cross-references them to guidelines set out by larger investment banks, like Fannie Mae and Freddie Mac. If you meet the guidelines laid out here, you are approved for the loan and it’s considered a “conforming loan”. In otherwords, your loan conforms to the guidelines.

There are ways to get non-conforming loans, but you’ll end up taking on a higher interest rate or having to put more down so investors know your mortgage is a safer bet. We’ll glance over this subject for now for simplicity’s sake.

Once your neighborhood bank approves you for the loan, you can buy a house! Your neighborhood bank gives the seller the 100K and you are in-debted to them for 30 years at a 5% interest rate. Once the transaction is done, however, something interesting happens. Your neighborhood bank doesn’t want to wait 30 years to get their 100K back. After all, they may not have a ton of money to invest in things and they want more to invest in other better investments. Because of this, the neighborhood bank will look to sell the loan to a larger bank. Larger investment banks will do this because your loan represents a safe investment and a good value. So, Bank 2, the larger bank will pay the neighborhood bank the 100K for the loan, and now you, the borrower, will start paying your loan to bank 2.

But why would the neighborhood bank want to do this? How would they make money? Fees. Mortgages will have closing fees attached to them. These fees are how neighborhood banks make money. The originating bank never has any intention of holding the loan and getting your payments. In fact, this is why MBS were invented. The neighborhood bank can supply endless mortgages with their small amount of cash and never have to worry about taking in more deposits. It gives them an avenue to stay profitable.

So now the neighborhood bank made its money, let’s move on to how the larger investment bank makes its money.

Bank 2 didn’t just buy your loan, it bought 999 other loans, let’s say all for the same price, and they all have the same interest rate and term. This is oversimplified, but it will make understanding it simpler.

So now, Bank 2 has 1000 loans for 100K that will give them 5% interest every year. In otherwords, they have 100 Million dollars of loans that will pay back 5% in interest each year, or 5 million dollars in interest. But that investment bank doesn’t want their money tied up in all of this, so they do something interesting. They create a corporation, say Big Mortgage Corp. and then they give that company the 1000 loans. That company is now pretty profitable. It’s worth 100 million dollars and will earn 5 million each year! Who wouldn’t want to invest in that company!? Well, that’s exactly what the big bank is thinking. The Investment bank, bank 2, will start selling shares of Big Mortgage Corp, these shares, are mortgage-backed securities.

So, how does bank number 2 make money? Through the selling of these shares. Let’s break down the math.

The bank creates 1 million shares Big Mortgage Corp. to sell to investors, like hedge funds, other banks, IRAs, etc. Each one of those shares is entitled to one 1 millionth of the companies profits. Over the life of the loans, they will pay back their initial loan amount, so each 100K mortgage. Times, 1000, they pay back the 100 million principle Bank number 2 paid. Then, they will also pay 5% interest every year they have the loan, so the 5 million dollars per year.

So, in theory, each investor in one of the shares of Big Mortgage Corp. will get back $100 from the principle ($100M/1M shares) and also get 5% interest per year, or $5, ($5M interest per year/1M shares). The bank then decides to sell each share for $105. Investors would be interested because over the life of the ownership of this share, they’d get back $100 + 30 years of $5 per year, or $150, totalling $250 in value for paying just $105 initially. If Bank 2 sells all 1 million shares, they would make 1 million times $105 per share, or 105 Million dollars! Since they just bought the shares from the neighborhood bank for 100M, they just made a cool 5 million dollars just by giving a company they created the mortgages and selling shares in that company. Not only that, but they got back their initial $100 million and they can just do this all over again.

So, now the neighborhood bank has made money on fees, the Investment bank has made money by selling mortgage-backed securities, or shares in Big Mortgage Corp., and the Investors will make money over time through interest paid out by Big Mortgage Corp.

This is all great, everyone makes money and homebuyers are able to buy houses and access debt easily. This is what mortgage-backed securities are. Shares in companies that hold 1000 mortgages. In actuality though, some of these mortgages will default( people won’t be able to pay) and some people will sell their home and pay off the mortgage. When this happens, the return on MBS goes down, but investors in MBS account for this through complicated models to determine the actual interest rates they will make from their investment. Generally, they assume 20% of the loans will not be held to term.

Here’s how 2008 happened though, oversimplified. Investment banks were running out of conforming mortgages to limp into these companies. Since they still wanted to turn a profit, they decided they needed to loosen their guidelines for what makes a “good mortgage.” They did. Nearly anyone could get a loan just by saying they made any amount of money. It didn’t matter, banks wanted more loans to sell.

These loans were terrible though. Why would anyone want to invest in a walmart cashiers 1 million dollar home loan? Surely that will default! The big banks knew that, but they also knew that there was safety in numbers. The original MBS are safe because even if 20% of people default on their loans, investors still get good return. Not everyone will default. The investment banks thought, or at least publically said, that if they group a bunch of these terrible new loans together, there’s still safety in numbers! While each loan on their own might be terrible and a risky investment, if you lump them all together, surely not everyone will default and you can earn crazy high interest rates. Since the loans were risky to begin with, banks could charge insane rates to make them more attractive. Lump all these loans together into MBS with high return, and investors would want to eat them up!

You’re probably thinking, well if that’s true why would investors want to buy those MBS? Couldn’t they just look at the loans disclosed in “Big Mortgage Corp’s” balance sheet and see they were terrible? Long story short, no one was doing that because agencies responsible for rating these MBS, how good or bad they were, were rating them all as AAA, meaning the highest of value. Investors took them at their word and bought up all the shares.

The problem was, the investment banks were in the pocket of these ratings agencies. They needed the agencies to rate their MBS well so they could sell them, and the agencies needed the banks to pay them so they could make money. The banks refused to pay them if they didn’t rate their MBS AAA, knowing full well that the loans that made up these AAA rated MBS were all terrible.

Long story short, Investors bought these MBS, insane numbers of borrowers defaulted, the investments became worthless, and the investors lost their money.

All that said, there’s a few other complexities and pieces of the puzzle here too. Let’s take a look at Collateralized Debt Obligations, or CDOs, and also take a look at something called a Credit Default Swap.

CDOs are types of mortgage-backed securities. In the example we posed before, MBS are simple shares of a company where every share gets the same amount back. CDOs are still shares of that company, but they have different levels of how much you get back, called tranches. Let’s say the Investment bank wanted to split Big Mortgage Corp into 3 tranches: Equity, Mezzanine, and Senior. These are the actual names used in the industry. Each tranche, or level, holds a handpicked number of shares from Big Mortgage Corp.

Equity is the lowest level, highest risk but highest return. They hold the shares of the riskiest mortgages. If borrowers default, holders of equity level CDOs are the first to feel the pain. However, if borrowers do end up paying up, the Equity tranche gets back the most money. For example, rather than 5%, let’s say they get back 7.5% on their investment. If you want to take the risk, it could pay off!

The next level is Mezzanine. These are the middle of the road CDOs. Moderate risk and moderate risk of default. Let’s say they get back 5% of their investment.

The safest level is the Senior Tranche. They hold very little risk but get lower return. If a ton of borrowers default, Big Mortgage Corp is going to underpay Equity and Mezzanine tranches to make sure the Senior tranche get’s their money. However, the Senior Tranche let’s say only earns a 3.13% interest rate.

CDOs are just MBS that have different levels of risk and different rates of return.

Now, let’s take a look at the math. For the original 100M in loans, we sold $40 Million in the senior CDO, $30 Million in the Mezzanine, and another $30 million in the Equity tranche. For simplicity here, we’re going to ignore the need for the Investment bank to make a profit on selling the stocks.

For example, We sold 400,000 shares of senior for $100 each, each paying out a 3.13% interest rate each year, or $3.13. We sold 300,000 of Mezzanine for $100 each, each paying out 5% interest each year, or $5. And finally, we sold 300,000 of Equity, for $100, each returning 7.5% each year, or $7.50.

The loans as a whole only return $5 million in interest each year assuming no one defaults. So, if it goes perfectly, the senior tranche gets $1.25 Million to split ($3.13 per share), the Mezzanine gets $1.5 Million to split ($5 per share), and Equity gets $2.25 Million to split ($7.50 per share).

However, let’s say 20% of people default and from now on Big Mortgage Corp can only bring in 80% of the original $5 million in interest per year, or $4 million per year.

In this case, Senior still get’s $1.25 million, Mezzanine still gets $1.5 Million, but Equity, well they’re the losers here. Equity shares only get back $1.25 Million to split, or $4.16 per share. They just saw their return go from 7.5% to 4.16% for the rest of the life of the share. All of the sudden their share is worth less than the Mezzanine share. Like I said, high risk, but if the economy is good and borrowers pay their mortgages, then Equity can yield high rates of return.

In 2008, let’s say something like 80% of all the mortgages in Big Mortgage Corp defaulted because all the loans inside were terrible. That means now there will only be 20% of the original $5 million in payments, or 1 million per year. Senior would get the full $1 million in payments, meaning only $2.50 per share. In this case, even the safest tranche, Senior, had their respective return cut from 3.13% to 2.5% for the foreseeable future. For the other tranches? Well, their shares basically just dropped to nothing.

That gives you a basic understanding of CDOs. They’re just a way of assigning levels of risk to MBS.

Now, onto the big kicker, Credit Default Swaps. Credit Default Swaps are essentially insurance on a security. Equity tranche buyers might buy these assets in case their shares become worthless they would be able to get some money back so their losses aren’t as bad, if anything. In essence, this “insurance” shorts the market, or only pays out if the MBS market fails. It’s used to protect MBS buyers from high risk.

The payout would increase based on the tranche level, but it would also cost more up front. For example, Equity tranches are high risk, which would make the credit default swap for this level pretty expensive, and the swap itself would only pay out a little. Basically just enough to cover losses or lessen the blow. If we go to the senior tranche, credit default swaps would be cheap. Since CDS are just bets that the market will fail, or the underlying security will lose value, that’s pretty unlikely for the Senior tranche, so they don’t have to be expensive. That said, it also means they have a very high rate of return, or payout if this does happen. After all, why would investors buy the CDS if they didn’t pay out a ton, since they were unlikely to pay out. Basically, CDS are just insurance on a stock just like insurance on a car.

In 2008 though, this market got interesting. You don’t have to own the underlying security to purchase a credit default swap on it. Banks in 2008 were willing to sell CDS on Senior tranche CDOs since it was assumed there was a crazy tiny chance that these CDOs would payout. To the banks, it was basically free money. Selling something that would never cost them anything, or so they thought. No one in theory would want to buy that though, either. Senior tranches don’t lose money, so buying a CDS for these assets would be like throwing away money. OR, in otherwords, it would be shorting the entire mortgage market. Buying CDS for senior tranches of CDOs is like betting the entire mortgage market is going to default and collapse.

In 2008, a few people dug into the MBS market, saw that credit agencies were misvaluing the assets, saw that even senior tranches were crap, and bought a ton of Credit default swaps. This is like realizing your neighbor is a terrible driver and buying insurance on his car so that when he crashes you get paid. Banks were happy to oblidge because they themselves didn’t know how bad the CDO securities were.

When the market did collapse, these people who shorted the market by buying CDS got a massive payday, like 500%. So if they bought the CDS for 100, they’d instantly get back 500 when the market collapsed. If you want to see this in action, watch the movie The Big Short.

And there you have it. There are some of the key variables in the mortgage market, some of the basic functions, and a little description on the 2008 mortgage market collapse. The actual functions of these markets have thousands of other variables that play into them. For the most part, it’s all technical jargon, and hopefully we were able to weed through some of that in this article.

Trevor is a civil engineer (B.S.) by trade and an accomplished writer with a passion for inspiring everyone with new and exciting technologies. He is also a published children’s book author and the producer for the YouTube channel Concerning Reality.

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