Many industry professionals and the majority of consumers are not familiar with Mortgage-Backed Securities (MBS), and do not know the role they play in mortgage liquidity and mortgage rate movements. Understanding this relationship will help you have a much clearer picture of the mortgage pricing process.
What is MBS?
A Mortgage-Backed Security is what groups of similar loans are turn into to be sold, bought, or traded in the securities market.
What is Securitization?
Securitization is the process of turning loans into securities. Securitization, though not without its risks, is largely beneficial for all parties involved, and is currently essential to maintaining availability of mortgage credit (ability of consumers to get a loan if they want one). Securitization also helps to maintain rates lower than they otherwise could be on average. The two basic building blocks of a mortgage-backed security are the CONSUMER who wants to borrow money (a mortgage, in this case), and an INVESTOR that wants to lend money in order to earn a return on investment. MBS cannot and will not exist without consumers who want to borrow and investors that want to lend.
How do MBS benefit the investor?
Investors main interest is to lend, they also want to be protected from risk. If an investor with $200k only made one loan to one consumer, and that consumer defaulted, that investor would shoulder the burden of the entire loss. Even if that investor has $1million, and makes 5 loans for $200k, depending on the rate of default, the investor could easily experience a very different rate of return than another investor with the same amount of money investing in the same kinds of loans. Lenders attempt to mitigate risk by applying underwriting standards, but securitizing loans as MBS further reduces risks for investors.
How does MBS reduce risk.
Securitization allows the risk to be “spread out” among similar loans. Here is an example of risk scenario for an investor:
Consider, the hypothetical investor has a 1 in 20 chance of losing $50k for every $200k they lend.
If 20 investors individually made each one of these loans, 19 of these would be profitable and one of them would be out of business. Even if you had just 2 Investors, Investor A and Investor B, and they could afford to make 20 loans each, and the default rate stays the same, 1 in 20 loans, Investor A could be holding both of the loans that default while Investor B holds none. Investors, no matter the quantity, STILL need a way to share risk equally in order to guaranty profitability. Securitization through MBS accomplishes this goal of risk-sharing.
Securitizing offers a trade-off between a small chance of big losses and a near certainty of small, predictable losses. For an investor, by taking the certainty and reliability of predicting the risk, they can easily adjust the price to account for that risk.
In the above example of 20 investors each making 1 loan of $200k, if they “pool” those 20 loans together, and if the default rate holds true (1 in 20), then they’ll have only one $50k loss divided among them ($50k / 20 investors = $2500 loss each). By doing this, the investor has traded the 5% chance of a $25% loss for a 100% chance of 1.25% loss ($200k x 1.25% = $2500), and knowing that the 1.25% chance of loss is coming makes it easier for the investor to adjust the price on the loan so that the lender stays profitable and in business.
Securitization through MBS is helpful to investors and consumers alike for several reasons. The greater the certainty with which lenders can predict losses, the smaller the margins can be that protect against losses. This translates directly into lower rates for consumers.
Through securitization, investors can participate buy a piece of a mortgage portfolio without financing every mortgage in it. This is like buying stock in a company rather than the company itself, it also provides a way for far greater participation in the mortgage market among investors. This participation provides a more liquid mortgage market, with more options for consumers to find a loan at affordable rates, while protecting the investors by thwarting risk.
As with everything, there are downsides to this model as well. Some might argue that the level of detachment between investors and these loans they are investing in was one of the reasons for the crisis. Indeed, it would be hard to argue otherwise. As a matter of fact, the failure of many credit rating agencies, like Moody's, Standard & Poor's and Fitch Ratings, to adhere to the credit rating standards was one of the main contributor to the run-up to the 2008 financial crisis. Nevertheless, the benefits of securitization (much more liquidity in mortgage markets, more loans for more people, lower rates, and less risk for investors) will likely be seen as outweighing the costs for the foreseeable future.