Mortgage-Backed Security, or MBS in English, is a loan investment bond based on home mortgages. The operating model of mortgage-backed bonds can be simply understood as a home buyer borrowing from a bank, the bank collects a certain amount of loans issued by it, and then packages and sells them to third-party institutions, and the bank recovers the principal of the loan. Third parties securitize these loans and sell them to investors. The final process is for the home buyer to slowly repay the loan money to the investor who purchased the mortgage-backed bonds. Investment in mortgage-backed bonds is closely linked to the development of the real estate industry and market interest rates. If real estate development is stable, the benefits of mortgage-backed bond investors will also be stable. When market interest rates begin to fluctuate, it will affect the fluctuations of the real estate industry, which will lead to unstable fluctuations in the benefits of mortgage-backed bond investors. The over-issuance of mortgage-backed bonds is considered one of the main causes of the 2008 financial crisis. Banks raise multiple loans and, when they reach a certain amount, package and sell the loans to third parties, usually government agencies (such as Ginnie Mace), government-guaranteed institutions (such as Fannie Mae), or private institutions (such as investment banks). When a loan is sold, the bank immediately recovers the principal on the loan and can immediately apply that principal into new loan issuances. After third parties buy these loans, they securitize them, that is, convert these loans into mortgage-backed bonds and sell them to individuals and securities institutions. Investment institutions, individual investors, etc. purchase these mortgage-backed bonds, and the third party immediately recovers the loan principal. The home buyer makes regular repayments according to the loan contract, and the repayment amount will be paid to the investment institution or individual investor according to the purchase agreement of the mortgage-backed bond. It can be seen that in the entire process, the bank plays the role of an intermediary, connecting lenders and investors, responsible for transferring the loan contract, and at the same time transferring the loan risk. The final investor earns income from the loan interest paid by the home buyer. Issuers of mortgage-backed bonds are usually relevant U.S. government agencies, such as the National Mortgage Association Ginnie Mae, or institutions trusted by the U.S. federal government, such as the National Mortgage Association Fannie Mae and the Federal Home Loan Mortgage Company Freddie Mac. There are also private issuers, usually called Private Label, including investment banks, financial institutions, and subsidiaries of home builders. Among these three types of issuers, Ginnie Mae is a government agency, so it has the lowest risk value. Although Fannie Mae and Freddie Mac are not guaranteed by the government, they have gained a high degree of trust from the government, and they have promised investors that they will fulfill their obligations and pay the amount. That is to say, if the home buyer cannot repay the loan, Fannie Mae and Freddie Mac will pay the principal and interest due to the investor on behalf of the home buyer. Private institutional issuers have the highest risk value among the three. Once the home buyer cannot perform the loan repayment, the investor will suffer direct losses. Investors receive monthly interest income based on the purchase contract of mortgage-backed bonds. Unlike most ordinary bonds that receive income every six months or annually, the payment frequency of mortgage-backed bonds is once a month, the same as the loan repayment frequency. There are two main types of mortgage-backed bonds currently on sale: Pass-Throughs and COMs: Pass-throughs are a relatively simple type of mortgage-backed bond. Loans are typically collected over 5, 15, or 30 years, and then in the form of a trust, the collected loan payments are distributed to investors proportionally, or based on fixed or adjustable interest rates to determine the income that investors can receive. Because these securities are directly tied to the homebuyer's loan, the length of the investment often falls below the expected maturity date of the investment as the borrower makes payments, especially if the borrower decides to pay off the loan early.
CMO, the full name is Collateralized Mortgage Obligations, which translates as mortgage-backed bonds. It is a mortgage-backed bond composed of several mortgage loan pools. Different mortgage loan pools are called "tranches". Each part has its own rules for calculating principal and interest. Investors need to conduct a lot of research to determine their investment objects before investing. How do commercial and investment banks, as well as MBS investors, make profits? Throughout the entire transaction process of mortgage-backed bonds, different links earn income in different ways. How lender banks make money After the lending bank issues a certain amount of loans, it packages and sells them to third-party institutions. In the process, the lending bank will charge some fees as revenue, such as Appraisal Fee, Origination Fee, Transfer Fee, Title Fee, etc. At the same time, because the lending bank immediately received the principal after selling the loan, it can issue the loan again to earn the same income again. At the same time, before the lending bank packages the loan and sells it to a third-party institution, the bank can still earn income by charging mortgage interest. How third-party organizations make money The profits of third-party institutions mainly come from the premium of MBS. That is to say, after third-party institutions purchase packaged loans from lending banks, they will add a premium to the purchase price and sell them to investors at a higher price. For example: A third-party institution purchased a $100 M loan with an interest rate of 5% (a total of $100 M x 5% = $5 M). The institution split it into 1 M shares, with the principal of each share being $100 ($100 M ÷ 1M = $100). At the same time, the interest per share was $5/year ($5M/year ÷ 1M = $5/year). Theoretically, each share of equity costs $100 and can generate $5 in profit per year. But third-party institutions will not sell at a cost price of $100. They will often sell at a higher price, such as $108/equity. In this way, if the third-party institution sells all the shares of the left and right 1M, it will immediately obtain a profit of $8M ($108 x 1M – $100 x 1M = $8M) How MBS investors make money The main income for investors is loan interest (Mortgage Interest), because, under normal circumstances, the income from MBS will be higher than deposit interest, as well as most treasury bonds, etc. As long as the borrower makes stable loan repayments, investors can earn higher investment returns than ordinary savings and Treasury bills. How did MBS cause the 2008 economic crisis? Mortgage-backed bonds were the main cause of the 2008 economic crisis. The main processes are: From 2000 to 2006, U.S. housing prices continued to rise, resulting in a large number of mortgage-backed bonds being issued. Because as the number of buyers increases, banks can obtain extremely high returns by reselling loans in large quantities. Third-party institutions also obtain high returns by issuing mortgage-backed bonds. Between 2000 and 2006, rising home prices led investors in mortgage-backed bonds to view them as a stable investment with good returns. At this time, the issuance of mortgage-backed bonds and market housing prices showed a mutually reinforcing trend. But in the first step of the process, banks' creditworthiness reviews of lenders decreased as loan volume increased, resulting in the issuance of a large number of subprime mortgages. That is, banks issued loans to lenders with lower credit ratings, leading to an increasing risk of loan repayment defaults. Beginning in 2007, the upward trend in house prices began to stop and began to trend downward. As a result, a large number of borrowers were unable to repay their loans due to the decline in home values. Among them, the largest number were those with subprime mortgages.
Continuous loan defaults led to the collapse of the real estate market and directly led to losses for mortgage-backed bond investors, including a large number of individual investors, pension funds, and financial institutions. So, almost everyone suffered losses. At this time, the institutions that issued mortgage-backed bonds wanted to sell a large number of unissued mortgage-backed bonds, but there was no market. This led to serious losses for a large number of institutions. For example, Lehman Brothers collapsed due to excessive losses during this economic crisis. When the mutually reinforcing trends of mortgage-backed bonds and house prices got out of balance, it triggered massive economic repercussions, so banks later tightened their standards for lenders to avoid a similar situation happening again.