Your mortgage loan may become part of an investment strategy after you close on your house. The loan can take on a new life far beyond the original lender through mortgage-backed securities.
Mortgage-backed securities are bundles of home loans packaged as investments. Hundreds or thousands of loans are collected together and sold in shares to investors. Monthly payments from homeowners generate income for those holding the shares.
The most common type are called pass-throughs. Your payment on principal and interest is passed through to the mortgage owner and allocated to investors. Other forms exist with varying structures based on risk, maturities, and interest payments. These are called collateralized mortgage obligations, or CMOs.
Commercial mortgage-backed securities are issued on loans for other real estate types like multifamily housing and business properties.
Lenders sell most loans so they can make more loans. Only a small number, often high-value jumbo loans, remain in a financial institution's portfolio. Loans are sold to middlemen companies that package mortgages into securities. These go-betweens include government-sponsored companies like Freddie Mac, Fannie Mae, or Ginnie Mae. Private issuers such as investment banks can also buy and package mortgages.
When you make mortgage payments, they are passed on to the mortgage owner and distributed to investors.
In the years before the 2008 financial crisis, the mortgage industry made especially risky loans. They knew they wouldn't hold the loans but sell them. Resellers packaged these risky loans extended to borrowers with poor credit histories. The risk was thought minimized because many were bundled together. Middlemen sold the pools as high-quality, low-risk investments.
As the housing market collapsed, millions of homeowners defaulted. The subprime mortgage-backed securities sold as safe investments became worthless. The U.S. government stepped in to save financial institutions and prop up the economy.
Mortgage-backed securities are a major component of the home loan industry's overall liquidity. They play a role in determining mortgage rates. As an element in the bond market, MBS prices react to economic conditions and investor sentiment. They don't directly determine rates but are essential to the interest rate ecosystem.
Investors use MBS in bond portfolios to enhance yield from interest-driven returns. While many investors are financial institutions and the U.S. government, individuals can buy them through mutual funds or exchange-traded funds.
A particular risk of MBS is prepayment. If interest rates fall, homeowners may refinance. MBS investors would see returns fall when alternative fixed-income securities are scarce.