MBS (Mortgage-backed security) are types of asset-backed securities that are formed by combining mortgage loans.
The bank has mortgage obligations of its clients with similar characteristics on its balance sheet. The bank combines these mortgage loans into one pool and sells it to specialized mortgage funds, or the bank issues MBS as an issuer, but only with the participation of a guarantor with a high credit rating.
For example, a specialized mortgage fund in the United States can be a government-sponsored agency (GSE), such as Fannie Mae or Freddie Mac or State National Mortgage Association Ginnie Mae. The difference between them is that Ginnie Mae provides guarantees from the US government and it is rated as risk-free in terms of credit risk, while Fannie Mae or Freddie Mac provide their own MBS guarantees.
Further, MBS are issued on the basis of this pool, where the amount of issue is the sum of all mortgage loans, and the cash flow is the payments on them. Because Mortgage loan payments are received by the bank on a monthly basis and not always evenly (with a differentiated flow of payments or early repayment), therefore, MBS have some differences comparing with traditional debt instruments:
- Coupon payments are usually paid once a month, less often once a quarter
- The balance of the principal debt at par is paid together with coupon payments, and not paid in full on the maturity date.
- The amount and number of coupon payments may change during the MBS circulation period
The advantages of issuing MBS for banks are that when they are issued, the pool of mortgage loans "leaves" the issuer’s balance sheet, while the bank receives additional liquidity for issuing new loans and earns on commissions when paying payments under MBS like government agencies or guarantors.
An investor who buys MBS receives a higher coupon rate when a guarantee of fulfillment of obligations is secured by the state or by guarantors with a high credit rating. And since the payment of the principal debt occurs every coupon period this gives the investor the opportunity to reinvest these funds.
Examples of MBS issues: