Business, Legal & Accounting Glossary
A mortgage-backed security (MBS) is an investment, which is secured by a single or a collection of mortgages. The owner earns undivided interest on this set of mortgages or a single mortgage as the case may be. Earnings from these mortgages are used to pay the interest and principal amount to investors. Income thus generated is termed ‘mortgage pass-through’.
When investing in MBS, an investor is essentially lending money to a business or real estate buyer. Regional banks often use MBS as instruments for lending mortgages to customers without worrying about the customers’ assets. The bank essentially does the job of a middleman between investment markets and builders.
Mortgage-based securities are also used to siphon off the principal sum and interest amounts to shareholders from these mortgages. Based on their risks, these mortgages with their respective earnings can have further classifications.
Investors earn interest and principal sum from their MBS, while the service provider, in most case the originator, earns service fees payable from the interest earned. Service fee is calculated as a fixed percentage of the outstanding principal sum and paid monthly. For instance, if a mortgage pool gives an earning of 8.5% and the servicing charge is 0.25%, then the effective yield works out to 8.25%. Thus the actual rate of return varies with the servicing fees.
The originator may sell off his servicing rights of the mortgages managed by him, to a third party.
The practice of pre-payments though common in mortgage pass-through involves uncertainty because of fluctuating mortgage rates.
A Collateralized Mortgage Obligation (CMO) is a variant of mortgage-based security, which involves creating distinct pools of pass-through rates for its bond-holders, dependent on the maturity period and value. These distinctive pools are termed ‘tranches’. Collateralized mortgage obligation offers lower yields, as they are usually backed by government securities and hence stand at a lower risk.
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This glossary post was last updated: 22nd November, 2021 | 0 Views.