Loan Types

What are Mortgage Backed Securities (MBS)?

What are Mortgage Backed Securities (MBS)?
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  • nesto
| Apr 4, 2023
Reviewed, Jun 14, 2023

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    Investing money offers various options, each with its advantages and disadvantages, but smart investors need to explore each different investment avenue and use them effectively, such as mortgage-backed securities (MBS). They are closely linked to the real estate market without the need to own any property. In this article, we will explore the basics of MBS in the US and in Canada and its impact on the Canadian housing market. 

    Key Highlights

    • MBS in the US have a much higher risk level compared to their counterparts in Canada.
    • Investing in Mortgage-Backed Securities in Canada can provide a stable and predictable source of income for investors.
    • MBS also helps support the Canadian housing market and provides affordable home financing options for Canadians.

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    What Is a Mortgage-Backed Security (MBS)?

    A mortgage-backed security (MBS) is a financial instrument that groups together a large number of mortgages and then sell it as a package to investors. 

    In other words, it means that when the banks provide mortgages to their clients, they keep the mortgages on their books or package them together as an MBS. Investors who buy an MBS are essentially buying a share of the cash flows that come from the mortgages in the pool.

    As the homeowners make their monthly mortgage payments, the cash flows are passed through to the investors who own a piece of the MBS.

    The History Of Mortgage-Backed Securities in the United States

    Mortgage-backed securities (MBS) have been around in the US since the 1970s, but they took off in the 1980s as a way for banks to transfer the risk of default on mortgages to investors.

    The government-sponsored entities Fannie Mae and Freddie Mac played a significant role in the growth of the MBS market by buying up large numbers of mortgages and packaging them into securities that could be sold to investors. 

    The MBS market continued to grow in the 1990s and 2000s, fueled in part by subprime mortgages and the securitization of those loans. 

    However, the 2008 financial crisis exposed the risks associated with MBSs, as many homeowners defaulted on their mortgages, causing losses for investors and contributing to a global economic downturn. 

    Since then, regulatory reforms have been put in place to address some of the issues that led to the crisis.

    How Are Mortgage Backed Securities Different for Canada? 

    Although the Mortgage-backed securities (MBS) in Canada are based on US practices, they resulted in becoming quite different from their counterparts in the US mainly due to their structure and their regulations. 

    One big difference is that a government-owned entity, the Canada Mortgage and Housing Corporation (CMHC), issues and guarantees MBS. The CMHC provides mortgage insurance and also facilitates the financing of affordable housing. In the US, MBSs are often issued by private entities, such as Fannie Mae and Freddie Mac, and may or may not be backed by the government.

    Another difference is that the Canadian MBS market is smaller and more centralized than the US market. This is partly because the Canadian banking system is more concentrated, with fewer large banks dominating the market. Additionally, the Canadian government has implemented stricter regulations on mortgage lending and securitization, which may have helped to prevent some of the excesses that led to the US housing market crash in 2008.

    Canada Mortgage Bonds

    Canada Mortgage Bonds are issued by the Canada Housing Trust and are also guaranteed by the CMHC. CMBs are similar to other types of bonds in that they are a way for investors to lend money to the government in exchange for regular (annual/semi-annual) interest payments and the return on their principal investment at the end of the bond’s term. CMB terms vary between 1 year and 10 years. 

    How Do Mortgage-Backed Securities Work?

    MBSs provide a way for financial institutions to transfer the risk of mortgage non-payments to the investors who bought them while freeing up capital to provide new loans to more homeowners. The banks become the middleman between homeowners and investors and don’t carry the risk of losing their money.

    They are complex financial instruments that have a significant impact on the housing market and the economy in general.

    Here Are The Types of Mortgage-Backed Securities

    Mortgage-backed securities (MBSs) come in two main types: pass-throughs and collateralized mortgage obligations (CMOs).

    Pass-throughs work like trusts, where mortgage payments are collected and then passed through to investors. They typically have fixed maturities of five, 15, or 30 years, but the actual life of the pass-through can be shorter if the principal payments on the underlying mortgages are paid off earlier.

    CMOs, on the other hand, consist of multiple pools of securities called tranches, each of which has a different credit rating that determines the return rate for investors.

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    What’s the Impact On Mortgage Rates?

    Mortgage-backed securities (MBSs) not only allow banks to transfer the risk of mortgage defaults to investors, but they also influence mortgage rates by affecting the supply and demand of mortgage funds in the market. 

    The yield on MBSs, which is influenced by various factors such as the credit profile of underlying mortgages, MBS term, and interest rate environment, largely determines mortgage rates. Thus, changes in MBS yield due to such factors can impact the rates that borrowers are charged by lenders.


    What Is a Mortgage-Backed Security (MBS)?

    A mortgage backed security (MBS) is a financial tool used by banks to group together a large number of mortgages that are then sold as a package to investors.
    Mortgage-backed securities (MBSs) involve banks serving as intermediaries between homeowners and investors. Banks originate individual mortgages and sell them as conventional loans. These mortgages are then pooled together with other similar mortgages and packaged as a mortgage-backed security, which is sold by the banks in the bond market.

    How are mortgage backed securities different in Canada? 

    Mortgage-backed securities (MBSs) in Canada are different from those in the United States in a few ways.

    Unlike the US where the majority of MBSs are issued and guaranteed by government-sponsored entities such as Fannie Mae and Freddie Mac, MBSs in Canada are primarily issued and guaranteed by the Canada Mortgage and Housing Corporation (CMHC), a government-owned corporation.

    Canadian MBSs have historically had a lower default rate than those in the US, due in part to stricter underwriting standards and regulations in Canada. As a result, Canadian MBSs have generally been perceived as less risky investments compared to their US counterparts.

    What are the rules for banks?

    Despite being privately owned entities, Fannie Mae, Freddie Mac, and Ginnie Mae establish regulations that banks and lenders are obligated to adhere to. These regulations are designed to ensure that loans purchased by these entities meet specific eligibility criteria for securitization and provide adequate protection for investors. 

    As such, banks and lenders must follow the guidelines set by these institutions to ensure that the loans they sell can be securitized, allowing them to free up capital to continue making new loans.

    Final Thoughts 

    In conclusion, mortgage-backed securities (MBS) have been a significant part of the Canadian financial market for decades, providing investors with a way to invest in the residential mortgage market while allowing banks to free up capital to continue making new loans.

    As we saw, Canadian MBS offers guaranteed payments of the principal and interest due to to their backing from the Canada Mortgage and Housing Corporation (CMHC).

    This has led to a more stable market and reduced risk for investors in Canada. However, investors should still carefully consider the risks associated with MBS before investing their money. We also suggest working with a qualified financial advisor to determine whether they are appropriate for your investment portfolio.

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