Understanding Mortgage Backed Securities: Theoretical Possibilities and Realities

Mortgage-backed securities (MBS) represent a unique investment opportunity that comes with its own complexities and considerations. This article aims to clarify the process behind MBS, specifically focusing on a theoretical scenario where a property owner buys 100 mortgages backed by their own home. We will explore the intricacies involved, including how funds are used and managed, and whether such an investment strategy is feasible and worthwhile.

The Process Behind Mortgage Backed Securities

Mortgage-backed securities are financial instruments that pool together multiple mortgages into a single entity. These securities are issued by financial institutions or government agencies to investors, who receive payments based on the performance of the underlying mortgages. Unlike a single mortgage, MBS are diverse packages that may contain dozens, if not hundreds, of individual mortgages with a total value of millions of dollars.

When a mortgage is issued, a portion of the funds is typically set aside in an escrow account to cover property taxes and insurance. This ensures that these expenses are consistently paid, without disrupting the regular mortgage payments. The remaining funds are then deposited into an account held by the investor, which is often the borrower in this scenario.

Theoretical Scenario: Buying 100 Mortgages Backed by Your Home

Let's consider a scenario where you are still paying off a mortgage on your home, but you are interested in buying 100 shares of a mortgage-backed security that includes your own mortgage. This situation presents several interesting and complex elements that need to be understood.

Funds Distribution and Management

In the pool of MBS, some funds are designated for property taxes and insurance. These costs are managed through a process similar to property tax escrow accounts. The processor, who acts as the intermediary, distributes the funds according to the terms of the agreements. This ensures that all necessary payments are made to maintain the property and secure the investment.

Additionally, there are fees associated with managing the mortgages and the overall MBS. These fees are deducted from the total funds before they are distributed to the investors, including you, as a security holder.

The remainder of the funds is deposited into the account of the investor, which, in this example, is you. This arrangement allows you to receive returns based on the performance of the underlying mortgages in the MBS.

Discrepancies Between Individual Mortgage Payments and Security Investments

It's important to note that owning a portion of a mortgage-backed security does not necessarily correlate with the state of your individual mortgage. Even if you have already secured and paid off your mortgage, MBS can still be sold and purchased. The pricing of these securities is determined by the creditworthiness of the underlying mortgages and the risk associated with these investments.

In the theoretical scenario where you have a $100,000 house with an $80,000 mortgage at an interest rate of 3%, the concept of buying 100 shares of an MBS might appear intriguing. However, the reality of such an investment is quite different.

First, the yield on MBS is typically lower than the interest rate on your mortgage. For example, an MBS yield might be around 2–5%, whereas your mortgage interest rate is 3%. Additionally, you would still be paying the mortgage on your home, effectively borrowing money at 3% interest to invest in an asset that yields a lower return. On top of this, there are fees and commissions involved in purchasing the MBS, leading to an immediate loss.

The effective yield, after accounting for these additional expenses and taxes, might further decrease. In this case, a 100K house at 3% interest would yield a net loss of approximately 1.75%.

Conclusion: Feasibility and Investment Strategy

While the idea of buying a portion of a mortgage-backed security that includes your own home might seem appealing, it is a complex investment with many drawbacks. Unless you have a very specific financial goal or need, such as diversifying your assets during a difficult economic period, the returns on MBS are often not enough to justify the investment.

It's crucial to weigh the potential risks and returns carefully. If you opt to purchase MBS shares, ensure that you understand the terms, fees, and overall performance of the underlying mortgages. Consulting with a financial advisor can provide valuable insights and help you make informed decisions.