In recent years, a process known as “securitization” has become increasingly popular. In this process, cash flows from various types of loans (e.g., mortgages, credit cards, car loans, etc.) are bundled (or pooled) together and sold to investors as securities. Of the many variations of securitized debt, asset-backed securities and mortgage-backed securities are the most common examples.
A mortgage-backed security (“MBS”) is a security debt obligation that represents a claim on the monthly payments from mortgage loans. Mortgage lenders (banks, mortgage companies, and other originators) sell individual mortgages to governmental, quasi-governmental, or private entities that bundle mortgages into a security. Most MBSs are issued by the Ginnie Mae, a U.S. government agency, or Fannie Mae and Freddie Mac, U.S. government-sponsored enterprises.
MBSs come in a variety of structures. The most basic type is a pass-through, which entitles the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. Pass-throughs include residential mortgage-backed securities and commercial mortgage-backed securities. A residential mortgage-backed security is backed by mortgages on residential property. A commercial mortgage-backed security is backed by mortgages on commercial property (apartment buildings, retail or office properties, hotels, industrial properties, etc.).
As with other bonds, MBSs may be sensitive to interest rate fluctuations and can lose value when interest rates rise. And, as was seen in the aftermath of the 2007 mortgage meltdown and subsequent financial crisis, while most MBSs carry a private guarantee or insurance, there is no guarantee that the guarantor or insurer will meet their obligations.
Asset-backed securities are security debt obligations created from car payments, credit card payments, student loans, or other loans that are backed by those underlying assets. As with MBSs, loans are bundled together and packaged as a security that is then sold to investors. Typically, a bundle of loans is divided into separate securities with different levels of risk and returns known as “tranches.” Payments on the loans are distributed first to the holders of the lower risk, lower interest securities and then to the holders of the higher risk, higher interest securities.