Finance / Investments · February 3, 2022

How Do Mortgage Backed Securities Make Money

Introduction to Mortgage Backed Securities

Mortgage Backed Securities (MBS) are bonds issued by banks and financial institutions to individual investors as a means of liquidating assets that have been frozen with them in the form of loans.

When you want to buy a house, you go to a bank and ask for a loan. The bank now has the option of either collecting principle and interest payments from you directly or sell the mortgage as bond to other entity.

Understanding with an example

Imagine Shami wants to buy a new house. She approaches a bank to ask for a home loan. Looking at her credit worthy, she gets the money to buy her desired house. On the other hand, the bank keeps the possession of her house.

This means that bank owns the asset until she repays the entire loan amount plus interest.

There will be many other such people who could be approaching the bank to grant a loan. In this way bank provides the necessary loans and owns all the asset under their umbrella.

In due course of time, the bank will start gaining a lot of such assets which will be idle and of not any value to the bank.

Thus, in order to liquidify these idle assets, the bank issues a bond to the investor. This bond is called Mortgage Backed Security. The value of these bonds are dependent on those assets that are owned by bank.

How do the investor make money

Interest earned from borrowers

Since the investors have bought the Mortgage Back Securities, it can simply imply that those investors now own a portion of assets. Thus, the interest that will be payable by the borrowers will now be in the hand of the investors who own the bond.

Hence, what may be the interest, the same gains are accumulated by the individual investors in due course of time. This implies that investors have provided the money to the home buyers, while the bank just acts like a mediator.

These securities are similar to debt investment products where the interest rate is fixed for the specified period.

Indirectly lending money to the home buyers

Mortgage Backed Securities can be an alternative to investor who are interested to provide money to people to buy houses, in a return to earn from the interest.

Since there is a high tendency of risk involved for an investor to directly provide money to the buyers, one may simply purchase Mortgage Backed Securities.

Also, in order for a person to buy a house, the investor will have to put up a significant amount of money as a loan.

The Mortgage Backed Securities are bonds that are sold in tradable Units. Thus, lowering the investor’s total investment and thereby lowering the risk.

How does it help the bank make money

Lending money for higher interest rates

As you know, real estate home loans fetch an interest rate of roughly 6 to 8% and they go for a long duration of 20 to 30 years. Thus, earning such low interest for a long duration may not be feasible to the bank.

Additionally, the bank may require capital in order to lend money to loans with higher interest rates. Thus, shifting the money from idle assets to using them to seize opportunities.

Using the money in alternative investments

Banks can use this money in alternative investments of their choice or use the money in the growth and expansion of their business.

There are ample number of opportunities for investments in today’s world for banks to invest and create a higher rate of return than as home loans.

Charging additional fees from the investors

Since banks are providing an investment alternative to the retail and other investors, it will charge a brokerage fees for processing and settlement of these bonds.

This brokerage gain will again be other source of income to the banks.

Making a win-win situation

The banks are able to liquidify the idle assets and find better investment alternatives. On the other hand, investors find an alternative source to invest debt instruments. Thus making it a win-win situation for banks and well as investors.

Conclusion

I highly recommend you to watch “The Big Shot” on Netflix. They have explained more about Mortgage Backed Securities and how the main character made money by short selling these securities. These short selling were done during the 2008 housing crash.

Also read: 6 Reasons Why REIT are Better Investment Than Physical Asset

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