What are mortgage-backed securities?
Mortgage-backed securities (MBS) are bonds secured by a home loan or a bundle of mortgages. Government-sponsored enterprises (GSE), like Fannie Mae, purchase these loans and package them up into MBSs to sell to investors. These investors consist of financial institutions, such as investment banks, pension funds and insurance companies. The shares that they receive are the mortgages’ principal and interest rates. This transaction occurs in the secondary mortgage market as a way to provide liquidity and stability to the primary market.
Without Fannie Mae, lending companies would not have adequate funds to produce home loans for homebuyers. Therefore, the secondary mortgage market plays an integral role in your ability to receive a mortgage loan. Furthermore, your interest rates are defined by the secondary market and how much investors are willing to supply. Fannie Mae also determines the eligibility criteria you must meet to obtain a conforming loan. This is to ensure that MBSs remain high quality and a low risk for investors. To learn more about mortgage-backed securities and how they affect the housing market, read the following sections below.
The Role of Mortgage-Backed Securities in the Housing Market
When issuing home loans to qualifying borrowers, lenders can either hold these loans in their books or sell them to a government-sponsored enterprise and replenish the funds they lost immediately. If a bank chooses to keep a loan, then this means that they must wait for the entire length of the loan to be reimbursed. This may hinder a lending company from issuing more than one mortgage loan, considering mortgages can take from five to 30 years to restore.
Otherwise, a lender may sell the loan to a GSE who will bundle the loan into a mortgage-backed security and sell it to investors. These investors are guaranteed to receive a profit from the principal and interest rates accumulated from these home loans. As a result, banks and credit unions will have enough capital to continue lending conventional mortgages. In order for a loan to be conventional or conforming, it must meet specific requirements set by GSEs. While investors can buy into MBSs with non-conforming loans, it is safer to invest in MBSs through GSEs that contain these restrictions as their borrowers are less likely to default on their mortgages. All in all, mortgage-backed securities allow people to purchase more homes through the availability of mortgages.
Find out more about how Fannie Mae works and other details about mortgage-backed securities by downloading our comprehensive guide.
Mortgage-Backed Securities and Fannie Mae
Formerly known as the Federal National Mortgage Association, Fannie Mae was created to salvage the housing market in 1939 after the Great Depression. The GSE was designed to provide liquidity, stability and accessibility to the mortgage market through a secondary mortgage market that would purchase mortgages and sell them as mortgage-backed securities. This way, struggling banks and credit unions would not only be able to restore their lost capital, but have enough funds to continue issuing mortgages.
Due to the mortgage crisis that occurred in 2008, the government-chartered corporation was soon taken into conservatorship under the Federal Housing Association (FHA). This was due to the corporation’s collapse in the stock market as a result of the selling and packaging of subprime loans into high-risk securities. Today, there is a meticulous Fannie Mae selling guide that approved lending companies must use to ensure that the mortgage-backed securities sold to investors consist of high-quality, low risk loans.
The Benefits and Risks of Mortgage-Backed Securities for Investors
If you are looking to invest in a mortgage-backed security through a GSE like Fannie Mae, then you will receive a guaranteed profit from the principal and interest rate derived from the bond’s home loans. However, it is important that you are aware of the risks associated with a security investment. For instance, there is a chance that the borrower pays his or her mortgage loan off early, reducing the initial term of the mortgage. In this case, you will receive all of your principal in return but you will not continue to receive interest for as long as you had expected.
Because of this uncertainty, Fannie Mae typically offers mortgage-backed securities with higher yields or higher returns. However, keep in mind that you may not redeem the benefits of these yields for their entire maturity. Furthermore, there is a chance that homeowners will decide to refinance their home loans whenever interest rates decrease. Homeowners who look into how to refinance a Fannie Mae home loan may receive a lower interest rate and, therefore, you will receive less in returns as the investor.
Additionally, investing in a Fannie Mae mortgage is much safer than investing in a security sold by a non-government institution. Because Fannie Mae is supported by the U.S. government, there is a higher chance that the U.S. Treasury will provide funding in the event of a financial crisis.
Types of Mortgage-Backed Securities
While the most common mortgage-backed securities are pass-throughs, investors can also invest in collateralized mortgage obligations (CMO). Pass-through MBSs involve mortgage payments that are collected by lenders and passed to investors through a trust. When a lending company collects a borrower’s monthly payments, they keep their servicing fee and pass the interest and principal to Fannie Mae. The enterprise then passes the remaining funds to a trust that distributes these funds to investors in the form of monthly payments.
Pass-through securities typically consist of adjustable-rate mortgages and fixed-rate mortgages, meaning they are generally long-term unless a loan’s principal is paid off ahead of time. On the other hand, collateralized mortgage obligations are much more complicated and consist of a hierarchy of securities organized by tranches based on the level of risk and maturity. Investors in CMOs receive their portion of the share based on predetermined agreements.
Fannie Mae Multifamily and Single-Family MBSs
Fannie Mae offers residential mortgage-backed securities in the form of single-family and multifamily properties. Single-family MBSs pool together mortgages for single-family properties of up to four units. Multi-family MBSs bundle together home loans for properties that are five units or more. Although these MBSs differ in property units, their properties must meet Fannie Mae appraisal requirements and project standards. Furthermore, the mortgages contained in these bonds must consist of adjustable-rate or fixed-rate mortgages but never a combination of the two. Additionally, these loans must conform to Fannie Mae standards as the enterprise promises the MBS trust that they will supplement any amounts received by investors.
To learn about the Fannie Mae standards for home loans, download our detail guide here.