Mortgage Backed Securities (MBS) Basics

What is MBS?

Any time you see us write MBS, or anywhere else for that matter, we're always going to be referring to Mortgage Backed Securities. These are the securities comprised of groups of similar mortgages, also known as "pools."  MBS function similarly to other bonds in that have a purchase PRICE and pay the investor back in installments based on the YIELD.  The PRICE always refers to the cost of buying $100 of that particular bond. For instance, if the price of a bond is 101.00, then an investor would pay $101.00, and in exchange, would then own only $100.00 worth of that bond. So why pay more or less?

In a word: YIELD. Yield is the rate of return paid on that bond over time. There are multiple different types of bonds, and each bond has a certain yield that it pays. You will sometimes hear us refer to yield as "coupon" or "issue." As you might guess, the higher the yield, the more the buyer will make over time, so the more the buyer is willing to pay. For instance, if an MBS with a 3.0% yield costs $104.50, the investor pays $104.50 for the ability to collect 3.0% interest on $100.00.  Conversely, yields that are low enough may have prices under Par (100.00), meaning that investors could buy $100.00 worth of MBS at a discount.  Bottom line, the higher the coupon of MBS, the higher the price will generally be.

For this same reason, when considering only one coupon (you might find it easier to think of it as "if the coupon stays the same") and the price is going higher, then the yield for the investor goes lower (because they're paying a higher price for the same coupon yield).  This is what we mean when we say "as price goes up, yields go down," which is a different concept that "higher yielding coupons fetch higher prices."  This can be a bit of paradox for some, but if it doesn't make sense at first, try to separate the two different approaches mentioned above:

1. In this case, we're looking at and/or considering the price/yield relationship of numerous MBS coupons, at one moment in time, and noticing that the higher the coupon, the higher the price.

2. In this case, we're looking at one specific MBS coupon.  The coupon doesn't change, but the price does.  As the price moves higher and lower over time we're noticing that investors are paying more or less for the same coupon yield.  Thus if prices for a particular coupon are moving higher, yields are moving lower.

Keep in mind that the COUPON YIELD of a particular MBS only determines the rate of return of whatever principal amount remains in the MBS pool purchased by the investor.  Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired.  Suppose you paid $104.00 for the right to collect interest on a $100.00 loan.  If the borrower pays you back before their first interest payment, now you've earned $100.00 for your $104.00 investment!!!  Not profitable!  You're realizing a MUCH lower yield than another investor whose borrowers keep their loan for several years. 

This is the "Prepayment Risk" that investors seek to avoid and it's the reason for the various "early pay-off" penalties charged to originators if loans are retired or refinanced within a certain time frame.

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