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What are mortgage backed securities?

If you’re interested in mortgage backed securities, you’re probably thinking about investing your money in a firm who specialise in them. Many people are unclear on what they are exactly and how money can be made from investing in them so we’ll demystify the process for you.
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Stock and bonds

A mortgage backed security investment is similar to an investment in stocks or bonds. Their value is backed by the value of the bundle of mortgages. Your money eventually finds its way to homeowners through banks who act as a middleman between the investor and the homeowner.

How it works

The bank or mortgage lender agree a loan with an individual or business. The bank then sells that loan to an investment firm who bundle a collection of loans with similar interest rates together. They then sell a security (MBS) to that debt which delivers the same payments that the bundle of mortgages does. The MBS is then sold on a secondary market to investors.

Types of mortgage backed securities

This is a very involved investment that can be made even more complicated. The simplest are pass through participation certificates that simply pay the investor their share of principal and interest payments made on the mortgages.

Tranches

In order to make even more attractive investments banks offer different tranches. These slice the bundle up into mortgages with similar risks. The least risky tranche only contains the first 3 years of a mortgage as borrowers are more likely to pay within the opening 3 years. For a higher risk and a great reward some investors opt for tranches that include the following 5 to 7 years of mortgage repayments.

Credit

Some of the recent global financial crisis has to be attributed to this type of finance because lenders could offer the money and leave the risk to investors, but don't let that put you off investing in an MBS.

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