M&A Deals

Mortgage Backed Securities

A mortgage backed security, or MBS, is an asset backed investment that is secured by one or more mortgages. This type of financing is rarely used to complete M&A deals; however, it’s an interesting investment. Occasionally, we like to inform our readers of interesting financial instruments or other matters of interest.

Investing in an MBS is similar to lending money to a homebuyer taking on a mortgage. However, instead of receiving a mortgage that is financed solely by the bank, the mortgage is funded by an open market of investors. Investors reap a return on their investment via the interest rate associated with monthly payments on the mortgage. Because of this functionality, it is clear why a MBS can also be referred to as a “mortgage pass through.” Mortgage backed securities generally achieve a rate of return that is slightly better than government treasury bills or high grade corporate debt.

The greatest risk to investing in an MBS is known as “prepayment risk,” or the chance that the mortgage is repaid ahead of time. Prepayments of mortgages are most likely to happen in a low interest rate environment or when interest rates are declining as homeowners refinance their mortgages at a lower interest rate. The acceleration of prepayments creates a “reinvestment risk” for the investor who must reinvest the principal that has been pre-paid in a now lower interest rate environment. Due to the reduction of interest rates, it is difficult for the investor to reinvest the principal at a rate comparable to the original rate of the original MBS investment.

The opposite of prepayment risk is “extension risk.” This is the risk that the mortgage repayment takes longer than expected. This scenario is most common in a rising interest rate environment as homeowners are less likely to make the required principal payments on their mortgages. This, in effect, extends the life of a low yielding investment in an environment where interest rates are increasing.