What Are Mortgage-Backed Securities (MBS)?

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Mortgage-backed securities (MBS) are bonds whose payments come from a pool of mortgage loans. An issuer buys or assembles many home loans (or commercial property loans), places them in a trust or similar vehicle, and sells securities that give investors a claim on the borrowers’ monthly payments of interest and principal. Buying an MBS is, in economic terms, lending money to a large group of borrowers at once, with the cash routed through a servicer and, for most of the U.S. market, guaranteed against borrower default by a government agency or a government-sponsored enterprise.

How mortgage-backed securities work

A mortgage on its own is an illiquid asset. A lender that holds it collects payments for up to 30 years and has that capital tied up the whole time. Securitization converts many such loans into tradable securities, so the lender gets cash back to make new loans and investors get a fixed-income asset backed by housing debt.

From loan to security

The process follows the same broad sequence whether the issuer is an agency or a private firm:

1. Origination. A bank, credit union or mortgage company lends to a homebuyer. The loan is secured by the property.
2. Pooling. The lender, or an aggregator that buys loans from many lenders, groups loans with similar features: fixed or adjustable rate, term, interest rate range, loan size and credit criteria.
3. Sale to an issuer. The pool is sold to a government-sponsored enterprise, to a trust set up by a private financial institution, or, for Ginnie Mae securities, packaged by an approved issuer under Ginnie Mae’s guarantee program.
4. Structuring and issuance. The issuer creates securities backed by the pool and sells them to investors. In the simplest form every investor gets a proportional share of all cash flows; in more complex forms the cash flows are divided into classes.
5. Servicing. A mortgage servicer collects borrowers’ monthly payments, manages escrow accounts for taxes and insurance, handles late payments and foreclosures, and forwards the cash to the trustee or paying agent.
6. Distribution. Investors receive their share of interest and principal, typically monthly, until the pool is paid down.

Throughout this chain the original lender becomes an intermediary between the homebuyer and the capital markets. It earns origination income and may keep the servicing rights, but once the loan is sold the default risk passes to the guarantor or to the investors. That transfer is not always complete: sellers usually make representations and warranties about the loans and can be required to buy back loans that breach them.

Who issues and guarantees MBS

Agency MBS come from three entities:

• Ginnie Mae (Government National Mortgage Association) is a government corporation inside the Department of Housing and Urban Development. It does not buy loans; it guarantees securities that approved issuers create from government-insured or government-guaranteed loans, such as FHA and VA mortgages. Its guarantee carries the full faith and credit of the U.S. government.
• Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are government-sponsored enterprises. They buy conforming loans from lenders, pool them and issue MBS with their own guarantee of timely payment. Their guarantee is a corporate obligation rather than an explicit federal one, but both have operated under federal conservatorship since 2008, and markets treat their backing as very close to government credit.

With an agency guarantee, if a borrower stops paying, the guarantor makes investors whole. The investor’s exposure becomes interest rate and prepayment risk rather than credit risk.

Non-agency or private-label MBS are issued by banks, investment banks and other private institutions, often backed by loans that do not meet agency standards: jumbo loans above conforming limits, loans with limited documentation, or, before 2008, subprime loans. No government entity guarantees them. Instead, the securities are split into tranches by seniority, so some investors absorb losses first in exchange for higher yields while senior investors are protected unless losses climb through the lower layers. Credit ratings from rating agencies are attached to these tranches.

Types of mortgage-backed securities

Pass-throughs

A pass-through is the basic form. The pool is held in a trust, and every payment that borrowers make, net of fees, is passed to investors in proportion to their holdings. Pass-throughs typically have stated maturities of 5, 15 or 30 years, matching the underlying loans. Their actual life is usually shorter than the stated maturity, because borrowers sell homes, refinance or pay extra principal. Most agency MBS are pass-throughs.

Collateralized mortgage obligations (CMOs)

A CMO takes the cash flows from one or more pools (often agency pass-throughs) and redistributes them into tranches, each with its own rules for receiving principal and interest. Common designs include:

• Sequential-pay tranches: principal goes first to tranche A until it is retired, then to tranche B, and so on. Early tranches behave like short-term bonds, later ones like long-term bonds.
• Planned amortization class (PAC) tranches: receive principal on a fixed schedule as long as prepayments stay within a set range, with “support” or “companion” tranches absorbing the excess or shortfall.
• Credit tranches in private-label deals: senior, mezzanine and subordinate layers that differ by who absorbs default losses first.

Each tranche is a separate security with its own coupon, expected life and rating, so investors can buy a single tranche rather than a whole pool. Tranching does not remove risk from the pool; it reallocates it.

Stripped mortgage-backed securities (SMBS)

Stripped MBS separate the interest and principal of a pool into two securities. The interest-only (IO) strip receives only interest, so it loses value when prepayments accelerate (the balance generating interest shrinks). The principal-only (PO) strip receives only principal, so it gains when prepayments speed up because the investor, who bought at a discount, gets par back sooner. Both are highly sensitive to rate and prepayment changes and are generally used by specialized investors and for hedging.

Residential versus commercial MBS

Residential MBS (RMBS) are backed by mortgages on one-to-four-family homes, condos and similar property. They can be agency or private-label.

Commercial MBS (CMBS) are backed by loans on income-producing property such as office buildings, shopping centers, hotels, warehouses and apartment complexes. CMBS loans usually have shorter terms, often with a large balloon payment at maturity, and frequently include prepayment penalties or lockouts, so prepayment risk is lower than in residential pools. Credit risk depends heavily on property type and the tenant economy, and CMBS are largely issued by private institutions, though the agencies issue securities backed by multifamily loans.

Worked example: one month of pass-through cash flow

The figures below are a hypothetical pool, not any issuer’s terms or current market levels.

Assumptions:

• Pool: $100 million of 30-year fixed-rate mortgages, all newly originated
• Borrowers’ mortgage rate: 6.50%
• Pass-through coupon to investors: 6.00% (the 0.50% difference covers servicing and the guarantee fee)
• Voluntary prepayments in month 1: 0.5% of the balance remaining after scheduled principal
• No defaults (or, for an agency pool, defaults are covered by the guarantor)

Step 1: Scheduled monthly payment. The standard amortizing payment is

Payment = Balance × r / (1 − (1 + r)^−n)

with r = 6.50% / 12 = 0.54167% and n = 360 months. That gives about $632,068 per month for the whole pool.

Step 2: Split the payment.

• Interest at the borrowers’ rate: $100,000,000 × 0.54167% = $541,667
• Scheduled principal: $632,068 − $541,667 = $90,401

Step 3: Pay the fees and the investors’ coupon.

• Investor interest at 6.00%: $100,000,000 × 0.50% = $500,000
• Servicing and guarantee: $541,667 − $500,000 = $41,667

Step 4: Add prepayments. The balance after scheduled principal is $99,909,599. A 0.5% prepayment is about $499,548.

Total distributed to investors in month 1: $500,000 + $90,401 + $499,548 = $1,089,949. An investor holding 1% of the pool would receive about $10,899.

Pool factor after month 1: remaining principal / original principal = ($100,000,000 − $90,401 − $499,548) / $100,000,000 ≈ 0.9941. The pool factor is published for each security so holders can calculate their outstanding principal.

The monthly prepayment rate of 0.5% is called the single monthly mortality (SMM). Annualized, it becomes the conditional prepayment rate (CPR): CPR = 1 − (1 − SMM)^12 = 1 − 0.995^12 ≈ 5.8%. If rates fell and borrowers refinanced so that SMM jumped to 3%, prepaid principal in a month like this would rise roughly sixfold, and the investor’s cash flow would shift heavily from interest toward early return of principal.

How MBS are measured and valued

Because cash flows depend on borrower behavior, MBS analysis relies on a set of pool-level measures:

• Weighted average coupon (WAC): the average interest rate on the loans in the pool, weighted by balance. Comparing the WAC with current mortgage rates indicates how much incentive borrowers have to refinance.
• Weighted average maturity (WAM) and loan age: how long the loans have left to run and how seasoned they are, which affects how they prepay.
• Prepayment speed (CPR or SMM): the rate at which principal is returning early, either observed or projected.
• Weighted average life (WAL): the average time until each dollar of principal is repaid, under a given prepayment assumption. A 30-year pass-through can have a WAL far shorter than 30 years.

Valuation follows the same logic as any discounted cash flow analysis: project the monthly cash flows, discount them, and solve for price or yield. The difference is that the projection itself depends on an assumption about prepayments, so a quoted yield is only meaningful together with the prepayment speed behind it. Analysts often run many interest rate paths and compute an option-adjusted spread (OAS), the spread over a benchmark curve after accounting for the value of the borrowers’ prepayment option.

MBS spreads usually refer to the gap between MBS yields and Treasury yields, often the 10-year Treasury, or between mortgage rates and MBS yields. For agency MBS the spread over Treasuries compensates investors mainly for prepayment and convexity risk, since credit risk is guaranteed. For private-label MBS it also compensates for credit and liquidity risk. A widening spread means investors are demanding more compensation to hold MBS; a narrowing spread means they are demanding less.

Duration and negative convexity

Duration measures price sensitivity to rate changes. For an ordinary noncallable bond it is fairly predictable. For an MBS it changes with rates:

• When rates fall, refinancing accelerates, expected life shortens, and the price rises less than a comparable Treasury would. Investors get their principal back at par just when they would prefer to keep the higher coupon.
• When rates rise, refinancing slows, expected life lengthens (extension risk), and the price falls more than investors might expect from the duration measured at the original rate.

This asymmetry, gaining less when rates fall and losing more when they rise, is negative convexity. It makes MBS behave like a bond combined with a short call option sold to the borrowers, and the higher yield on MBS versus Treasuries is partly payment for writing that option.

How mortgage-backed securities are used

For lenders, securitization recycles capital, which supports the availability of long-term fixed-rate mortgages in the U.S. A large share of U.S. mortgage debt, by value, ends up packaged into MBS.

For banks and institutional investors, agency MBS are a core fixed-income holding. Banks hold them as high-quality, liquid assets; insurers and pension funds use them for income; bond funds include them in broad portfolios. An “MBS portfolio” at a bank or fund is typically managed for spread, duration and prepayment exposure rather than credit.

For trading and funding, most agency pass-throughs trade in the to-be-announced (TBA) market, a forward market where buyer and seller agree on issuer, coupon, maturity, face amount, price and settlement date, but not the specific pools, which are identified shortly before settlement. Standardization makes agency MBS highly liquid. Investors also use dollar rolls, selling TBA for one settlement month and buying back for a later month, which works as a form of financing.

For monetary policy, the Federal Reserve bought large amounts of agency MBS after the financial crisis and again in later easing programs to push down mortgage rates and support credit. When it shrinks its holdings, other investors, such as money managers, have to absorb a larger share of the market.

For individual investors, MBS can be bought through a broker, though minimums vary by issuer and the bonds are aimed mainly at institutions. Most individuals get exposure through mutual funds and exchange-traded funds that hold agency MBS, or through broad bond index funds where MBS are a major component.

History of mortgage-backed securities

The modern U.S. market traces back to the Housing and Urban Development Act of 1968, which split Ginnie Mae from Fannie Mae and turned Fannie Mae into a privately owned, government-sponsored company. The aim was to give lenders a way to sell mortgages to third parties so they would have fresh capital to originate new loans.

Ginnie Mae guaranteed the first residential MBS in 1970. Freddie Mac, created in 1970, issued its first participation certificates the following year, and Fannie Mae began issuing MBS in the early 1980s. The first private-label MBS was issued by Bank of America in 1977. The first CMO followed in 1983, introducing tranching to the mortgage market.

MBS and the 2007 to 2008 financial crisis

Rising home prices in the early 2000s and strong investor demand for higher-yielding private-label tranches pushed lenders to loosen underwriting. Loans to borrowers with weak credit, little documentation or sharply resetting payments were pooled into private-label MBS, which were often repackaged into collateralized debt obligations (CDOs) that pooled tranches from many deals and tranched them a second time. Many senior pieces received top credit ratings that did not reflect their concentrated exposure to the same weak loans. Fannie Mae and Freddie Mac also expanded their exposure to riskier mortgages and private-label securities.

U.S. home prices peaked in 2006. As they fell, subprime borrowers with resetting payments began to default, and many homeowners whose homes were worth less than their loans walked away. Defaults spread beyond subprime. Losses moved up the tranche structures faster than models had assumed, and securities rated as near riskless were downgraded and marked down sharply.

Because so many banks and investors held these securities, often financed with short-term borrowing, losses and uncertainty about who held what froze credit markets. Lehman Brothers failed in 2008, Fannie Mae and Freddie Mac were placed into conservatorship, and the crisis wiped out trillions of dollars in household and market wealth.

The response

Congress authorized $700 billion for the Troubled Asset Relief Program (TARP) in 2008, including almost $250 billion to stabilize banks through capital injections. The Dodd-Frank Act of 2010 reduced TARP’s authorization to $475 billion and introduced risk-retention rules requiring securitizers to keep part of the credit risk in many deals, along with stricter disclosure and mortgage underwriting standards. Separately, the Federal Reserve’s large-scale purchases of agency MBS helped stabilize mortgage financing.

The lasting change in market structure is that agency MBS now account for the great majority of residential MBS issuance and trading, while private-label RMBS volumes and trading are a small fraction of the agency market.

Benefits of mortgage-backed securities

• Higher yield than Treasuries. Agency MBS typically yield more than Treasuries of similar average life, mainly as compensation for prepayment and convexity risk rather than credit risk.
• Monthly income with principal returned along the way. Most bonds pay semiannual coupons and return principal at maturity. MBS pay monthly and return principal gradually, which suits investors matching assets against regular outgoing payments.
• Diversification. One MBS spreads exposure across hundreds or thousands of loans, and its returns respond to housing and prepayment factors that differ from those driving corporate bonds and stocks.
• Credit protection and liquidity in agency securities. The agency guarantee covers borrower defaults, and the TBA market makes agency MBS among the most actively traded fixed-income instruments.

Risks and limitations of mortgage-backed securities

Prepayment and extension risk. Prepayments can be voluntary (refinancing, home sales, extra payments) or involuntary (defaults that end in a guarantor buyout or a foreclosure). Refinancing is the largest driver. When rates fall, investors who bought above par lose the premium faster and reinvest at lower rates. When rates rise, prepayments slow and investors hold below-market coupons longer than expected. This is the negative convexity described above.

Interest rate risk. Existing MBS lose value when rates rise. Higher rates also reduce origination and refinancing, which shrinks new MBS supply.

Credit risk. Minimal for agency MBS, but real for private-label MBS and CMBS, where defaults and loss severities flow to investors according to the tranche structure. Economic downturns, regional housing declines or weak commercial property markets can all raise losses.

Liquidity risk. Private-label MBS, smaller CMO tranches and stripped securities can be thinly traded, with wide bid-ask spreads, especially in stress.

Model risk and uncertain timing. Yield, duration and value can change materially if borrower behavior departs from prepayment and default assumptions, as the crisis showed for credit models. Because the timing of principal is unknown, MBS are a poor fit for an investor who needs a specific sum on a specific date.

MBS compared with related terms

MBS versus asset-backed securities (ABS). An ABS is a security backed by any pool of cash-generating assets: auto loans, credit card balances, student loans, equipment leases or receivables. MBS are a subset of ABS backed specifically by mortgages, though in market convention “ABS” usually refers to the non-mortgage sectors. Many ABS have little prepayment risk compared with residential MBS, and none carry the agency guarantees available in the mortgage market.

MBS versus CDOs. A CDO pools debt instruments, which can include MBS tranches, corporate bonds or loans, and divides the pool into tranches again. A CMO is a mortgage-specific structure built from mortgage pools. CDOs built from subprime MBS tranches concentrated risk rather than diversifying it, which is why they were so damaging in 2007 and 2008.

MBS versus mortgage bonds and covered bonds. “Mortgage bond” is used loosely as a synonym for MBS, but it can also mean a bond issued by a company and secured by its own real estate. Covered bonds, common in Europe, are issued by a bank and backed by a pool of mortgages that stays on the bank’s balance sheet, so investors have a claim on both the bank and the collateral. With an MBS, the loans are sold to a separate vehicle and investors rely on the pool and any guarantee, not on the originating bank.

MBS versus a mortgage. A mortgage is a single loan between a borrower and a lender. An MBS is a security representing a share of many mortgages. The homeowner’s loan terms do not change when the loan is securitized, though the servicer may.

FAQs

The Bottom Line

MBS matter most to banks, insurers, pension funds and bond fund investors who want monthly income and a yield above Treasuries. Agency MBS largely remove credit risk, so the main exposure is prepayment and negative convexity, while private-label deals add credit and liquidity risk by tranche. Because principal timing is uncertain, MBS suit regular income needs better than a specific sum due on a specific date.