Key takeaways
A mortgage-backed security is an investment product that consists of thousands of individual mortgages.
Investors can purchase MBSs on the secondary market and directly from the issuer.
When MBS prices fall, residential mortgage rates tend to rise -- and vice versa.
If you have a mortgage, you may be unknowingly participating in a mortgage-backed security (MBS). That is, your home loan may be part of a pool of mortgages that has been packaged and sold to income-oriented investors on the secondary market. Being part of an MBS won't change much (if anything) about how you repay your home loan, but it's helpful to understand how these investment products work and how they impact the mortgage and housing industries.
A mortgage-backed security is a type of financial asset, somewhat like a bond (or a bond fund). It is created out of a portfolio, or collection, of residential mortgages.
When a company or government issues a traditional bond, they are essentially borrowing money from investors (the people buying the bond). As with any loan, interest payments are made and then principal is paid back at maturity. However, with a mortgage-backed security, interest payments to investors come from the thousands of mortgages that underlie the bond -- specifically, the repayments in interest and principal the mortgage-holders make each month.
Mortgage-backed securities offer key benefits to the players in the mortgage market, including banks, investors and even mortgage borrowers themselves. However, investing in an MBS has pros and cons.
High interest rates, low housing prices and risky lending practices all contributed to the 2008 financial crisis, during which mortgage-backed securities collapsed from continued defaults on loans.
While we all grew up with the idea that banks make loans and then hold those loans until they mature, the reality is that there's a high chance that your lender is selling the loan into what's known as the secondary mortgage market. Here, aggregators buy and sell mortgages, finding the right kind of mortgages for the security they want to create and sell on to investors. If your loan servicer changes soon after you've gotten a mortgage, it's probably because the loan's been packaged into a mortgage-backed security.
Mortgage-backed securities consist of a group of mortgages that have been organized and securitized to pay out interest, similar to a bond or a bond fund MBSs are created by companies called aggregators, including government-sponsored entities such as Fannie Mae or Freddie Mac. They buy loans from lenders, including big banks, and structure them into a mortgage-backed security.
Think of a mortgage-backed security like a giant pie with thousands of mortgages thrown into it. The creators of the MBS may cut this pie into potentially millions of slices -- each perhaps with a little piece of each mortgage -- to give investors the kind of return and risk they demand. Mortgage-backed securities typically pay out to investors on a monthly basis, paralleling the monthly repayments on the individual mortgages underlying them.
Mortgage-backed securities may have many features depending on what the market demands. The creators of MBSs think of their pool of mortgages as streams of cash flow that might run for 10, 15 or 30 years -- the typical length of mortgages. But the bond's underlying loans may be refinanced, and investors are repaid their principal and lose the cash flow over time.
By thinking of the characteristics of the mortgage as a stream of risks and cash flows, the aggregators can create bonds that have certain levels of risk or other characteristics. These securities can be based on home mortgages (residential mortgage-backed securities, or RMBS) or on loans to businesses on commercial property (commercial mortgage-backed securities, or CMBS).
Several types of mortgage-backed securities exist, differing in structure and complexity:
Pass-through securities: In this type of mortgage-backed security, a trust holds many mortgages and allocates mortgage payments to its various investors depending on what share of the securities they own. This structure is relatively straightforward.
Collateralized mortgage obligation (CMO): This type of MBS is a legal structure backed by the mortgages it owns, but it has a twist. From a given pool of mortgages, a CMO can create different classes of securities that have different risks and returns (like different size slices, to use our pie metaphor again). For example, it can create a "safer" class of bonds that are paid before other classes of bonds. The last and riskiest class is paid out only if all the other classes receive their payments.
Stripped mortgage-backed securities (SMBS): This kind of security basically splits the mortgage payment into two parts: the principal repayment and the interest payment. Investors can then buy either the security paying the principal (which pays out less at the start but grows) or the one paying interest (which pays out more but declines over time).
These structures allow investors to invest in mortgage-backed securities with certain risks and rewards. For example, an investor could buy a relatively safe slice of a CMO and have a high chance of being repaid, but at the cost of a lower overall return.
The first modern-day mortgage-backed security was issued in 1970 by the Government National Mortgage Association, better known as Ginnie Mae. Its MBSs were -- and still are -- actually backed by the U.S. government, with a guaranteed income stream. That made them especially enticing to investors.
Ginnie Mae began providing mortgage-backed securities in an effort to bring into the lending market extra funds, which were then used to purchase more home loans and expand affordable housing. Shortly after, government-sponsored enterprises Fannie Mae and Freddie Mac also began offering their version of MBSs.
The first private MBS -- backed by mortgage providers, rather than a federal agency -- was not issued until 1977, when Lew Ranieri of the investment group Salomon Brothers developed a residential mortgage-backed security. MBSs were offered in five- and 10-year mortgage bonds, which appealed to investors because they could see returns more quickly.
Over the years, mortgage-backed securities have evolved and grown significantly. As of the fourth quarter of 2021, more than $12 trillion of mortgage-backed securities were outstanding, according to the Securities Industry and Financial Markets Association (SIFMA).
The housing collapse of 2007-08 took a direct toll on mortgage-backed securities and resulted in enormous financial losses within the global market.
A housing boom in the mid-2000s led to a complete collapse and government bailout, beginning in the mid-2000s. Lenders began to target subprime borrowers with low income and poor credit by offering them high-risk loans. Many of these borrowers were then unable to make their mortgage payments (and subsequently defaulted on their loans), jumpstarting the market collapse.
This bust resulted in enormous losses in MBSs, many of which contained these subprime loans. As mortgage holders began to default, the price of MBSs plummeted, leading to an eventual government bailout.
While mortgage-backed securities notoriously were at the center of the global financial crisis in 2008 and 2009, they continue to be an important part of the economy today. That's because they serve real needs and provide tangible benefits to players across the mortgage and housing industries.
Not only does securitization of mortgages provide increased liquidity for investors, lenders and borrowers, it also offers a way to support the housing market, which is one of the largest engines of economic growth in the U.S. A strong housing market often bolsters a strong economy and helps employ many workers.
No investment is without risk, and MBSs have their advantages and disadvantages.
For instance, mortgage-backed securities typically pay out to investors on a monthly basis, like the mortgages behind the securities. But, unlike a typical bond where you receive interest payments over the bond's life and then receive your principal when it matures, an MBS may often pay both principal and interest over the life of the security, so there won't be a lump-sum payment at the end of the MBS's life.
Here are some of the other advantages and disadvantages of investing in MBSs.
Pay a fixed interest rate
Typically have higher yields than U.S. Treasuries
May be backed by the U.S. government
Can be structured to offer different risks and cash flows
May be highly diversified across thousands of mortgages
Despite an MBS holding a diversified mortgage portfolio, investors' returns still rely exclusively on a single type of asset -- real estate loans. So if something damages that market, MBSs will feel the brunt
Borrowers may refinance or pay down their loan faster than expected, meaning investors may not receive the returns they expected
It's tough to know exactly the quality of mortgages packaged in a given MBS
MBSs help provide liquidity to the mortgage market, creating greater efficiency and lowering the costs of financing for many borrowers. For example, a certain community may have only one or two local banks interested in lending to their area. But with the MBS market, other lenders may decide to make loans there because they can later sell the loans to mortgage aggregators. So local home buyers can have more choices, and more choices often leads to lower mortgage rates.
Mortgage-backed securities reduce lenders' risk, encouraging them to originate and offer loans, and providing them with the capital to do so. Their presence helps keep money flowing throughout the financial system, keeping it running smoothly. A liquid market ultimately offers greater access to mortgages for homebuyers, more loan options, and more competitive rates, as well.
Why do mortgage-backed securities make sense for the players in the mortgage industry? Mortgage-backed securities actually make the industry more efficient, meaning it's cheaper for each party to access the market and get its benefits:
Lenders: By selling their mortgages, lenders save on maintenance costs, and receive money they can then loan out to other borrowers, allowing them to more efficiently use their capital. They often require borrowers to meet conforming loan standards so that they can sell mortgages to aggregators. They can also sell the loans they might not want to keep, while retaining those they prefer.
Aggregators: Aggregators package mortgages into MBSs and earn fees for doing so. They may give mortgage-backed securities features that appeal to certain investors. A steady supply of conforming loans allows aggregators to structure MBSs cheaply.
Borrowers: Because aggregators demand so many conforming loans, they increase the supply of these loans and push down mortgage rates. So, borrowers may be able to enjoy greater access to financing and more competitive mortgage rates than they otherwise would.
Of course, easier access to financing is beneficial for the housing construction industry, too: Developers can build and sell more houses to consumers who are able to borrow more cheaply.
Investors like mortgage-backed securities, too, because these bonds may offer certain kinds of risk exposure that the investors, mainly big institutional players, want to have. Even the banks themselves may invest in MBSs, diversifying their portfolios.
While the lender may sell the loan, it may also retain the right to service the mortgage, meaning it earns a small fee for collecting the monthly payment and generally managing the account. So, you may continue to pay your lender each month for your mortgage, but the real owner of your mortgage may be the investors who hold the mortgage-backed security containing your loan.
As of 2021, 65% of total home mortgage debt was securitized into mortgage-backed securities, according to the Federal Reserve Bank of New York.
While you might not deal with a mortgage-backed security in your daily life, your mortgage may be part of one. And if so, it's a cog in the machinery that keeps the financial system running and helps borrowers access capital more cheaply. It can be useful to understand that the MBS market ultimately has a powerful influence over qualifications for mortgages, resulting in who gets a loan -- and for how much.
Aggregators buy loans from banks -- or other lenders -- who issue the home loans and structure them into a mortgage-backed security. These MBSs can then be sold to investors.
The Federal Reserve can buy and sell mortgage-backed securities as instructed by the Federal Open Market Committee (FOMC). These actions can stimulate the economy or slow it, helping the Fed to manage inflation.
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