# Understanding Mortgage-Backed Securities: Types, Risks, and Benefits

> **Definition**
>
> Mortgage-backed securities (MBS) are investments like bonds. Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them.

## What Are Mortgage-Backed Securities (MBS)?

Mortgage-Backed Securities (MBS) represent claims on the cash flows from pooled home loans, offering investors periodic income similar to bond payments. The MBS market, significantly evolved since the 2007-2008 financial crisis, plays a crucial role in today's financial system. Explore their structure, benefits, and risks to decide if MBS fit into your investment strategy. Investors in mortgage-backed securities receive periodic payments like bond coupon payments.

The MBS market has changed a lot since the 2007-2008 crisis caused by the collapse of subprime mortgages and complex MBS derivatives. Today, the MBS market remains a major part of the global financial system, albeit with new regulations and increased scrutiny from investors and policymakers. By total value, over three in five mortgages in the U.S. are repackaged as MBS.

As investments in them steadily grow again, reaching figures last seen before the financial crisis, should there be a greater concern that the next recession could set off waves of mortgage defaults that could again wreak havoc on the world economy? In what follows, we take you through the details of what these investments are, why they exist, and their place in the markets of the 2020s. We'll then leave you better able to decide whether they have a place in your own portfolio and that of the nation.

### Key Takeaways

*   Mortgage-backed securities (MBS) are investments backed by pools of mortgages and offer periodic payments similar to bond coupon payments.
*   Agency MBS are considered the highest credit quality due to backing by government-sponsored enterprises, while non-agency MBS carry higher risk and potentially higher yields.
*   MBS were central to the financial crisis of 2007-2008 due to their links to subprime mortgages, leading to significant economic repercussions.
*   MBS provide a stream of income to investors but are sensitive to interest rate changes and prepayment risks, impacting their value.
*   The U.S. MBS market remains substantial, with agency MBS considered less risky due to government guarantees, attracting investors seeking stable fixed-income returns.

![Mortgage-Backed Securities (MBS)](https://www.investopedia.com/thmb/ejYxSy4EhiC_lHbzO-ghsumWQgs=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/MBS-c5e8072c892f47058ff0740d8e8c38d5.jpg)

*— Julie Bang / Investopedia*

## How Mortgage-Backed Securities (MBS) Work

MBS are [asset-backed securities](https://www.investopedia.com/terms/a/asset-backedsecurity.asp) formed by pooling together mortgages. The investor who buys a mortgage-backed security is essentially lending money to homebuyers. An MBS can be bought and sold through a broker. The minimum investment varies between issuers.

As became glaringly obvious in the [subprime mortgage meltdown of 2007 to 2008](https://www.investopedia.com/terms/s/subprime-meltdown.asp), an MBS was once only as sound as the mortgages that back it up. In the 2020s, most MBS have the backing of the U.S. government; these are called agency MBS.

To be sold on the markets today, an MBS must be issued by a [GSE](https://www.investopedia.com/terms/g/gse.asp) or a private financial company, and the MBS must have received one of the top two ratings issued by an accredited credit rating agency. Non-agency MBS, meanwhile, are issued by private financial institutions and are not guaranteed. Instead, securities are grouped by seniority and sold to investors with different appetites for risk.

> **Important**
>
> Mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth.

### The Formation Process of Mortgage-Backed Securities

The best way to understand MBS is to see how they are formed in the first place. Let's walk you through the steps:

1.  **Origination:** A financial institution, such as a bank, provides mortgages to homebuyers. These loans are secured by the properties being bought.
2.  **Pooling:** The bank pools many of these mortgage loans, which have similar characteristics such as interest rates and maturity dates.
3.  **Securitization:** The pooled mortgages are sold to a trust, GSE, or private financial institution. The trust then structures them into MBS.
4.  **Issuance:** The MBS are issued and sold to investors, backed by mortgage loans in the pool.
5.  **Servicing:** A mortgage servicer collects monthly payments from borrowers and distributes these to MBS investors.
6.  **Investment:** Investors buy MBS and receive periodic interest and principal repayments.  
    

## Key Types of Mortgage-Backed Securities Explained

These are the two broadest types of MBSs: pass-throughs and collateralized mortgage obligations (CMOs). Beneath them is a table with descriptions for other major types within these MBS.

1.  **Pass-throughs**: Pass-throughs are structured as trusts in which mortgage payments are collected and passed to investors. They typically have stated maturities of five, 15, or 30 years. The life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that make up the pass-through.
2.  **Collateralized mortgage obligations (CMOs)**: CMOs consist of multiple pools of securities known as slices or [tranches](https://www.investopedia.com/terms/t/tranches.asp). The tranches are given credit ratings, which determine the rates that are returned to investors. Tranches within an MBS can [have different credit risk profiles](https://www.investopedia.com/terms/c/credit_loss_ratio.asp).

## The Evolution of Mortgage-Backed Securities

Mortgage-backed securities were introduced after the passage of the Housing and Urban Development Act in 1968. The act created [Ginnie Mae](https://www.investopedia.com/terms/g/ginniemae.asp), a group that separated from [Fannie Mae](https://www.investopedia.com/articles/investing/091814/fannie-mae-what-it-does-and-how-it-operates.asp).

The new entity allowed banks to sell their mortgages to third parties so that they would have more capital to lend out and originate new loans. This, in turn, made it possible for institutional funds to buy up and package many loans into an MBS.

Ginnie Mae introduced the first mortgage-backed securities for the retail housing market in 1970. The first private MBS was introduced by Bank of America in 1977.  

## Impact of Mortgage-Backed Securities on the 2007-2008 Financial Crisis

Mortgage-backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth, bring down [Lehman Brothers](https://www.investopedia.com/terms/l/lehman-brothers.asp), and roil the world financial markets.

In retrospect, it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost.

### The Crisis

That was the beginning of the [subprime](https://www.investopedia.com/terms/s/subprime_mortgage.asp) MBS. With Freddie Mac and Fannie Mae supporting the mortgage market, the quality of all mortgage-backed securities declined, and their ratings became meaningless. Then, in 2006, housing prices peaked.

Subprime borrowers started to default, which is the failure to repay a loan. As a result, the housing market began its prolonged collapse. More people began walking away from their mortgages because their homes were worth less than their loans. Even the conventional mortgages underpinning the MBS market had steep declines in value. The avalanche of nonpayments meant that many MBSs and collateralized debt obligations [(CDOs)](https://www.investopedia.com/terms/c/cdo.asp) based on pools of mortgages were soon vastly overvalued.

Losses grew as investors and banks struggled to sell their bad MBS investments. Credit tightened, causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire [economy](https://www.investopedia.com/terms/e/economy.asp) was at risk of collapse.

### The Bailout

The U.S. Congress authorized a $700 billion financial system bailout to ease the [credit crunch](https://www.investopedia.com/terms/c/creditcrunch.asp). Also, the U.S. Federal Reserve bought $4.5 trillion in MBS over several years while the Troubled Asset Relief Program [(TARP)](https://www.investopedia.com/terms/t/troubled-asset-relief-program-tarp.asp) injected capital directly into banks.

Some of the measures of the bailout included the following:

*   Almost $250 billion to stabilize the banking industry
*   $27 billion to stabilize the credit markets
*   $80 billion to support the U.S. auto industry
*   Almost $70 billion to bail out insurance giant American International Group
*   $46 billion was allocated to help struggling families avoid home [foreclosure](https://www.investopedia.com/terms/f/foreclosure.asp), which is when a mortgage lender or bank seizes a borrower’s home because of nonpayment of the loan

TARP ended in 2010, the same year the [Dodd-Frank Act](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp) was passed. The Dodd-Frank law reduced the initial $700 billion authorized for TARP to $475 billion.

## Pros and Cons of Investing in Mortgage-Backed Securities

Advantages

*   Fixed interest rates and monthly payouts
    
*   More diversification than single loans  
    
*   Relatively low correlation with corporate bonds or the stock market
    

Disadvantages

*   Returns may be affected by borrowers refinancing or paying off their loans early.
    
*   If interest rates increase, the price of an MBS may drop.
    

## Benefits of Mortgage-Backed Securities

### Attractive Yield

For investors, mortgage-backed securities have some advantages over other securities. They pay a fixed interest rate that is usually higher than U.S. government bonds. Moreover, they typically offer monthly payouts, while bonds offer a single lump-sum payout at maturity.

### Safe Investment

Mortgage-backed securities are also considered relatively low-risk, given the government backing for most of them. If an MBS is guaranteed by the federal government, investors do not have to absorb the costs of a borrower’s default. Moreover, they offer diversification from the markets of corporate and government securities.  

## Risks Associated with Mortgage-Backed Securities

### Prepayment Risk

Prepayments can be either voluntary, such as when borrowers refinance or relocate, or involuntary from defaults. Refinancing is the most significant source of prepayment, as borrowers can pay off their remaining balance at par without penalty when market interest rates decline. This makes MBS callable securities, limiting their price appreciation potential and resulting in negative convexity. The weighted average coupon [(WAC)](https://www.investopedia.com/terms/w/wac.asp) can estimate the prepayment characteristics of a pool of underlying mortgages. The WAC will change periodically as mortgages are paid off.

This is related to duration risk, which arises from the sensitivity of MBS prices to changes in interest rates. MBS typically have extended maturities and pay fixed coupons, resulting in high duration and significant price sensitivity to interest rate movements. However, unlike traditional [fixed-income](https://www.investopedia.com/terms/f/fixed-incomesecurity.asp) securities, the duration of MBS is not fixed but remains uncertain because of the potential for borrowers to prepay their loans at any time.

### Interest Rate Risk

MBSs are also sensitive to [changes in interest rates](https://www.investopedia.com/terms/i/interestraterisk.asp) on loans and mortgages. If interest rates rise, fewer people will take out mortgages, causing the housing market to decline.

### Liquidity Risk

Liquidity varies significantly across different types of MBS, with agency MBS benefiting from the highly liquid to-be-announced or TBA forward market and the ability to execute dollar rolls for funding. In contrast, private-label MBS have much more limited liquidity.

## Mortgage-Backed Securities Today

In the U.S., the MBS market is massive, with over $11 trillion in outstanding securities and almost $300 billion in average daily trading volume, according to the Federal Reserve Bank of New York. The market is divided into two main categories: agency MBS, which are issued by government-sponsored entities like the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), and non-agency MBS, which are issued by private financial institutions.

Agency MBS are considered less risky because they are backed by Fannie Mae and Freddie Mac guarantees, which promise to pay investors even if homeowners default on their loans. This guarantee is ultimately backed by the U.S. government, making agency MBS attractive to investors looking for stable, fixed-income returns. In May 2024, agency MBS's average daily trading volume reached $292.9 billion, a 19.4% increase over May 2023.

Non-agency MBS, meanwhile, do not have explicit government guarantees and typically carry higher credit risk. Investors in non-agency MBS face potential losses if homeowners default on their mortgages. Non-agency MBS often have higher yields than agency MBS to compensate for this increased risk. In May 2024, non-agency MBS's average daily trading volume was around $1.62 billion, a 6.8% increase over May 2023, but only a tiny fraction of agency MBS.

The MBS market has grown due to rising demand, global economic growth, and monetary policy efforts. However, the market also faces challenges, such as interest rate risk.

> **Important**
>
> When residential MBS values drop, mortgage values usually rise, and vice versa.

MBS prices are inversely related to interest rates, meaning that existing MBS become less valuable when rates rise. Also, when homeowners refinance their mortgages at lower rates, they pay off their existing loans early, which can cut the cash flows that investors expect to receive from MBS. Economic downturns can also lead to increased mortgage defaults, resulting in losses for MBS investors.

Despite these challenges, the MBS market remains highly active, with massive liquidity. The Federal Reserve bought many MBS during the crisis and has gradually sold them off. As such, the market has shifted from traditional bank and Fed holdings to money managers and other institutional investors. This change is partly because of new regulations and the Fed's [quantitative tightening](https://www.investopedia.com/quantitative-tightening-6361478) program.

MBS spreads, the gap between investor rates and 10-year Treasurys, nearly doubled from pre-pandemic levels by 2023 but began narrowing in the mid-2020s. This means investors have wanted less compensation for taking them on, suggesting more confidence in the quality of these securities. However, there's also been a more limited supply of MBS, given the high interest rates.

## What’s the Relationship Between MBS and a Bank?

Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS.

The bank records the sale as a plus on its balance sheet and loses nothing if the homebuyer defaults sometime down the road. This process works for all concerned as long as everyone does what they’re supposed to do: The bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time; and the credit rating agencies that review MBS perform due diligence.

## What Is an Asset-Backed Security (ABS)?

An ABS is a type of financial investment collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time until maturity.

For income-seeking investors, ABSs can be an alternative to other debt instruments, like corporate bonds or bond funds. ABSs allow issuers to raise cash that can be used for lending or other investment purposes.

## What Role Do Mortgage Servicers Play in the MBS Market?

Mortgage servicers have a major role in the MBS market by managing the day-to-day administration of the mortgage loans within the pool. They are responsible for collecting monthly mortgage payments from borrowers, managing escrow accounts, handling delinquencies, and ensuring that investors receive their scheduled payments.

## The Bottom Line

Mortgage-backed securities (MBS) represent a unique way for investors to earn income from homeowners' mortgage payments. Agency MBS, backed by government guarantees, have experienced significant growth and offer relatively low-risk returns. However, the market's potential volatility requires vigilance due to risks like prepayment, interest rate changes, and liquidity challenges. For investors, staying informed about the evolving MBS landscape and understanding these risks is essential for making informed decisions about including MBS in their portfolios.  

> **Article Sources**
>
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>     
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