A mortgage-backed security (MBS) is a debt instrument that represents a claim on the cash flows from a pool of mortgage loans. A lender or sponsor gathers many individual loans, transfers them to a separate legal vehicle, and that vehicle issues securities to investors. The monthly interest and principal paid by the homeowners or property owners, after deduction of servicing and guarantee fees, is passed on to the holders. MBS allow lenders to turn illiquid loans into cash that can fund new lending, and they give investors access to mortgage credit without originating loans themselves.
MBS are the largest category of asset-backed security in the broad sense, although in market usage the two labels are kept apart, with the latter reserved for pools of other assets such as car loans and credit card balances. The United States has by far the largest market, built around government-sponsored guarantors.
How an MBS is created
The process is a form of securitisation. An originator makes each mortgage loan and sells it, directly or through an aggregator, to an issuing trust or special purpose vehicle. The transfer is structured so that the loans are legally isolated from the seller, meaning that the seller's insolvency does not affect investors. The vehicle issues securities backed by the pool and uses the proceeds to pay for the loans.
After issuance, a servicer collects payments from borrowers and remits them through a trustee to investors. The servicer's role, and the separate asset it gives rise to, is described under mortgage servicing rights. Investors rely on pool-level data, such as loan sizes, interest rates, borrower credit scores and the loan-to-value ratio, rather than on knowledge of individual borrowers.
Main types
MBS are classified by who stands behind them, by the kind of property and by structure:
- Agency MBS. These are issued or guaranteed by Fannie Mae or Freddie Mac, or guaranteed by the government agency Ginnie Mae. The guarantor promises timely payment of principal and interest, so investors bear little credit risk. Ginnie Mae guaranteed the first modern pass-through security in 1970.
- Non-agency MBS. Also called private-label, these are issued by banks and other firms without such a guarantee, and they rely on credit enhancement within the structure to protect senior investors.
- Residential and commercial. Residential mortgage-backed securities are backed by home loans, and commercial mortgage-backed securities by loans on offices, shops, hotels and similar property.
- Pass-throughs and structured classes. In a pass-through, every investor receives a proportional share of all payments. A collateralised mortgage obligation instead divides the cash flows into classes with different maturities or priorities.
Prepayment and other risks
The distinctive risk of an MBS is uncertainty about timing. Most residential borrowers may repay early without penalty, and they do so when they move house or when interest rates fall and refinancing becomes attractive. Prepayment returns principal to investors just when reinvestment rates are low. When rates rise, the opposite happens: prepayments slow, the security lasts longer than expected, and investors are locked into a below-market return. These are known as contraction risk and extension risk.
The result is that an MBS gains less than an ordinary bond when rates fall and loses more when they rise, a property called negative convexity, for which investors demand a higher yield than on government bonds. Analysts model prepayment speeds using standard conventions and compare securities on that basis.
Credit risk matters where there is no guarantee. Losses arise when borrowers default and the sale of the property does not cover the debt. Non-agency structures allocate these losses through tranching, so that junior classes absorb them first.
Role in the 2007 to 2009 financial crisis
In the years before 2007, issuance of private-label MBS backed by subprime and other weakly underwritten loans grew rapidly in the United States. Many of the lower-rated classes were repackaged into collateralised debt obligations, and large amounts were held by banks and funded with short-term borrowing. When house prices fell and defaults rose, securities that had carried high credit ratings suffered heavy losses, their market froze, and the institutions holding them faced funding runs. Fannie Mae and Freddie Mac were placed into government conservatorship in September 2008.
Reforms followed. The Dodd-Frank Act introduced ability-to-repay standards for lenders and risk retention for securitisers, and the European Union adopted similar retention and transparency rules. Private-label issuance has remained far below its earlier peak, while the agency market has continued to dominate.
Central banks and investors
Agency MBS are held by banks, pension funds, insurers, mutual funds, foreign official institutions and specialised real estate investment trusts. The Federal Reserve became a very large holder through its asset purchase programmes from 2008 onwards and during the pandemic, buying MBS to lower mortgage rates, and has since allowed its holdings to run down.