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What Are Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are financial instruments that pool several mortgages, divide the pool into shares, and sell the shares to investors. Each MBS is part of a larger bundle of real estate debt or home loans that investors acquire from government agencies or banks that issue the loans to lenders. An MBS is usually traded in the secondary market, allowing third-party investors to benefit from the real estate industry without dealing directly with mortgagors or selling or buying properties. A secondary market refers to a market where financial instruments like stocks, bonds, mortgages, and derivatives that have already been issued are acquired by an investor.

By purchasing an MBS, investors directly or indirectly lend money to property buyers. In an MBS, banks or financial institutions often function as middlemen between mortgagors and investors. Selling their mortgages makes financial institutions more liquid, enabling them to offer more real estate loans.

The formation of a typical MBS involves a series of steps. First, the financial institution provides a real estate loan to the mortgagor or home buyer. The financial institution, in conjunction with other financial institutions, pulls these loans together. To be part of a pool, the loans must have common characteristics. For instance, they should have similar maturity dates and interest rates. After the financial institutions pool the loans, a government agency, a trust, or a financial institution buys the mortgages, bundles them, and sells them to investors.

MBS investors receive monthly payments. The mortgage servicer is the administrative manager of the MBS and is responsible for administrative duties such as recovering loan payments from defaulters.

Government-sponsored enterprises (GSE) such as Ginnie Mae and Fannie Mae fund an agency MBS. Private entities issue the non-agency MBS. Because a non-agency MBS is not government-guaranteed, it usually has more risk and corresponding higher yields.

In addition to these categorizations, there are different types of MBSs. They are collateralized mortgage obligations, residential mortgage-backed securities, stripped mortgage-backed securities, and pass-through mortgage-backed securities.

Collateralized mortgage obligations contain different pools of securities called tranches. Every tranche has unique priorities, maturities, and credit ratings. The tranche with the most risk has the highest interest rate, while tranches with less risk have lower interest rates.

Mortgage loans usually back a residential MBS for condos or single-family homes. The risk with this MBS varies and largely depends on the issuer and underlying mortgage. Stripped mortgage-backed securities are usually divided or split into interest-only or principal-only strips. This means that the investors can only get earnings or cash flow from either the interest or principal of the acquired mortgage, as opposed to acquiring cash flow from both. Investment bankers often issue this type of MBS and sell them to experienced investors with a good understanding of the intricacies of mortgage-backed securities.

Pass-through securities are structured like trusts. In this MBS, the principal and interest payments are remitted to the investor proportionately. So, if a mortgagor defaults on their payment, the investor's dividends are also affected. Under this type of MBS, the holder of the pass-through certificates gets charged as though they are the direct owner of the trust allotted to the certificate.

MBS usually has risks. If borrowers decide to pay off their loans early, the investor might not earn as much return as they had projected. Investors also have to deal with the likelihood of default on the part of the borrowers. If a handful of borrowers within the pool default, the investor will record significant losses.