What Are Mortgage-Backed Securities?

Definition of mortgage-backed securities

Mortgage-backed securities are investment products backed by pools of mortgage loans. Lenders bundle multiple home loans together and sell them to government agencies or financial institutions, which then use these mortgages as collateral to issue MBSs. Investors buy these securities on the bond market and receive payments based on the homeowners’ mortgage repayments.

Unlike traditional bonds, which typically pay interest semiannually, MBSs often provide monthly payments that include both principal and interest. This structure can create a steady income stream for investors, but it also introduces unique risks such as early repayment or homeowner defaults.

Most MBSs are issued by Ginnie Mae, a U.S. government agency, or by Fannie Mae and Freddie Mac, which are government-sponsored enterprises. Private financial institutions, such as investment banks, may also create MBSs; however, government-backed securities are more common.

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History and evolution of mortgage-backed securities

Mortgage-backed securities were first created in the late 1960s to make home loans more accessible and attract investors to the housing market.

The government formed Ginnie Mae in 1968 to guarantee the first mortgage-backed securities backed by federally insured loans. Later, Fannie Mae and Freddie Mac began issuing their own MBSs to help expand mortgage lending nationwide.

How did MBSs contribute to the financial crisis?

As demand for these investments grew, private financial institutions began creating their own versions in the 1990s and early 2000s. To stay competitive, many lenders lowered their lending standards.

Banks and financial institutions were regulated, but MBSs weren’t, and many risky home loans were bundled into these investments. When large numbers of borrowers defaulted, it helped trigger the 2008 financial crisis.

Where do MBSs stand today?

Today, MBSs are considered relatively safe investments, thanks to new rules and oversight introduced after the 2008 financial crisis. The Dodd-Frank Act and similar regulations strengthened lending standards and improved transparency. The mortgage industry is now more heavily regulated to protect both borrowers and investors.

Role of MBSs in financial markets and the economy

Mortgage-backed securities play a major role in keeping the housing and financial markets running smoothly. By connecting lenders, investors and borrowers, they help make mortgage money more available and affordable.

When lenders sell mortgages to create MBSs, they free up cash to issue new loans. This process, called liquidity, keeps mortgage credit flowing so more people can buy homes without waiting for banks to recover funds from existing loans.

Here’s how MBSs help the broader economy:

• Provide liquidity: Banks and lenders can quickly turn mortgage debt into cash, which helps stabilize the housing market.
• Attract global investment: MBSs give investors around the world a way to earn income from U.S. real estate without directly owning property.
• Influence mortgage rates: When demand for MBSs is strong, interest rates on home loans tend to fall. When demand drops, rates often rise.
• Support financial stability: Government-backed MBSs from Fannie Mae, Freddie Mac and Ginnie Mae create confidence in the mortgage system, even during economic downturns.

How mortgage-backed securities work

MBSs are investment vehicles for individuals, and they can also be profitable for lenders. When you take out a mortgage loan at your bank, the bank handles the application process and the initial servicing of the loan. It could continue to collect your principal and interest payments, or it may sell your loan (along with many others) to investors.

Selling loans packaged as MBSs places cash back into the lender’s hands to use on other loan opportunities. The bank still makes money by collecting loan origination fees and interest payments. It also lowers the bank’s overall risk profile by selling off loans with 15- and 30-year terms.

The securitization process

Here’s a simplified look at how mortgage-backed securities are created:

1. Loan origination: Homebuyers take out mortgages from banks or other lenders.
2. Aggregation: Lenders bundle similar mortgages together based on type, size and risk level.
3. Securitization: These mortgage bundles are sold to government agencies (like Fannie Mae, Freddie Mac or Ginnie Mae) or private financial firms, which create a trust to hold the loans.
4. Issuance: The trust turns these loans into tradable securities (mortgage-backed securities) and sells them to investors.
5. Ongoing servicing: Even after being sold, a servicer continues collecting monthly payments from homeowners and forwards them to investors.

This process allows lenders to recover funds quickly, issue more home loans and keep the housing market moving.

Payment flow and oversight

Once the MBS is created, the payment flow begins:

• Homeowners make their monthly mortgage payments to the loan servicer.
• The servicer collects principal and interest, takes a small servicing fee and sends the rest to investors.
• Trustees and regulators oversee the process to ensure investors are paid correctly and that loans meet compliance standards.

This setup gives investors a steady income stream while helping lenders keep funds available for new borrowers.

Mortgage-backed securities for investors

Savvy investors may choose to purchase MBSs for their potential to earn higher yields than other bond investments (such as treasury bonds) offer. MBSs are considered a relatively safe investment compared to stocks because they’re typically tied to fixed-rate mortgages. These loans are also vetted and backed by GSEs.

With any loan, however, there’s always a risk of default. If a large number of loans within an MBS are in default, the investor won’t make money from a borrower’s interest and principal payments.

On the flip side, the investor could lose the opportunity to earn interest payments if the borrower pays off the mortgage loan earlier than expected or decides to refinance with another lender.

Mortgage-backed securities for buyers

Look for a lender that services its own loans if you want to work with the same company through the life of your mortgage.

If your mortgage is sold as an MBS, your loan terms won’t change, and you’ll continue to make monthly mortgage payments (often to a new servicer, however). Your financial institution is required to alert you of any changes to your loan status by sending a transfer notice. If your loan has been sold, pay close attention to any payment instructions included in the document.

Some lenders don’t sell their mortgage loans; credit unions and small community banks are more likely to continue to service your loan until the term ends. If working with the same lender is important to you, be sure to ask potential lenders if they resell their mortgage loans before you enter into a loan agreement.

» MORE: 9 mortgage questions to ask your lender

Types of mortgage-backed securities

There are three different structures of mortgage-backed securities: pass-throughs, stripped MBSs and collateralized mortgage obligations. These differ in how the loans are packaged and sold as MBSs. MBSs can also be classified by asset class (residential versus commercial).

Pass-throughs

With pass-throughs, the MBS issuer collects monthly mortgage payments from borrowers and then distributes a portion of that cash (both principal and interest payments) to the bondholders. Most of the mortgages pooled are fixed-rate loans, although some could have adjustable rates.

The maturity dates can vary — usually between five, 15 and 30 years. For the most part, mortgages in pass-throughs are similar in nature, so the income is more predictable.

Stripped mortgage-backed securities

Stripped mortgage-backed securities (SMBSs) split the borrower’s monthly payments into interest and principal groups. If an investor isn’t interested in a pass-through because of the upfront investment required, an SMBS may be more appealing. They can choose to invest in either the interest or the principal payments of the loan.

Collateralized mortgage obligations

Collateralized mortgage obligations (CMOs) are made up of mortgages with varying loan terms. Similar mortgages within a CMO are grouped together and called a “tranche”; each CMO may comprise many tranches. These tranches also have different rules regarding principal and interest payments, so the income from CMOs can be less reliable than that of pass-throughs.

Residential vs. commercial MBSs

Residential mortgage-backed securities (RMBS) are backed by home loans made to individual borrowers. This is the most common type of MBS and includes fixed-rate or adjustable-rate mortgages for single-family homes. Because they’re tied to the housing market, RMBS performance depends on factors like home prices, borrower credit quality and interest rate trends.

Commercial mortgage-backed securities (CMBS), on the other hand, are backed by loans on commercial properties, such as office buildings, shopping centers or apartment complexes. CMBS investors often face different risks, including fluctuations in rental income and commercial real estate values.