What is a Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is a type of an asset-backed security where the cash flows are backed by the interest and principal payments of a set of mortgage loans.

Mortgage-backed securities have become very popular among financial institutions looking for opportunities to invest in their communities, especially having in mind the benefits they provide to investors such as yield, liquidity, and capital management flexibility. Thus, investors in MBSs include banks, insurance companies, pension funds, corporations, etc.

However, mortgages can be paid off in their entirety earlier (prepayment) or more than the required monthly payment can be made (curtailment). This affects the remaining loan principal and makes the precise prediction of the monthly cash flow of an MBS impossible, which creates additional risk to MBS investors.

Understanding How an MBS Works

Lenders group similar mortgage loans they have originated into "pools of mortgages" and then provide them to organizations like Fannie Mae and Freddie Mac which in turn securitize them.

When institutions like Fannie Mae, Freddie Mac and Ginnie Mae issue MBSs these MBSs are known as "agency" mortgage securities. Some private institutions also issue MBSs, and such mortgage securities are known as "private-label". Naturally, investors typically favor agency mortgage-backed securities because of their stronger guarantees and better liquidity.

Issuers or servicers of agency MBSs collect the monthly mortgage payments and then "pass through" the interest and principal to investors (therefore these pools are also known as mortgage pass-throughs). The mortgage-backed securities are further backed by the mortgaged properties.

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