Mortgage-Backed Securities Explained Simply

A mortgage-backed security (MBS) is a bond whose payments come from a pool of home loans. Instead of a lender holding each mortgage until it is repaid, many loans are bundled together, and investors buy shares in the stream of principal and interest that borrowers pay every month. The idea turns a slow, local loan into something that can be traded.

An MBS is the building block behind several of the products discussed on this site, including those covered in CDS and CDOs explained. This article describes the mechanics. It is general education only and not financial advice.

Start with one mortgage

A borrower takes a mortgage and repays it monthly. Each payment has two parts: interest, which is the lender’s charge for the loan, and principal, which reduces the amount owed. In the early years of a typical repayment schedule most of the payment is interest; later, more of it is principal.

For the lender, a mortgage ties up money for years. Selling the payments frees that money for more lending, which is the commercial logic of securitisation.

From loans to a security

According to Wikipedia’s article on mortgage-backed securities, an MBS is an asset-backed security secured by a mortgage or a pool of mortgages. The steps are:

1. Originate. Lenders make many mortgages.
2. Pool. A sponsor gathers loans with similar features into a pool.
3. Issue. Securities are created that give investors claims on the pool’s payments.
4. Service. A servicer collects monthly payments from borrowers, passes them on and handles missed payments.

In the simplest design, the pass-through, interest and principal from borrowers are passed to the holders. The rate paid to investors is almost always lower than the average rate on the underlying loans, because the difference covers servicing costs. Because principal is repaid with each payment, the face value of the security falls over time.

Who issued them

Two broad groups issued mortgage-backed securities.

• Agency securities come from Ginnie Mae, Fannie Mae and Freddie Mac. Ginnie Mae’s guarantee is backed by the full faith and credit of the US government, according to the same article. Wikipedia dates Ginnie Mae’s first guaranteed pass-through to 1968, Freddie Mac’s first to 1971 and Fannie Mae’s to 1981.
• Private-label securities come from banks and investment banks. Wikipedia says their issuance rose sharply between 2001 and 2007, then ended abruptly in 2008. The Federal Reserve’s history of the crisis states that private-label securities supplied most of the funding for subprime mortgages.

That difference mattered. Agency pools carried some form of guarantee against borrower default, while private-label pools depended on the structure of the deal and on the credit ratings assigned to it.

Tranches: slicing the same pool

Many securities were divided into tranches, each with a different priority in the repayment stream. The investor.gov glossary explains that, in structures called collateralised mortgage obligations, principal and interest from the pool go to different classes under an order of priority, and each class may have different balances, coupon rates, prepayment risks and maturity dates.

A simple, hypothetical illustration shows how the ordering works. Suppose a pool is divided into three tranches. Senior investors are paid first, mezzanine investors second, and the junior tranche last. If a few borrowers fail to pay, the junior tranche absorbs the first losses. Only when losses are much larger do the mezzanine and then senior holders feel them. The senior tranche gets a lower interest rate in return for its protected position, and the junior tranche earns more because it carries more risk. The numbers here are invented to show the principle.

The Federal Reserve history notes that some securities were viewed as low-risk because other securities would take losses first. That protection only works if the pool’s losses stay within the range the designers expected.

Two kinds of risk

Prepayment risk

Homeowners can repay early, especially when interest rates fall and they refinance. Investors then get their principal back when rates are lower, and may be unable to reinvest it at the same return. The investor.gov glossary names this as the main concern in these securities.

Credit risk

This is the risk that borrowers fail to pay. For agency securities, a guarantee covers much of it. For private-label securities, it depends on the quality of the loans and the structure. Investors in these securities may also face market and liquidity risks, according to the same glossary.

Where things went wrong in 2007 and 2008

The Federal Reserve’s account describes how the system worked while house prices rose: rising prices kept losses low. When prices peaked, borrowers found it harder to refinance or sell, and mortgage losses climbed. Many private-label securities were downgraded to high risk and several subprime lenders closed. The bond funding for subprime mortgages collapsed, lenders stopped making such loans and falling demand pushed prices lower still. The Fed also notes that the riskiness of these securities may not have been well understood.

The wider course of events is covered in the financial crisis timeline.

What the structure does and does not do

Securitisation spreads risk but does not remove it. It can also make risk harder to see, because the investor holds a claim on a pool, not a loan they can inspect.

Frequently asked questions

Is a mortgage-backed security a bond?

It works like one, paying regular amounts to holders, but the payments depend on borrowers’ mortgage payments. The amount and timing can change because of prepayments and defaults.

What is the difference between agency and private-label securities?

Agency securities are issued or guaranteed through Ginnie Mae, Fannie Mae or Freddie Mac. Private-label securities are issued by private institutions and have no such guarantee.

What is a tranche?

A slice of a security with a particular priority in receiving payments and absorbing losses. Senior tranches are paid first, junior tranches last.

Are mortgage-backed securities still used?

Yes. They remain a large part of mortgage finance, and the market for high-quality ones recovered after the crisis, according to Wikipedia. Rules and market conditions change, so check official sources for current details.

Note

This article is general education. It does not recommend buying or selling any security and makes no promise about returns. Anyone considering an investment should consult a qualified adviser and read the official disclosures.