A mortgage-backed security (MBS) is a fixed-income security whose payments come from a pool of mortgages. Investors receive cash flows funded by homeowners’ principal and interest payments (minus fees), so the security’s value depends on interest rates, borrower behavior, and credit performance.
How An MBS Is Created (Securitization)
The basic securitization chain is:
- Origination: lenders make mortgages to households.
- Pooling: many loans are bundled together to diversify idiosyncratic default risk.
- Issuance: the pool is placed into a legal structure (often an SPV/trust) that issues securities to investors.
- Servicing: a servicer collects payments and handles delinquencies/foreclosures.
Two broad families matter economically:
- Agency MBS: mortgages are guaranteed (or effectively guaranteed) against credit losses by a government agency or a government-sponsored channel. Credit risk is muted; interest-rate and prepayment risk dominate.
- Non-agency (private-label) MBS: investors bear more direct credit risk and rely on structural protections and underwriting quality.
Pass-Throughs vs. Tranches
An MBS can be structured in different ways:
- Pass-through MBS: investors receive a pro-rata share of the pool’s cash flows.
- Tranche structures (CMO-style): cash flows are “sliced” into securities with different rules. Some tranches get paid first and have shorter expected lives; others absorb more timing risk and may offer higher yields.
Tranching can redistribute risk, but it does not eliminate it. It also introduces complexity and model dependence (valuations depend on assumptions about defaults and prepayments).
Key Risks In Mortgage-Backed Securities
Prepayment and extension risk (timing risk)
Most mortgages allow borrowers to prepay (for example, by refinancing).
- When market rates fall, refinancing becomes attractive, prepayments speed up, and investors get principal back sooner than expected (shorter life, reinvestment at lower rates).
- When market rates rise, prepayments slow, the security’s life extends, and investors are locked into below-market coupons for longer (duration extends).
This embedded prepayment option creates negative convexity: price gains are capped when rates fall, and price losses can be larger when rates rise.
Credit and underwriting risk (especially non-agency)
If borrowers default and collateral values fall, investors can face losses. Credit enhancement (overcollateralization, subordination, guarantees) can reduce but not remove this risk.
Liquidity and systemic risk
When funding markets tighten, even high-quality securitized products can become hard to trade. If institutions are highly leveraged, forced selling can amplify stress.
Why MBS Matter For The Economy
MBS markets are tightly connected to macroeconomic outcomes:
- They shape the cost and availability of mortgage credit, which affects housing demand and construction.
- They influence how monetary policy transmits to long-term borrowing rates.
- Poor underwriting incentives and opaque structures can contribute to credit booms and busts, as the 2007-2008 crisis illustrated.
Related Terms
- Securitization
- Asset-Backed Security
- Tranche
- Collateralized Debt Obligation
- Credit Default Swap
- Mortgage
- Sub-Prime Mortgage
- Yield Curve
- Yield Spread
- Default