What Are Mortgage-Backed Securities?

Mortgage-backed securities (MBS or MBSs) received a bad rap for their role in the 2008 financial crisis. 

But in the years since, tighter regulations and stricter oversight have seen new, risk-adjusted MBSs enter the scene. These securitized debts promote homeownership, keep the mortgage market liquid and diversify investors’ portfolios.  

What are mortgage-backed securities, and how can you take advantage of them? (Or should you?) 

How Do Mortgage-Backed Securities Work?

Mortgage-backed securities are a type of asset-backed security created by pooling multiple residential mortgages together. 

After originating or buying enough loans, qualified mortgage lenders, banks or government-sponsored enterprises (GSEs) bundle them into one asset. Then, investors buy the newly securitized mortgage, often through brokerages, and profit from homeowners’ monthly payments. 

This setup allows investors to buy into the mortgage market without originating or owning whole mortgage loans. Meanwhile, their investments inject much-needed liquidity and stability into the housing market. 

The Process of Securitization

The securitization process starts when a mortgage lender originates individual mortgages. The lender then sells the mortgage loan to a qualified third-party entity, like Fannie Mae or Freddie Mac, or certain private financial companies. Selling the loan frees up cash flow so the original lender can underwrite more loans. In some cases, the mortgage lender may keep the loan and complete the next steps itself.

Next, the securitizing entity pools hundreds or thousands of loans and transforms the bundle into a tradable, interest-bearing security. Each security gives the owner the right to claim mortgage principal and interest payments. These payments are collected by mortgage servicers, who distribute the money to the IRS, investors and insurers.

The newly securitized asset is accredited by a credit rating agency and sold, often to a large investment bank. The buying entity may divide the MBS into “tranches,” or smaller segments, based on factors like quality, risk or interest rate.

Then, investors can buy into the MBS, usually through their broker, and earn interest paid by homeowners. 

Types of Mortgage-Backed Securities

There are several kinds of MBS available to investors, each with its own formats, benefits and risks. 

• Pass-through MBS: The quintessential MBS, these assets are structured into trusts. The trust collects mortgage payments from homeowners over 5-30 years, which then pass through to investors. Pass-through investors should beware of potential risks like homeowner defaults, early prepayment and interest rate risks that could impact their returns. 
• Collateralized mortgage obligations (CMOs): More complex than pass-throughs, CMOs consist of multiple tranches divided by interest rates, maturity dates or other factors. Each tranche receives a credit rating determining its rate of return. Investors may prefer CMOs because they can select assets that best fit their risk tolerance or investing goals. However, they should be aware of prepayment and interest rate risks. 
• Real estate mortgage investment conduits (REMICs): These special-purpose vehicles pool, securitize and sell mortgage-based assets (individual mortgages, tranches, bonds or others) on the secondary mortgage market. While some REMICs may suit risk-averse investors because of their structure, they’re still susceptible to prepayment, interest rate and credit risks.  

Benefits of Mortgage-Backed Securities

Mortgage-backed securities offer several advantages that ripple through the housing, lending and investing markets. 

On a general level, MBSs keep the housing industry flush by ensuring lenders have plenty of liquidity. Freeing up cash allows lenders to issue more loans and be choosier about which loans they sell. And the ability to sell off assets means non-bank lenders can more easily enter the market, increasing homebuyers' options. 

Facilitating mortgage lending, in turn, promotes individual homeownership. Increased loan availability keeps mortgage rates (relatively) low, which trickles into more affordable housing. Cheaper borrowing can also spark higher demand, spurring increased sales and new housing construction.

Investors benefit from MBS from perks like:

• Increased portfolio diversification
• Relatively low risk because of strict industry regulation
• Higher fixed interest rates than most government bonds pay
• Monthly payments instead of lump sums at maturity
• Relatively affordable buy-ins ($5,000-$10,000 compared to the price of a house)

However, MBS are only as safe as their underlying mortgages – assuming homeowners keep making payments.  

Risks and Considerations

While MBS are safer now than in the past, they’re still essentially large debts – and all debts present risks. 

To start, all MBS carry some credit risk (default risk), no matter how slight. When borrowers miss payments or stop paying entirely, investors lose valuable cash flow. 

Additionally, MBS are susceptible to interest rate risk, which occurs when interest rates fluctuate. High interest rates may see fewer people take out loans, causing housing values (and MBS returns) to decline. Lower interest rates may spike refinancing activity, which lowers the rate of return on individual mortgages. 

MBS investors also have to consider prepayment risk, which is the risk that homeowners will repay their mortgage early. Faster repayment translates to smaller principal, which means investors will collect less interest on the home loan. 

Current and future housing market conditions also impact MBS performance. In tight markets, houses sell faster – and often for higher prices – meaning that new MBS hit the market more frequently. But when fewer people buy, housing prices drop, potentially leading to smaller principals, an increase in defaults and foreclosures or both. 

Historical Significance and Role in the Financial Crisis

While modern mortgage-backed securities have plenty of benefits, it’s been a long road to overcoming their role in the 2008 financial crisis. 

In the early 2000s, mortgage lending exploded in the U.S. An overabundance of cheap credit and relaxed lending standards post-9/11 saw more banks offering subprime loans, which are loans to bad credit or unqualified borrowers. At the same time, housing prices spiked as the market heated up. These overpriced subprime mortgages were then packaged into mortgage-backed securities and sold globally. 

In 2006, housing prices peaked after the Fed hiked interest rates to combat the housing bubble. Soaring rates and falling home values saw many subprime borrowers fall behind on their mortgages, particularly borrowers with adjustable-rate or interest-only mortgages. As a result, they couldn’t make payments, refinance to a cheaper loan or even sell their houses. 

By July 2008, 21% of subprime borrowers fell delinquent, leaving MBS investors holding trillions in defaulted assets. Banks and investors panicked as they struggled to unload these bad debts, and many teetered on the edge of insolvency. Within months, the impacts of these delinquent debts rippled outward, kicking off the global financial crisis. 

Eventually, the U.S. Treasury stepped in with billions of bailout dollars, and the Federal Reserve bought trillions in MBS to stabilize the markets. After the crisis ended, the government tightened regulations on the financial industry, limiting subprime mortgage access and regulating MBS activities. 

Current Market Trends and Outlook

Thanks to increased regulation after the Great Recession, today’s mortgage-backed securities are generally safer than their predecessors. But the impacts of the Great Recession still resound today. 

In fact, it’s only within the last few years that the Federal Reserve has begun exiting the MBS market. The Fed has also hiked interest rates 11 times in two years, more than doubling the 30-year rate to 7.75% in just three years. 

While the combination of high rates and prices bodes well for newly issued MBS, the combination has seen parts of the housing market slow. Fewer home sales have already translated into fewer new mortgage securitizations in 2023, though investors still find their relatively high yields attractive. 

No Debt Security is Risk-Free

Mortgage-backed securities provide investors with a unique chance to profit from a historically resilient housing market in the U.S. Despite their profit potential, these debt-based assets still carry substantial risks, particularly for smaller investors. Like always, it’s essential to vet the potential risks and rewards of any security before buying. 

Frequently Asked Questions