What Is a Mortgage-Backed Security?

A 2023 SoFi poll revealed that nearly 54% of investors hold stocks in their portfolios. But only 26% hold bonds. In many cases, that’s attributable to the fact that bonds are generally a lower risk asset class, which results in more modest gains (and losses) than equities.

Whether you’re a seasoned investor looking to diversify your portfolio or a novice investor interested in understanding various asset classes, it’s worthwhile learning about how a mortgage-backed security (MBS) operates. For income-oriented investors, an MBS typically offers higher yields than government bonds while still providing low risk.

Read on to learn more about what an MBS is, how it works and whether or not it aligns with your personal finance goals.

What is a mortgage-backed security?

An MBS is an asset-backed security that functions similar to a bond. They gained popularity in the United States beginning in the mid-20th century and were originally introduced to increase the liquidity of the mortgage market. MBSs became a source of funding for lenders, thereby enabling homeownership to expand in the U.S.

These financial debt instruments are securitized and offered to investors as shares of a pool of mortgages that pay regular interest until the loans on the underlying assets are satisfied. MBSs are bought and sold on the secondary market, and are often offered by government-sponsored enterprises like Fannie Mae, Freddie Mac and Ginnie Mae, which buy mortgages in order to make homeownership more accessible, and then sell shares of MBSs.

How do mortgage-backed securities work?

An MBS begins with mortgage origination. Homebuyers take out mortgage loans from lenders. Those lenders typically do not hold onto the mortgage, and instead sell it on the secondary market.

When enterprises purchase these loans, they pool them before they are securitized, or converted in order to be marketable to investors. These mortgage pools are divided into tranches, categories based on criteria such as interest rates, overall risk and expected maturity dates.

Once securitization is complete, the MBS can be sold to investors in shares. MBS shareholders receive regular installments of interest that are generated from the payments made by the homeowners in the underlying mortgage pool.

Types of mortgage-backed securities

There are two types of MBSs. The following section provides information about each.

Pass-through MBS

With a pass-through MBS, the issuer collects monthly payments from the mortgage pool and then passes on a share of the principal and interest to bondholders. Investors receive a monthly proportionate distribution of principal and interest payments collected from homeowners. These distributions continue until homeowners in the mortgage pool satisfy their debts in full.

Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a repackaged collection of pass-through MBSs. CMOs take the mortgage pools from pass-through MBSs and categorize them based on terms, interest rates and time horizons for repayment of principal amounts. These categories of bond classes are known as tranches — an important distinction between CMOs and pass-through MBSs.

Beyond the protections provided by a pass-through MBS, CMO tranches offer bondholders additional protection from prepayment risk. By redirecting cash flows of principal and interest into these tranches while still offering high yields, tranches provide investors with a more predictable payment schedule.

CMOs offer various tranches to provide investors with a choice of risk profiles and repayment terms. Someone who wants higher returns and has a higher risk tolerance can invest in tranches with higher yields that take longer to mature but which could be subject to interest rate changes or prepayment risk. A more risk-averse investor might choose a short-term tranche that has less yield but a faster return. Tranches are also categorized in terms of priority of payments, with senior tranches being paid interest from the CMO before junior tranches.

Pros and cons of mortgage-backed securities

Like any investment, there are pros and cons to consider before committing your funds to mortgage-backed securities. The following section discusses some of the benefits and drawbacks of MBSs.

Pros of mortgage-backed securities

Low-risk investments

Because an MBS is backed by tangible assets, it is considered a lower-risk investment compared to some other asset classes. An MBS holds the underlying physical real estate or real property associated with the mortgages as collateral. Mortgage delinquency rates recently fell to an all-time low, further supporting the safety of MBSs.

Higher yields than U.S. government bonds

While a Treasury bond is lower risk than an MBS, it only pays interest and typically does so semi-annually. Yields for an MBS are generally higher and bondholders receive income monthly. Additionally, with an MBS, investors collect recurring interest payments as well as principal repayment.

Portfolio diversification and investment income

An MBS can help investors diversify their portfolios while also providing safety. MBSs provide exposure to the real estate and mortgage markets. They’re treated as bonds, which are typically more stable than equities and therefore are generally safer investments. Bond prices tend to be stable and predictable, making them a desirable asset to include in a well-diversified portfolio, which can hedge against potential downside in equity holdings.

Additionally, an MBS is an attractive option to income investors who are looking to generate regular and recurring yield. Since an MBS produces reliable and easily calculable monthly interest payments, it can be used as part of a blended income strategy.

Cons of mortgage-backed securities

Prepayment risk

One of the biggest risks of investing in an MBS is the possibility of prepayment — when homeowners repay the outstanding balances on their mortgages sooner than expected. This reduces the amount of interest a mortgage pool produces, thereby reducing the income paid to MBS bondholders. Additionally, when interest rates fall and mortgage refinancing becomes more attractive, prepayment risk increases.

Borrower default risk

MBSs are widely considered low-risk investments. Nonetheless, they can still face some default risk. If homeowners are delinquent on their mortgage payments and end up in default on their home loans, issuers and bondholders are protected because physical real estate is used as collateral for the loans. However, loss of collateral can occur if a homeowner defaults and the sale of the underlying real property is insufficient in covering the loss.

Interest rate risk

Mortgage rates have an inverse relationship with MBSs: Whenever interest rates rise, MBS prices typically fall. Conversely, when interest rates fall, MBS prices usually increase. Therefore, in a high interest rate environment like we’ve seen since March 2022 when the Federal Reserve began its hiking cycle, MBS prices have moved lower.

Furthermore, when there are lower interest rates, lenders provide better terms and homeowners are often encouraged to refinance mortgages. This can reduce the number of years homeowners would be making mortgage payments and thereby potentially reduce the interest payments received by investors.

Role of mortgage-backed securities in the 2008 financial crisis

The root cause of the 2008 financial crisis was subprime mortgage lending — a practice that created greater credit risk by approving homebuyers with below-average credit scores for mortgages amid a housing market boom. The crisis was exacerbated by rampant speculation and a rapid emergence of mortgage securities to meet investor demand.

MBSs were one of these instruments that were used to meet the demand. The driving ideology was that by creating these securities, it would offset the risk associated with subprime mortgage lending. However, because the risks of these securities wasn’t understood well, it spread beyond the MBS market and throughout the financial system. Ultimately, it affected institutions with any exposure to the mortgage market, even if they weren’t directly involved in mortgage securitization.

These mortgage derivatives — like pass-through MBSs and CMOs — proved to worsen the situation. Rather than generating cash flow for MBS investors based on the actual mortgages in a pool, they began tracking the performance of mortgage securities, enabling speculation to worsen the crisis. Ultimately, this led to the most severe economic crisis since the Great Depression, with repercussions felt around the world.

Summary of Money's What Is a Mortgage-Backed Security?

Mortgage-backed securities (MBSs) are securitized debt instruments that pool mortgages and offer investors a means of receiving regular interest payments. MBSs are bought and sold on the secondary market after loan origination, bundled with similarly categorized mortgages and then marketed as either a pass-through MBS or a CMO. They face some risks, such as loan default, prepayment and interest rate adjustments, but are generally regarded as safe investment vehicles and are a good way to diversify a portfolio.