A mortgage-backed securities (MBS) is a financial product backed by home loans. Banks and mortgage lenders issue these loans to homebuyers. Instead of keeping the loans, they sell them to financial institutions. 

These institutions bundle many loans together and sell shares to investors. Institutions such as investment banks or government agencies buy mortgages, package them into an MBS, and sell them to individual investors.

The bank acts as the middleman between MBS investors and home buyers. Typical buyers of MBS include individual investors, corporations, and institutional investors.

A mortgage contained in an MBS must have originated from an authorised financial institution and Investors earn returns from the mortgage payments made by homeowners.

Types of Mortgage-Backed Securities

There are two main types of MBS, and they include

Pass-Through Securities:
They are the simplest form of MBS, and it comes with a specific maturity date, but the average life may be less than the stated maturity age.

These securities give investors a share of the mortgage payments collected from homeowners. The structure functions as a trust, ensuring principal and interest payments pass through to investors.

The trust that sells pass-through MBS is taxed under the grantor trust rules, which dictate that the holders of the pass-through certificates should be taxed as the direct owners of the trust apportioned to the certificate.

Collateralised Mortgage Obligations (CMOs):
CMOs divide mortgages into risk levels known as slices or tranches and credit ratings are given to each slice, and they determine the return on investment for investors.

Each tranche comes with different maturities and priorities in the receipt of the principal and the interest.

The least risky tranches offer the lowest interest rates, while the riskier tranches come with higher interest rates and, thus, are generally more preferred by investors.

How a Mortgage-Backed Security Works

The process follows these steps:

Banks issue mortgages:

A financial institution, such as a bank, provides mortgages to homebuyers. These loans are secured by the properties being bought.

Let say  you want to buy a home, you approach a bank to give you a mortgage. If the bank confirms that you are creditworthy, it will deposit the money into your account. You must make periodic payments to the bank according to your mortgage agreement.

The bank may choose to collect the principal and interest payments, or it may opt to sell the mortgage to another financial institution.

Loans are pooled together

Financial institutions buy these loans and bundle them into a mortgage pool. The loans in the pool typically have similar characteristics, such as interest rates and maturity dates.

If the bank decides to sell the mortgage to another bank, government institution, or private entity, it will use the proceeds from the sale to make new loans.

MBS is created and sold
The pool is converted into securities, which are sold to investors.

Investors receive payments
As homeowners pay their mortgages, investors earn a share of the payments. MBS allows banks to free up money for more loans, helping the housing market grow. However, risks exist, especially if homeowners default on payments.

Related Terms

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