What Are Mortgage-Backed Securities?

As a trusted personal finance writer and mortgage specialist, Maryalene LaPonsie has interviewed hundreds of certified financial planners, CPAs and wealth advisors, and distills their expertise into accessible articles on topics ranging from retirement planning to tax-saving strategies. She is a regular contributor to multiple financial publications, and her work has been syndicated nationwide.

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Maryalene LaPonsieMortgages Expert

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Deborah KearnsMortgages Expert

With two decades of experience as a respected journalist and communications leader in the mortgage field, Deborah Kearns is passionate about helping consumers make smart homeownership and personal finance decisions. Her work has appeared in The New York Times, USA Today, Associated Press, Forbes Advsior, Yahoo Finance, CNBC, MarketWatch, Money, NerdWallet and Bankrate. She has held several leadership roles in digital newsrooms and with top mortgage and real estate companies.

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Deborah KearnsMortgages Expert

Mortgages Expert

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Updated: Jun 9, 2023, 2:19pm

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Mortgage-backed securities (MBS) can be an attractive option if you want to invest in the real estate market without owning property. They are investments secured by a pool of mortgages that are bought and sold on the secondary market. This avenue generally comes with minimal risk and can provide ongoing cash flow.

Understanding Mortgage-backed Securities

Mortgage-backed securities were first offered in 1968. Those early securities were issued by private entities, but by 1970, government-backed MBS were available from the Government National Mortgage Association, better known as Ginnie Mae today.

Now, investors can buy MBS in one of two ways:

Agency MBS. An agency MBS is issued by Ginnie Mae, Freddie Mac and Fannie Mae. These agencies provide certain guarantees to investors, and their MBS are considered relatively safe and low-risk investments.
Non-agency MBS. A non-agency MBS comes from a private financial institution, such as a bank. The loans included in these securities are typically non-conforming loans that come with greater risk. These investments may not be advisable for most individual investors.

How Mortgage-backed Securities Work

Mortgage-backed securities enable lenders to sell mortgages to investors, regardless if it’s an agency or non-agency MBS. Once a loan has been placed in an MBS, the original lender may collect payments, but investors receive the cash flow.

For example, Bank A may approve a mortgage and originate the loan. Then, that loan is sold to an aggregator, such as Fannie or Freddie. Those aggregators create an MBS that contains many mortgages, and investors can buy into that security. Bank A continues to service the loan, earning a fee for collecting payments and managing the account, while investors receive the principal and interest.

By selling loans for MBS, banks and finance companies can free up capital that will allow them to lend more money to borrowers. Meanwhile, since agency MBS come with certain guarantees, there’s relatively little risk to investors, although that isn’t to say there is no risk.

How Mortgage-backed Securities Affect Mortgage Rates

People often think of the federal funds rate, which is set by the Federal Reserve, as the main driver of mortgage rates. However, MBS may be just as influential.

Banks consider how much profit they can make by selling loans for MBS when setting their rates. If the price of MBS drops, banks may raise their rates to compensate. Likewise, they may be inclined to lower rates to attract borrowers when MBS prices are high.

Types of Mortgage-backed Securities

Mortgage-backed securities can be structured in different ways. Investors should understand the following three types of MBS to ensure they’re making a purchase that fits with their risk tolerance and cash flow needs.

Pass-throughs

These MBS have a straightforward structure. All investors receive a share of principal and interest payments made on a pool of mortgages. These mortgages typically all share similar characteristics and terms.

Collateralized Mortgage Obligations

With collateralized mortgage obligations, commonly called CMOs, the process of determining investor payouts becomes more complex.

With a CMO, mortgages with a variety of terms are brought together and then split up to create classes of securities that can create different levels of income. They’re typically for the investor who wants a very specific type of cash flow.

CMOs are separated into what are called tranches. Each tranche generally has its own level of risk and coupon rate. Those invested in high-risk tranches may not receive income until those in other classes have received their payments first.

Stripped Mortgage-backed Securities

Stripped mortgage-backed securities (SMBS) splits payments into principal-only and interest-only classes. The value of these securities is more sensitive to interest rate changes than other MBS types.

Principal-only strips from MBS tend to provide greater yields when interest rates are low while interest-only strips benefit from rising mortgage rates. Investors who purchase SMBS may buy a mix of principal-only and interest-only strips for their portfolio.

Why Borrowers Should Care About Mortgage-backed Securities

Most borrowers will never know that their mortgage is part of an MBS, but they likely have benefited from these securities. Selling mortgages to the secondary market allows banks to have the capital to continue offering loans to new homeowners, according to Ginnie Mae.

MBS transfers the risk associated with a mortgage from a single institution and spreads it across a group of investors. So long as the mortgages are sound, the system is a win-win scenario with borrowers having more access to loans and banks and investors both profiting from them.