Mortgage-Backed Security (MBS)

A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.

Mortgage-backed security (MBS) is a variation of an asset-backed security but one that is formed by pooling together mortgages exclusively. The investor who buys a mortgage-backed security is essentially lending money to home buyers. An MBS can be bought and sold through a broker. The minimum investment varies between issuers.

As became glaringly obvious in the subprime mortgage meltdown of 2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up. An MBS may also be called a mortgage-related security or a mortgage pass-through.

Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on its balance sheet and loses nothing if the homebuyer defaults sometime down the road.

This process works for all concerned as everyone does what they're supposed to do. That is, the bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time, and the credit rating agencies that review MBS perform due diligence.

In order to be sold on the markets today, an MBS must be issued by a government-sponsored enterprise (GSE) or a private financial company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings issued by an accredited credit rating agency.

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations (CMO).

Pass-Throughs: Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors. They typically have stated maturities of five, 15, or 30 years. The life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that make up the pass-through.
Collateralized Mortgage Obligations (CMO): CMOs consist of multiple pools of securities which are known as slices, or tranches. The tranches are given credit ratings which determine the rates that are returned to investors.