A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that can be sold to investors. The principal and interest payments from the underlying mortgages are passed through to the MBS holder.
Mortgage-backed securities are created when a lender (such as a bank) originates a mortgage loan and then sells the loan to an entity (such as a government agency or investment bank) that securitizes the loans. The entity that securitizes the loans packages the loans together into a security that can be sold to investors. The entity that securitizes the loans also provides a guarantee that the payments on the underlying mortgages will be made even if some of the borrowers default on their loans.
Mortgage-backed securities offer a number of benefits to investors. First, they are backed by a physical asset - a mortgage - which provides some level of security in the event of default. Second, they offer a higher yield than other types of fixed-income securities, such as government bonds. And third, they offer the potential for capital appreciation if the underlying mortgages are paid off early or if interest rates decline.
Mortgage-backed securities are not without risk, however. The most significant risk is credit risk - the risk that the borrowers will default on their loans. This risk is mitigated to some extent by the fact that the loans are typically securitized by a government agency or investment bank, but it cannot be completely eliminated. Interest rate risk is also a concern, as rising interest rates can lead to lower prices for MBS. And finally, prepayment risk - the risk that the underlying mortgages will be paid off early - can also lead to lower prices for MBS.
If you're considering investing in mortgage-backed securities, here are a few things to keep in mind: