Mortgage-Backed Security
A mortgage-backed security (MBS) is a fixed income instrument created by pooling a collection of residential or commercial mortgage loans and selling interests in that pool to investors, with the principal and interest payments from the underlying borrowers flowing through to security holders. MBS are a central component of the U.S. fixed income market.
The U.S. mortgage-backed securities market is one of the largest fixed income markets in the world, with trillions of dollars in outstanding securities. The market divides broadly into agency MBS — guaranteed by Ginnie Mae (a true federal agency) or issued by Fannie Mae and Freddie Mac — and non-agency MBS, which carry no government guarantee and are backed solely by the credit quality of the underlying loan pool and any structural credit enhancements.
Agency MBS are often described as pass-through securities: the principal and interest payments made by thousands of individual mortgage borrowers are collected by a servicer, stripped of a servicing fee, and passed through to the MBS investors on a monthly basis. The guaranteeing agency protects investors against credit losses from borrower defaults, but it does not protect against prepayment risk — the risk that borrowers will refinance or pay off their mortgages faster than expected, returning principal to investors sooner than anticipated.
Prepayment risk is the defining complexity of MBS investing. When interest rates fall, mortgage borrowers tend to refinance, accelerating prepayments and shortening the effective life of the MBS pool. This causes the security to return principal at exactly the wrong time — when reinvestment rates are lower. Conversely, when rates rise, prepayments slow, extending the duration of the MBS and causing it to underperform. This characteristic, called negative convexity, makes MBS valuation substantially more complex than vanilla fixed-rate bond analysis and requires option-adjusted spread models to compare MBS yields to alternatives fairly.
Non-agency MBS, also called private-label MBS, played a central role in the 2007-2009 U.S. housing and financial crisis. These securities, many backed by subprime and Alt-A mortgage loans, experienced severe credit losses as housing prices declined and default rates rose far beyond model assumptions. The resulting market disruptions prompted sweeping regulatory reforms under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, including risk retention rules requiring MBS sponsors to retain a portion of the credit risk in securitizations they originate.
The Federal Reserve purchased over $2 trillion in agency MBS during its quantitative easing programs following the 2008 crisis and again beginning in 2020, making the central bank one of the largest single holders of agency MBS globally. Fed purchases and subsequent balance sheet reduction (quantitative tightening) have had measurable effects on mortgage spreads and, by extension, on the mortgage rates paid by American homeowners.