What Are Mortgage-Backed Securities?

As the name implies, mortgage-backed securities are bonds that are backed by pools of mortgage loans. In the most basic type of MBS, homeowners’ mortgage payments are passed through to the bondholder, meaning the bondholder receives monthly payments that include both principal and interest. This is a key difference between MBS and other bonds such as Treasuries, which pay interest every six months and return the whole principal at maturity.

There are several steps involved in creating a mortgage-backed security:

• A mortgage lender, such as a bank, extends a loan to a homeowner.
• The mortgage lender then sells the loan to one of the government sponsored enterprises (agencies), such as Fannie Mae or Freddie Mac (see below for more on MBS issuers) or to a private entity, like a bank or finance company. The lender may still service the mortgage, making this process invisible to the borrower.
• The agency or private entity then takes a number of the mortgage loans it has purchased and bundles them together into a "pool" (the actual number of individual mortgages in the pool can vary from a few loans to thousands of loans).
• The agency or private entity then sells claims on the cash flow generated by the pool of mortgages, in the form of securities, to investors. After the initial sale, MBS trade on the open market.
• Mortgage payments, consisting of interest and principal, are passed through the chain, from the mortgage servicer to the bondholder.

Who Issues Mortgage-Backed Securities?

MBS are issued and/or guaranteed by a U.S. government or government-related agency or by a private entity. Three major agencies are responsible for the majority of MBS issuance:

Government National Mortgage Association

GNMA or Ginnie Mae is a government agency that guarantees mortgage securities issued by approved private institutions (most are mortgage lenders). GNMA securities are the only MBS backed by the full faith and credit of the United States, the same guarantee afforded to U.S. Treasury bonds. This guarantee assures investors of the timely payment of interest and principal.

Federal National Mortgage Association

FNMA or Fannie Mae is a government-sponsored enterprise. It is a publicly owned corporation that operates under a Congressional charter with U.S. government oversight. Fannie Mae both issues and guarantees mortgage securities. Although its securities are not backed by a U.S. government guarantee, they carry an implied AAA credit rating.

Federal Home Loan Mortgage Corporation

FHLMC or Freddie Mac is also a government-sponsored enterprise. In fact, Freddie is a competitor to Fannie and operates in much the same way. Its securities likewise possess an implied AAA-level credit quality.

These three agencies issue the majority of mortgage-backed securities, but there are also private companies that issue MBS. These "private-label" MBS are typically issued by homebuilders or financial institutions through subsidiaries and are backed by residential loans that do not conform to the agencies’ requirements. Private-label MBS are rated by rating agencies and often feature credit enhancements such as overcollateralization or letters of credit that are designed to help protect investors from delinquencies or losses on the underlying loans.

Why MBS May Offer Higher Yields Compared to Similar High-Quality Bonds

Mortgage-backed securities issued by the federal agencies tend to have high credit quality because they are backed by the residential real estate underlying the loans and by the issuing agency. However, MBS have historically offered higher yields than bonds of similarly high credit quality, such as U.S. Treasuries.

The reason MBS have historically offered higher yields relative to Treasuries is to compensate investors for the uncertainty in MBS caused by mortgage refinancing. An investor buying a 30-year Treasury can hold that bond and collect the same interest payments for 30 years. An investor buying an MBS backed by a pool of 30-year mortgages, however, will collect the stated interest rate for an uncertain period of time due to the fact that few homeowners will hold their mortgages for the full 30 years; some will refinance their mortgages when interest rates fall, and others will sell their homes within the first 10 years. In either case, the mortgages are prepaid and investors in the MBS backed by those mortgages receive their principal back early.

Because mortgage prepayments, defined as early repayments on mortgage bonds, typically accelerate when interest rates fall, MBS investors may need to reinvest their money in a low interest-rate environment. Conversely, when rates rise, prepayments tend to slow down, and the investor receives lower than expected prepayments when reinvestment rates are relatively high. To compensate MBS investors for this uncertainty, an anticipated level of prepayments, based on historical data, is factored into the price and yield of any MBS.

Types of Mortgage-Backed Securities

Mortgage-backed securities can be structured in a number of ways. Here are the two most common types:

Pass-Throughs
Pass-through securities, also known as participation certificates, are the most basic mortgage-backed bonds and are collateralized by pools of similar mortgage loans. Most are issued and/or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. As the name suggests, the cash flow from the underlying mortgage payments is passed through to the MBS investor.

Collateralized Mortgage Obligations (CMOs)

CMOs are structures that may utilize pools of pass-throughs and/or mortgage loans as collateral. CMOs typically have three or more bond classes, generally called tranches. Each tranche has its own expected maturity and cash flow pattern. Relative to pass-throughs, some CMO’s are stable, low risk investments, while others are more volatile. The unique cash flow patterns of each CMO tranche allows investors to tailor their mortgage exposure to meet a range of investment objectives, since different classes can have different risk/return characteristics.

MBS are the Largest Segment of the U.S. Bond Market

With $6.9 trillion in mortgage-related debt outstanding as of June 30, 2007, mortgages are the largest segment of the U.S. bond market, accounting for 24% of all bond market debt outstanding, according to estimates by the Bond Market Association. For comparison, corporate bonds account for 20% of the market, and Treasury debt accounts for another 15%.

Mortgages are also among the most actively traded securities in the U.S. bond market. Primary dealers – the large banks authorized to deal directly with the Federal Reserve – traded on average more than $300 billion per day of agency MBS in 2007, according to data from the Bond Market Association and New York Federal Reserve Bank. For comparison, primary dealers traded about $26 billion per day of corporate bonds with maturities of more than one year in 2007.

Conclusion
Mortgage-backed securities, backed by pools of individual mortgage loans, are primarily issued by federal agencies such as Fannie Mae, Freddie Mac and Ginnie Mae. Mortgage-backed securities’ high credit quality and attractive yield relative to other high-quality bonds have helped MBS grow into the largest sector of the U.S. bond market.