Mortgage-Backed Security (MBS)

A mortgage-backed security — or MBS — is a debt instrument secured by a pool of residential mortgages. When homeowners make monthly mortgage payments (principal and interest), those payments flow through to MBS investors. The security provides diversification across many borrowers, reducing any single borrower’s default risk, though the pool remains exposed to housing market risk.

How MBS work: cash flow from mortgages

An MBS is created when a bank originates mortgages and pools them together. A $500 million pool of 1,000 residential mortgages is securitized and sold to investors as one security. When homeowners make monthly payments, those payments flow to MBS investors.

A homeowner with a $300,000, 4%, 30-year mortgage makes monthly payments of approximately $1,432. Of that payment, the early payments are mostly interest (about $1,000) and little principal (about $432). Each payment flows to the MBS investor.

If the pool contains 1,000 such mortgages, the pool receives approximately $1.432 million monthly from homeowner payments. After administrative costs and any servicer fees, MBS investors receive that cash stream.

Prepayment risk: refinancing and shortening duration

MBS investors face a unique risk: prepayment risk. When interest rates fall, homeowners refinance their mortgages, paying off the old loans early. This forces MBS investors to reinvest the returned principal at lower rates.

If an investor holds an MBS yielding 4% and rates fall to 2%, the investor faces a choice: refinance the mortgages, returning principal to investors (who must reinvest at 2%), or let homeowners refinance and prepay the mortgage, forcing the investor to reinvest at 2%.

This is the flip side of the callable bond problem — issuers (in this case, homeowners) have the incentive to refinance when rates fall, shortening the investor’s duration and forcing reinvestment at lower yields.

The MBS market prices prepayment risk explicitly. When rates are well above refinancing incentive (say, 5% MBS yield when Treasury rates are 6%), prepayment risk is low and the MBS price is close to par. When rates are well below the mortgage coupon (say, 5% MBS when Treasury rates are 2%), prepayment risk is high and the MBS is cheaper relative to straight bonds of similar maturity.

Agency and non-agency MBS

Agency MBS are issued or guaranteed by government-sponsored enterprises (Fannie Mae, Freddie Mac, Ginnie Mae). This implicit or explicit government backing means agency MBS carry minimal credit risk — investors are largely exposed to prepayment risk and interest-rate risk, not default risk.

Non-agency MBS are not guaranteed by government entities and carry actual credit risk from the underlying homeowners. They yield more to compensate investors for that risk. The 2008 financial crisis devastated non-agency MBS because mortgage defaults spiked.

Agency MBS are now the dominant form, with tens of trillions outstanding. The Fed holds hundreds of billions of agency MBS on its balance sheet.

Duration and interest-rate sensitivity

MBS duration is uncertain because it depends on prepayment assumptions. When rates are stable, an MBS has an expected duration of perhaps 5 years. But if rates fall sharply, prepayments accelerate, and duration shortens to 2–3 years.

This negative convexity is unique to mortgages — when rates fall (good for most bonds), MBS duration shortens, limiting price appreciation. When rates rise, duration extends, amplifying price declines. This asymmetry makes MBS less attractive than straight bonds in rising-rate environments.

The 2008 crisis and MBS aftermath

The 2008 financial crisis exposed massive problems in mortgage securitization. Non-agency MBS backed by subprime mortgages defaulted at extraordinary rates, causing trillions of dollars in investor losses. The crisis revealed that MBS credit analysis had been deeply flawed and that lenders had originated mortgages with minimal credit underwriting.

Post-crisis, regulation tightened dramatically. Originators must retain 5% of non-agency MBS risk; underwriting standards improved; subprime lending collapsed. Agency MBS credit quality improved substantially because the mortgages backing them meet stricter standards.

The Federal Reserve and MBS markets

The Fed purchased over $1 trillion of agency MBS during the financial crisis and again during the 2020 COVID pandemic. These purchases supported the housing market and monetary policy. The Fed’s mortgage holdings remain substantial, making it one of the largest MBS investors in the world.

Fed mortgage holdings were reduced starting in 2017 and halted from 2019–2020. In 2022–2023, the Fed began running down its mortgage holdings as part of balance-sheet normalization.

Comparison to Treasury securities and corporate bonds

Agency MBS trade at yields only slightly above Treasury securities of comparable duration, reflecting minimal credit risk. Non-agency MBS trade at wider spreads. Both face duration uncertainty due to prepayment risk, making them riskier than straight Treasury or corporate bonds.

For investors comfortable with prepayment risk, MBS can offer attractive yields with modest credit risk. For investors wanting certain duration or liability matching, Treasury securities or straight corporate bonds are preferable.

See also