Mortgage-Backed Security (MBS)

MBS are created through securitization. Lenders pool many mortgages together and sell them to an entity that issues securities. As homeowners make their monthly payments, the money flows through to investors.

In the United States, a large part of the MBS market is made up of securities issued or guaranteed by government-sponsored enterprises, Fannie Mae and Freddie Mac, and by the government agency Ginnie Mae. These carry little credit risk because of the guarantees. Other MBS, called private-label or non-agency MBS, are issued by banks and other firms without such guarantees.

For example, a pension fund might buy agency MBS to earn a slightly higher yield than government bonds while taking little credit risk.

MBS carry a distinctive risk called prepayment risk. When interest rates fall, many homeowners refinance and repay their mortgages early, so investors get their money back sooner than expected and must reinvest at lower rates. When rates rise, prepayments slow, extending the security's life. In the years before 2008, MBS backed by risky subprime mortgages suffered heavy losses when borrowers defaulted, contributing to the financial crisis.