Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.
Most mortgage-backed securities are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, and such securities are known as “private-label” MBS.
Mortgage-backed securities exhibit a variety of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of mortgage loans. More complicated mortgage-backed securities, known as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (REMICs), consist of multiple classes of securities designed to appeal to investors with different investment objectives and risk tolerances. In a CMO, principal and interest payments made on the pool of mortgage loans are distributed to the different classes of securities, known as “tranches”, according to a priority of payments. Each tranche may have different principal balances, coupon rates, prepayment risks, and maturity dates.
An important risk with regard to residential mortgage-backed securities and collateralized mortgage obligations involves prepayments, typically because homeowners refinance when interest rates fall. Such prepayments tend to return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive. In addition to prepayment risk, investors in these securities may also be exposed to significant market and liquidity risks.