Mortgage-backed securities are bonds backed by payments on mortgage loans.
Once a mortgage loan has been extended, it may be sold by the originator into a pool. The pool then issues securities entitling the holders to a prorata share of the interest and principal payments on the loans.
Mortgage-backed securities, or MBS, differ from conventional bonds in two key respects. Conventional bonds make fixed interest payments until they mature, at which point they repay principal. MBS return some principal along with each interest payment, corresponding to how homeowners repay their loans.
Also, homeowners have the option to prepay some or all principal at any point, creating uncertainty for investors in MBS. Prepayments typically increase when interest rates fall, encouraging refinancing. This puts MBS investors in the position of having to reinvest principal at lower interest rates. Conversely, when rates rise, prepayments slow, preventing the MBS investor from reinvesting at higher rates.
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To compensate investors for prepayment risk, MBS offer higher yields than conventional bonds of comparable quality.
There are various types of MBS. Ginnie Mae MBS are guaranteed by the federal government. Ginnie Mae, a government agency, guarantees investors full and timely payments even if borrowers default.
Fannie Mae and Freddie Mac are government-sponsored enterprises that guarantee full and timely payments on their MBS. This is not a federal government guarantee.
Other MBS are entirely private. Some hold residential mortgages, others hold commercial mortgages.