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A mortgage-backed security (MBS) is a type of asset-backed security (an "instrument") which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential;[1] another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings.

The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations (CMOs, often structured as real estate mortgage investment conduits) and collateralized debt obligations (CDOs).[2]

In the U.S. the MBS market has more than $11 trillion in outstanding securities and almost $300 billion in average daily trading volume.[3]

A mortgage bond is a bond backed by a pool of mortgages on a real estate asset such as a house. More generally, bonds which are secured by the pledge of specific assets are called mortgage bonds. Mortgage bonds can pay interest in either monthly, quarterly or semiannual periods. The prevalence of mortgage bonds is commonly credited to Mike Vranos.

The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as tranches (French for "slices"), each with a different level of priority in the debt repayment stream, giving them different levels of risk and reward. Tranches of an MBS—especially the lower-priority, higher-interest tranches—are/were often further repackaged and resold as collateralized debt obligations.[4] These subprime MBSs issued by investment banks were a major issue in the subprime mortgage crisis of 2006–2008.

The total face value of an MBS decreases over time, because like mortgages, and unlike bonds, and most other fixed-income securities, the principal in an MBS is not paid back as a single payment to the bond holder at maturity but rather is paid along with the interest in each periodic payment (monthly, quarterly, etc.). This decrease in face value is measured by the MBS's "factor", the percentage of the original "face" that remains to be repaid.

In the United States, MBSs may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks.

Securitization

[edit]
Value of mortgage-backed security issuances in $US trillions, 1990–2009. (source: sifma statistics, structured finance)
Single-family home mortgage-backed security issuance, 2003–2017

The process of securitization is complex and depends greatly on the jurisdiction within which the process is conducted. Among other things, securitization distributes risk and permits investors to choose different levels of investment and risk.[5] The basics are:

  1. Mortgage loans (mortgage notes) are purchased from banks and other lenders, and possibly assigned to a special purpose vehicle (SPV).
  2. The purchaser or assignee assembles these loans into collections, or "pools".
  3. The purchaser or assignee securitizes the pools by issuing mortgage-backed securities.

While a residential mortgage-backed security (RMBS) is secured by single-family, one- to four-unit real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multi-family properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties, and other commercial sites. A CMBS is usually structured as a different type of security than an RMBS.

These securitization trusts may be structured by government-sponsored enterprises as well as by private entities that may offer credit enhancement features to mitigate the risk of prepayment and default associated with these mortgages. Since residential mortgage holders in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety usually without financial penalty (prepayment), the monthly cash flow of an MBS is not known in advance, and an MBS therefore presents a risk to investors.

In the United States, the most common securitization trusts are sponsored by Fannie Mae and Freddie Mac, US government-sponsored enterprises. Ginnie Mae, a US government-sponsored enterprise backed by the full faith and credit of the US government, guarantees that its investors receive timely payments but buys limited numbers of mortgage notes. Some private institutions also securitize mortgages, known as "private-label" mortgage securities.[6][7] Issuances of private-label mortgage-backed securities increased dramatically from 2001 to 2007 and then ended abruptly in 2008, when real estate markets began to falter.[8] An example of a private-label issuer is the real estate mortgage investment conduit (REMIC), a tax-structure entity usually used for CMOs; among other things, a REMIC structure avoids so-called double taxation.[9]

Advantages and disadvantages

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The securitization of mortgages in the 1970s had the advantage of providing more capital for housing at a time when the demographic bulge of baby boomers created a housing shortage and inflation was undermining a traditional source of housing funding, the savings and loan associations (or thrifts), which were limited to providing uncompetitive 5.75% interest rates on savings accounts and consequently losing savers' money to money market funds. Unlike the traditional localized, inefficient mortgage market where there might be a shortage or surplus of funds at any one time, MBSs were national and international in scope and regionally diversified.[10] Mortgage-backed securities helped move interest rates out of the banking sector and facilitated greater specialization among financial institutions.

However, mortgage-backed securities may have "led inexorably to the rise of the subprime industry" and "created hidden, systemic risks". They also "undid the connection between borrowers and lenders". Historically, "less than 2% of people lost their homes to foreclosure", but with securitization, "once a lender sold a mortgage, it no longer had a stake in whether the borrower could make his or her payments."[11]

History

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Among the early examples of mortgage-backed securities in the United States were the slave mortgage bonds of the early 18th century[12] and the farm railroad mortgage bonds of the mid-19th century which may have contributed to the panic of 1857.[13] There was also an extensive commercial MBS market in the 1920s.[14]

US government

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In June 1933, the Glass–Steagall Act was signed into law by President Franklin D. Roosevelt. This legislative initiative separated commercial banking from investment banking, providing safeguards against possible corruption with many types of investment securities (like the MBS). Even though the fixed-rate mortgage did not yet exist at this time, the law deemed it illegal for a banking institution to both sponsor debts and design investment vehicles or market-making tools as the selfsame entity. In other words, the Mortgage-Backed Security could probably not have existed at this time (without a little tweaking of the laws).[15]

As part of the New Deal following the Great Depression, the US federal government created the Federal Housing Administration (FHA) with the National Housing Act of 1934 to assist in the construction, acquisition, and rehabilitation of residential properties.[16] The FHA helped develop and standardize the fixed-rate mortgage as an alternative to the balloon payment mortgage by insuring them, and helped the mortgage design garner usage.[17]

In 1938, the government also created the government-sponsored corporation Fannie Mae to create a liquid secondary market in these mortgages and thereby free up the loan originators to originate more loans, primarily by buying FHA-insured mortgages.[18] As part of the Housing and Urban Development Act of 1968, Fannie Mae was split into the current Fannie Mae and Ginnie Mae to support the FHA-insured mortgages, as well as Veterans Administration (VA) and Farmers Home Administration (FmHA) insured mortgages, with the full faith and credit of the US government.[19] In 1970, the federal government authorized Fannie Mae to purchase conventional mortgages—that is, those not insured by the FHA, VA, or FmHA, and created Freddie Mac to perform a role similar to that of Fannie Mae.[19] Ginnie Mae does not invest in conventional mortgages.

Securitization

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Ginnie Mae guaranteed the first mortgage pass-through security of an approved lender in 1968.[20] In 1971, Freddie Mac issued its first mortgage pass-through, called a participation certificate, composed primarily of conventional mortgages.[20] In 1981, Fannie Mae issued its first mortgage pass-through, called a mortgage-backed security.[21] In 1983, Freddie Mac issued the first collateralized mortgage obligation.[22]

In 1960 the government enacted the Real Estate Investment Trust Act to allow the creation of the real estate investment trust (REIT) to encourage real estate investment, and in 1977 Bank of America issued the first private label pass-through.[23] In 1983 the Federal Reserve Board amended Regulation T to allow broker-dealers to use pass-throughs as margin collateral, equivalent to over-the-counter non-convertible bonds.[24] In 1984 the government passed the Secondary Mortgage Market Enhancement Act to improve the marketability of private label pass-throughs,[23] which declared nationally recognized statistical rating organization AA-rated mortgage-backed securities to be legal investments equivalent to Treasury securities and other federal government bonds for federally chartered banks (such as federal savings banks and federal savings associations), state-chartered financial institutions (such as depository banks and insurance companies) unless overridden by state law before October 1991 (which 21 states did[25]), and Department of Labor–regulated pension funds.[26]

The Tax Reform Act of 1986 allowed the creation of the tax-exempt real estate mortgage investment conduit (REMIC) special purpose vehicle for the express purpose of issuing pass-throughs.[27] The Tax Reform Act may have contributed to the savings and loan crisis of the 1980s and 1990s that resulted in the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which dramatically changed the savings and loan industry and its federal regulation, encouraging loan origination.[28][29]

Nevertheless, probably the most influential action that encouraged the subprime mortgage crisis of 2008 (other than the neglectful actions of banking institutions) was the Financial Services Moderation Act (also called the Gramm–Leach–Bliley Act).[30] It was signed into law in 1999 by President Clinton, and allowed sole, in-house creation (by solitary banking institutions) of Mortgage-Backed Securities as investment and derivatives instruments. This legislative decision did not just tweak or finesse the preexisting law, it effectively repealed the Glass-Steagall Act of 1933, the only remaining statutory safeguard poised against the ensuing disaster.[31]

Subprime mortgage crisis

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Main article: Subprime mortgage crisis

Low-quality mortgage-backed securities backed by subprime mortgages in the United States caused a crisis that played a major role in the 2008 financial crisis. By 2012 the market for high-quality mortgage-backed securities had recovered and was a profit center for US banks.[32]

Types

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Most bonds backed by mortgages are classified as an MBS. This can be confusing because a security derived from an MBS is also called an MBS. To distinguish the basic MBS bond from other mortgage-backed instruments, the qualifier pass-through is used, in the same way that "vanilla" designates an option with no special features.

Subtypes of mortgage-backed security include:

Pass-through securities are issued by a trust and allocate the cash flows from the underlying pool to the securities holders on a pro rata basis. A trust that issues pass-through certificates is taxed under the grantor trust rules of the Internal Revenue Code. Under these rules, the holder of a pass-through certificate is taxed as a direct owner of the portion of the trust allocatable to the certificate. In order for the issuer to be recognized as a trust for tax purposes, there can be no significant power under the trust agreement to change the composition of the asset pool or otherwise to reinvest payments received, and the trust must have, with limited exceptions, only a single class of ownership interests.[33]

A collateralized mortgage obligation, or "pay-through bond", is a debt obligation of a legal entity that is collateralized by the assets it owns. Pay-through bonds are typically divided into classes that have different maturities and different priorities for the receipt of principal and in some cases of interest.[34] They often contain a sequential pay security structure, with at least two classes of mortgage-backed securities issued, with one class receiving scheduled principal payments and prepayments before any other class.[35] Pay-through securities are classified as debt for income tax purposes.[36] A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:

    • An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.
      • A net interest margin security (NIMS) is re-securitized residual interest of a mortgage-backed security[37]
    • A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.

There are a variety of underlying mortgage classifications in the pool:

Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc. Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)[38] Alt-A mortgages tend to be larger in

Uses

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Risk, Return, Rating and Yield relate

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities:

  1. transform relatively illiquid, individual financial assets into liquid and tradable capital market instruments
  2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities
  3. can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically a public market transaction)
  4. are often a more efficient and lower-cost source of financing in comparison with other bank and capital markets financing alternatives.
  5. allow issuers to diversify their financing sources by offering alternatives to more traditional forms of debt and equity financing
  6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently, and achieve compliance with risk-based capital standards

The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.[citation needed]

Reasons (other than investment or speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing).

Market size and liquidity

[edit]

As of the second quarter of 2011, there was about $13.7 trillion in total outstanding US mortgage debt. There were about $8.5 trillion in total US mortgage-related securities, with about $7 trillion of that securitized or guaranteed by government-sponsored enterprises or government agencies, and the remaining $1.5 trillion being pooled by private mortgage conduits.

As of 2021, the volume of mortgage-backed securities (MBS) outstanding in the United States has surpassed 12 trillion U.S. dollars, marking a significant growth in the market size. This expansion reflects the increasing role of MBS in the financing of residential real estate, demonstrating the importance of these securities in the overall financial system and housing market.

According to the Bond Market Association, gross US issuance of agency MBS was:

2005: USD 0.967 trillion 2004: USD 1.019 trillion 2003: USD 2.131 trillion 2002: USD 1.444 trillion 2001: USD 1.093 trillion This data underscores the fluctuating nature of the MBS market over time, influenced by varying economic conditions, interest rates, and housing market dynamics.

Pricing

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Valuation

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The weighted-average maturity (WAM) and weighted average coupon (WAC) are used for valuation of a pass-through MBS, and they form the basis for computing cash flows from that mortgage pass-through. Just as this article describes a bond as a 30-year bond with 6% coupon rate, this article describes a pass-through MBS as a $3 billion pass-through with 6% pass-through rate, a 6.5% WAC, and 340-month WAM. The pass-through rate is different from the WAC; it is the rate that the investor would receive if he/she held this pass-through MBS, and the pass-through rate is almost always less than the WAC. The difference goes to servicing costs (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors).

To illustrate these concepts, consider a mortgage pool with just three mortgage loans that have the following outstanding mortgage balances, mortgage rates, and months remaining to maturity:

Loan Outstanding mortgage balance Mortgage
rate 		Remaining
months to maturity 		Percentage of pool's total $900,000 balance
(the loan's "weighting")
Loan 1 $200,000 6.00% 300 22.22%
Loan 2 $400,000 6.25% 260 44.44%
Loan 3 $300,000 6.50% 280 33.33%
Overall Pool $900,000 WAC: 6.277% WAM: 275.55 100%

Weighted-average maturity

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The weighted-average maturity (WAM) of a pass-through MBS is the average of the maturities of the mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an average across mortgages, as distinct from concepts such as weighted-average life and duration, which are averages across payments of a single loan.

The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance or initiation of the MBS. The WAM for the above example is computed as follows:

WAM = (22.22% × 300) + (44.44% × 260) + (33.33% × 280) = 66.66 + 115.55 + 93.33 = 275.55 months

Another measure often used is the Weighted-average loan age.

Weighted-average coupon

[edit]

The weighted-average coupon (WAC) of a pass-through MBS is the average of the coupons of the mortgages in the pool, weighted by their original balances at the issuance of the MBS. For the above example this is:

WAC = (22.22% × 6.00%) + (44.44% × 6.25%) + (33.33% × 6.50%) = 1.33% + 2.77% + 2.166% = 6.277%

Theoretical pricing

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Pricing a "vanilla" corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure.[39] The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay increases when interest rates decrease. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.[40]

Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model and the sophistication of the prepayment IR dependence, to the point that no closed-form solution (i.e., one that could be written down) is widely known. In models of this type, numerical methods provide approximate theoretical prices. These are also required in most models that specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use specialised Monte Carlo methods or modified Binomial Tree numerical solutions.

Interest rate risk and prepayment risk

[edit]

Theoretical pricing models must take into account the link between interest rates and loan prepayment speed. Mortgage prepayments are usually made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). In other words, the proceeds received would need to be reinvested at a lower interest rate.[9] Hence the term prepayment risk.

Professional investors generally use arbitrage-pricing models to value MBS. These models deploy interest rate scenarios consistent with the current yield curve as drivers of the econometric prepayment models that models homeowner behavior as a function of projected mortgage rates. Given the market price, the model produces an option-adjusted spread, a valuation metric that takes into account the risks inherent in these complex securities.[41]

There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, such as:

  • economic growth, which is correlated with increased turnover in the housing market
  • home prices inflation
  • unemployment
  • regulatory risk (if borrowing requirements or tax laws in a country change this can change the market profoundly)
  • demographic trends, and a shifting risk aversion profile, which can make fixed rate mortgages relatively more or less attractive

Credit risk

[edit]
Main article: Credit risk

The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because:

  1. Most mortgage originations include research on the mortgage borrower's ability to repay, and will try to lend only to the creditworthy. An important exception to this is "no-doc" or "low-doc" loans.
  2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the full faith and credit of the US federal government.[42] This is not the case with Fannie Mae and Freddie Mac, but these two entities have lines of credit with the US federal government; however, these lines of credit are extremely small compared to the average amount of money circulated through these entities in one day's business. Additionally, Fannie Mae and Freddie Mac generally require private mortgage insurance on loans in which the borrower provides a down payment that is less than 20% of the property value.
  3. Pooling many mortgages with uncorrelated default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments (see Copula). Although the risk neutral credit spread is theoretically identical between a mortgage ensemble and the average mortgage within it, the chance of catastrophic loss is reduced.
  4. If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default.

If the MBS was not underwritten by the original real estate and the issuer's guarantee, the rating of the bonds would be much lower. Part of the reason is the expected adverse selection against borrowers with improving credit (from MBSs pooled by initial credit quality) who would have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).

Real-world pricing

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Because of the diversity in MBS types, there is a wide variety of pricing sources. In general, the more uniform or liquid the MBS, the greater the transparency or availability of prices.[43] Most traders and money managers use Bloomberg and Intex to analyze MBS pools and more esoteric products such as CDOs, although tools such as Citi's The Yield Book, Barclays POINT, and BlackRock's AnSer are also prevalent across Wall Street, especially for multi–asset class managers. Some institutions have also developed their own proprietary software.

Complex structured products tend to trade less frequently and involve more negotiation. Prices for these more complicated MBSs, as well as for CMOs and CDOs, tend to be more subjective, often available only from dealers.[43]

The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases.

If an investor has acquired a pool at a premium (>100), as is common for higher coupons, then they are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar prepaid, which may significantly decrease the yield. This is likely to happen as holders of higher-coupon mortgages can have a larger incentive to refinance.

Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS pool was bought at a discount (<100). This is due to the fact that when the borrower pays back the mortgage, he or she does so at "par". If an investor purchases a bond at 95 cents on the dollar, as the borrower prepays the investor gets the full dollar back, increasing their yield. However, this is less likely to occur, as borrowers with low-coupon mortgages have lower, or no, incentives to refinance.

The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high-premium (high-coupon) MBSs backed by mortgages with an original loan balance no larger than $85,000 command the largest pay-ups. Even though the borrower is paying an above market yield, he or she is dissuaded from refinancing a small loan balance due to the high fixed cost involved.

Low Loan Balance: < $85,000
Mid Loan Balance: $85,000–$110,000
High Loan Balance: $110,000–$150,000
Super High Loan Balance: $150,000–$175,000
New Loan Balance Buckets:

$175,000–$200,000
$200,000–$225,000
$225,000–$250,000
$250,000–$275,000
TBA: > $275,000 The plurality of factors makes it difficult to calculate the value of an MBS security. Often market participants do not concur, resulting in large differences in quoted prices for the same instrument. Practitioners constantly try to improve prepayment models and hope to measure values for input variables implied by the market. Varying liquidity premiums for related instruments and changing liquidity over time make this a difficult task. One factor used to express the price of an MBS security is the pool factor.

Recording and Mortgage Electronic Registration Systems

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One critical component of the securitization system in the US market is the Mortgage Electronic Registration Systems (MERS) created in the 1990s, which created a private system wherein underlying mortgages were assigned and reassigned outside of the traditional county-level recording process. The legitimacy and overall accuracy of this alternative recording system have faced serious challenges with the onset of the mortgage crisis: as the US courts flood with foreclosure cases, the inadequacies of the MERS model are being exposed, and both local and federal governments have begun to take action through suits of their own and the refusal (in some jurisdictions) of the courts to recognize the legal authority of MERS assignments.[44][45] The assignment of mortgage (deed of trust) and note (obligation to pay the debt) paperwork outside of the traditional US county courts (and without recordation fee payment) is subject to legal challenge. Legal inconsistencies in MERS originally appeared trivial, but they may reflect dysfunctionality in the entire US mortgage securitization industry.

See also

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References

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Bibliography

[edit]
[edit]
Revisions and contributorsEdit on WikipediaRead on Wikipedia

Mortgage-backed security

View on Grokipedia
from Grokipedia
A mortgage-backed security (MBS) is a debt obligation representing claims to the cash flows from pools of mortgage loans, typically residential, where investors receive periodic payments of principal and interest derived from borrowers' mortgage payments. These securities are created by aggregating individual mortgages into pools, often through government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, or Ginnie Mae for agency MBS, or private issuers for non-agency versions, thereby transforming illiquid loans into tradable assets. Originating in the United States in the late 1960s, the first private-label pass-through MBS was issued in 1968, with Ginnie Mae providing the initial government guarantee in 1970 to enhance market confidence amid rising interest rates and thrift institution disintermediation. The market expanded rapidly as GSEs standardized pooling and issuance, fostering a secondary mortgage market that increased liquidity for originators, enabling them to replenish lending capacity and lower borrowing costs for homebuyers by attracting diverse investors seeking yield and diversification. While agency MBS, implicitly or explicitly backed by the government, have maintained relative stability through credit enhancements and conservative underwriting, the growth of private-label MBS securitizing subprime and non-conforming loans in the 2000s amplified systemic risks, as securitization decoupled originator incentives from loan performance, contributing to deteriorated lending standards and the 2008 housing collapse when defaults surged. Empirical analyses confirm that non-agency residential MBS experienced severe losses due to overextended credit to high-risk borrowers, faulty ratings, and excessive leverage, underscoring how the structure facilitated risk mispricing rather than inherent design flaws in basic MBS mechanics.

Fundamentals

Definition and Basic Structure

A mortgage-backed security (MBS) is a debt obligation that represents claims to the cash flows generated from a pool of mortgage loans, primarily residential mortgages, where investors receive periodic payments of principal and interest derived from borrowers' mortgage payments. These securities transform illiquid individual mortgages into tradable financial instruments, enabling mortgage originators to replenish liquidity and fund additional lending. The basic structure of an MBS begins with the aggregation, or pooling, of similar mortgage loans—often hundreds or thousands—by an issuer, such as a government-sponsored enterprise (GSE) like Fannie Mae, Freddie Mac, or Ginnie Mae, or a private financial institution. The pooled mortgages serve as collateral for the security, with a servicer responsible for collecting monthly payments from borrowers, deducting servicing fees and expenses, and distributing the net cash flows pro-rata to MBS holders as pass-through payments. In agency MBS, the issuer provides a guarantee of timely payment of principal and interest, backed by the full faith and credit of the U.S. government for Ginnie Mae securities, mitigating credit risk for investors. While simple pass-through MBS distribute cash flows proportionally without further segmentation, more complex variants like collateralized mortgage obligations (CMOs) divide the pool into tranches with prioritized payment structures to allocate prepayment and credit risks differently among investors, tailoring risk-return profiles. This tranching redistributes the inherent uncertainties of mortgage prepayments—driven by borrower refinancing or home sales—across classes of securities, with senior tranches receiving priority payments and subordinate ones absorbing initial losses. The structure relies on legal isolation of the mortgage pool from the issuer's bankruptcy estate to ensure investor claims on cash flows remain insulated from originator insolvency.

Securitization Process

The securitization process for mortgage-backed securities (MBS) begins with the origination of residential or commercial mortgage loans by lenders, such as banks or nonbank financial institutions, which extend credit to borrowers secured by real property. Originators evaluate borrower creditworthiness and property value during a typical 30- to 90-day lock period, adhering to underwriting guidelines, particularly for agency-eligible loans. These loans are then sold by originators to aggregators, government-sponsored enterprises (GSEs) like Fannie Mae or Freddie Mac, or private issuers, often through mechanisms such as whole-loan conduits or forward sales in the to-be-announced (TBA) market to hedge interest rate risk. The purchasing entity pools hundreds or thousands of similar loans—based on factors like interest rate, maturity, and loan-to-value ratio—into homogeneous groups to standardize cash flow predictability. The pooled loans are transferred to a bankruptcy-remote special purpose vehicle (SPV) or trust, isolating them from the originator's or issuer's balance sheet to achieve true sale treatment and mitigate bankruptcy risk. The SPV issues MBS certificates representing pro-rata ownership interests in the pool's principal and interest payments, which are structured as pass-through securities where monthly borrower payments (net of servicing fees) flow directly to investors. For agency MBS, GSEs like Freddie Mac guarantee the timely payment of principal and scheduled interest to investors, regardless of borrower defaults or prepayments, with the guarantee fee typically ranging from 0.05% to 0.25% annually of the pool balance. In non-agency or private-label securitizations, absent such guarantees, issuers incorporate credit enhancements including subordination of tranches, excess spread, overcollateralization, or third-party insurance to protect senior investors from losses. Servicers, often retained by the issuer, handle ongoing administration: collecting payments, advancing delinquencies, managing foreclosures, and remitting net cash flows to the trust for distribution. This process enables originators to replenish liquidity rapidly—often within days via the TBA market—allowing them to originate additional loans without tying up capital for the full 15- to 30-year amortization period, while providing investors diversified exposure to mortgage cash flows. Rating agencies assess pool credit quality and structure, assigning ratings that influence investor demand and pricing.

Role of Guarantees and Credit Enhancements

In agency mortgage-backed securities (MBS), guarantees from entities such as Ginnie Mae, Fannie Mae, and Freddie Mac serve as the primary mechanism to mitigate credit risk for investors by ensuring the timely payment of principal and interest, irrespective of defaults or delinquencies in the underlying mortgage pool. Ginnie Mae provides an explicit full faith and credit guarantee backed by the U.S. government, which has supported the issuance of approximately $2.5 trillion in Ginnie Mae-guaranteed MBS as of 2023, representing FHA, VA, and USDA loans. Fannie Mae and Freddie Mac, under conservatorship since 2008, offer comparable guarantees drawn from their own capital and retained earnings, with implicit government support that was actualized through Treasury bailouts totaling over $187 billion during the financial crisis, underscoring the transfer of ultimate risk to taxpayers. These guarantees elevate agency MBS to investment-grade status, often AAA-rated, enabling yields that are typically 50-100 basis points above comparable Treasuries while broadening the investor base beyond risk-tolerant institutions. For non-agency or private-label MBS, lacking governmental backing, credit enhancements are structural and financial safeguards designed to absorb losses from borrower defaults, thereby protecting senior tranches and achieving higher credit ratings. The most prevalent form is subordination within real estate mortgage investment conduits (REMICs), where junior or mezzanine tranches bear initial losses—up to 20-30% in some pre-2008 structures—before impacting senior AAA-rated slices, which comprised over 80% of issuance volume in robust markets. Overcollateralization provides an additional buffer by aligning the pool's face value with mortgages exceeding the securities' principal by 5-15%, while excess spread captures the margin between mortgage interest rates (often 6-7%) and MBS coupon payments (4-5%), accumulating in reserve accounts to cover shortfalls. Other enhancements include third-party mechanisms such as financial guaranty insurance from monoline insurers or letters of credit from banks, which historically covered 10-20% of potential losses in private-label deals before the 2008 insolvencies of firms like Ambac and MBIA exposed their fragility. Reserve funds, funded upfront or via cash flow waterfalls, further bolster protection, with initial sizes calibrated to historical default rates of 1-2% on prime loans. These layered protections reduce expected losses, lowering funding costs for originators by 50-200 basis points relative to unsecured debt, but their efficacy hinges on accurate modeling of correlated defaults—as subprime MBS losses exceeded 50% in subordinated classes during 2007-2009, revealing overreliance on optimistic assumptions. Post-crisis regulations, including Dodd-Frank risk retention rules mandating 5% skin-in-the-game for issuers since 2016, have reinforced these enhancements to align incentives and curb moral hazard.

Historical Development

Government Origins and Early Initiatives (1930s-1970s)

The Great Depression of the 1930s triggered widespread mortgage defaults and foreclosures, prompting the U.S. government to intervene in the housing finance system to stabilize lending and promote homeownership. In 1934, Congress established the Federal Housing Administration (FHA) under the National Housing Act to insure mortgages, thereby reducing lender risk and enabling longer-term, amortizing loans with lower down payments—typically 20% previously reduced to 10% or less. This initiative shifted the market from short-term balloon loans to fixed-rate, 20- to 30-year mortgages, increasing liquidity by encouraging private lending backed by federal insurance. In 1938, the Federal National Mortgage Association (Fannie Mae) was created as a wholly owned government corporation with initial purchasing authority of $1 billion in FHA-insured mortgages, aiming to provide a secondary market by buying loans from originators and holding them in portfolio. This separated mortgage origination from funding, allowing lenders to recycle capital into new loans rather than tying it up long-term, though Fannie Mae initially focused on government-insured loans exclusively and did not engage in securitization. Post-World War II, the Servicemen's Readjustment Act of 1944 introduced Veterans Administration (VA) loan guarantees, expanding the pool of insurable mortgages and further deepening Fannie Mae's role in liquidity provision. By 1954, legislation authorized Fannie Mae to purchase conventional (non-government-insured) mortgages, broadening its scope amid growing housing demand. The late 1960s marked a pivot toward securitization amid rising interest rates and thrift institution strains. The Housing and Urban Development Act of 1968 restructured Fannie Mae into a private shareholder-owned entity while carving out the Government National Mortgage Association (Ginnie Mae) as a government agency within the Department of Housing and Urban Development (HUD) to oversee special assistance programs and guarantee securities. In 1970, Ginnie Mae launched the nation's first mortgage-backed securities (MBS) program, issuing pass-through securities backed by pools of FHA- and VA-insured mortgages, with the full faith and credit of the U.S. government guaranteeing timely principal and interest payments to investors. This innovation transformed illiquid whole loans into tradable securities, injecting capital into the market during credit crunches. That same year, the Emergency Home Finance Act created the Federal Home Loan Mortgage Corporation (Freddie Mac) as a government-sponsored enterprise affiliated with the Federal Home Loan Bank System, tasked with purchasing conventional mortgages from thrift institutions to parallel Fannie Mae's operations and alleviate their funding pressures from interest rate mismatches. Freddie Mac issued its first mortgage participation certificates—a precursor to modern MBS—in 1971, enabling thrifts to offload loans and access broader investor capital without direct government guarantees. These initiatives laid the groundwork for a national secondary mortgage market, though issuance volumes remained modest in the 1970s, totaling under $10 billion annually by decade's end, primarily driven by Ginnie Mae's guarantees amid persistent inflation and regulatory constraints.

Private Innovation and GSE Expansion (1980s-2000s)

In the early 1980s, private sector innovation significantly advanced the mortgage-backed securities (MBS) market, building on government-initiated structures. Lewis Ranieri, head of the mortgage trading desk at Salomon Brothers, played a pivotal role by pioneering the securitization of mortgages into tradable bonds, coining the term "securitization" and developing the first private-label MBS in collaboration with Bank of America around 1980. These securities pooled non-agency mortgages, decoupling lending from traditional bank balance sheets and attracting bond investors wary of prepayment risks inherent in pass-through MBS. By 1983, innovations like collateralized mortgage obligations (CMOs), first issued by Freddie Mac, allowed private issuers to tranche payments into sequential bonds, mitigating duration risks and broadening investor appeal; private firms quickly adopted this structure to enhance liquidity and yield customization. Government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac simultaneously expanded their MBS activities, dominating issuance and providing implicit guarantees that lowered borrowing costs. Fannie Mae began issuing its own guaranteed MBS in 1981, followed by Freddie Mac, which shifted from participation certificates to pass-through securities, fueling market growth as outstanding MBS volume surged from negligible levels in the late 1970s to over $1 trillion by the late 1980s. Their combined market share in single-family mortgage securitization rose steadily, reaching approximately 50% of new originations by the mid-1990s and sustaining high levels into the 2000s, supported by regulatory charters emphasizing secondary market liquidity. This expansion was aided by GSE-led innovations, including standardized pooling and trading conventions, which private issuers emulated to compete, though agency MBS retained advantages from perceived government backing. Throughout the 1990s and into the 2000s, private-label MBS issuance grew alongside GSE dominance, particularly as originators securitized riskier loans outside GSE underwriting standards. Private volume remained modest relative to agency MBS until the early 2000s, comprising less than 10% of total issuance in the 1990s but accelerating with subprime and Alt-A pools that offered higher yields to investors. GSEs maintained their core role by purchasing and securitizing conforming loans, with their MBS portfolios expanding to finance broader homeownership amid low interest rates and housing demand, yet private innovation introduced greater market segmentation and complexity. This dual track of private creativity and GSE scale transformed MBS into the largest fixed-income market, surpassing U.S. Treasuries by the late 1990s.

The 2008 Crisis and Government Interventions

The expansion of non-agency mortgage-backed securities (MBS), particularly those backed by subprime and Alt-A mortgages, played a central role in amplifying the 2008 financial crisis. Private-label MBS issuance surged from $126 billion in 2000 to $1,145 billion in 2006, comprising over half of total MBS issuance in 2005 and 2006, as originators securitized loans with increasingly lax underwriting standards to weak borrowers whose repayment capacity was overestimated amid rising house prices. This process concealed credit risks through tranching and overly optimistic credit ratings, enabling banks to originate and distribute high volumes of risky assets while investors, lured by high yields, underestimated default probabilities until housing prices peaked in early 2006 and began declining sharply in 2007. Subprime defaults accelerated in 2007, eroding the value of these securities and triggering liquidity freezes in repo markets and among structured investment vehicles, which exposed leveraged institutions to massive losses—non-agency residential MBS issued through 2008 ultimately delivered payoffs far below par, with cumulative losses exceeding expectations from even pessimistic models. The crisis intensified in mid-2008 as delinquencies on underlying mortgages reached 14% for subprime first-lien loans, leading to failures like Bear Stearns in March and Lehman Brothers in September, with MBS-related writedowns totaling hundreds of billions across global banks. Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, holding or guaranteeing about $5 trillion in mortgages, faced insolvency due to their exposure to declining agency MBS values and implicit guarantees that encouraged risky purchases to meet affordable housing mandates, culminating in their placement into conservatorship by the Federal Housing Finance Agency on September 7, 2008, with Treasury providing $187 billion in initial capital infusions. In response, the U.S. government enacted broad interventions to stabilize the MBS market and prevent systemic collapse. The Emergency Economic Stabilization Act, signed October 3, 2008, authorized the $700 billion Troubled Asset Relief Program (TARP), which allocated funds to purchase toxic assets including MBS from banks, though much was redirected to capital injections for institutions like Citigroup and Bank of America. The Federal Reserve complemented this by launching large-scale purchases of agency MBS starting November 25, 2008, totaling over $1.25 trillion by 2010 to restore liquidity and support mortgage rates, while also backstopping GSE debt. These measures, while averting a deeper depression, transferred losses to taxpayers and reinforced moral hazard by rescuing entities whose failures stemmed from misaligned incentives in securitization chains. Post-crisis analyses indicate TARP's ultimate cost to the government was a net profit after repayments, but the interventions underscored the interconnected risks of GSE dominance and private-label excesses in the pre-crisis MBS ecosystem.

Post-Crisis Reforms and Market Evolution (2010-2025)

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, introduced key reforms to securitization practices, including Section 941, which mandates that sponsors of asset-backed securities retain at least 5% of the credit risk of the underlying assets to mitigate moral hazard in the originate-to-distribute model. These risk retention rules, finalized in 2014 and effective for residential mortgage-backed securities (RMBS) on December 24, 2015, apply primarily to non-agency issuances and provide exemptions for qualified residential mortgages meeting strict underwriting criteria, such as low debt-to-income ratios and no negative amortization. The rules aimed to ensure originators maintained "skin in the game," reducing incentives for lax lending standards that contributed to pre-crisis defaults. Complementing Dodd-Frank, the Consumer Financial Protection Bureau's Ability-to-Repay and Qualified Mortgage (ATR/QM) Rule, effective January 10, 2014, requires lenders to make reasonable, good-faith assessments of borrowers' repayment ability based on verified income, assets, and debt, with QMs—defined by criteria like a 43% debt-to-income cap and no balloon payments—offering liability protections. A temporary GSE patch, extended through 2021 and phased out thereafter, exempted loans eligible for purchase by Fannie Mae or Freddie Mac from the full QM strictness, preserving liquidity in agency securitizations while elevating overall mortgage underwriting quality. These measures, alongside enhanced capital and liquidity requirements under Basel III and Dodd-Frank's Volcker Rule, constrained banks' securitization activities, contributing to a more conservative MBS market structure. Post-crisis, the MBS market shifted decisively toward agency securities guaranteed by government-sponsored enterprises (GSEs), with private-label (non-agency) issuance plummeting from a 2005 peak of $740 billion to near zero by 2009 and remaining under 2% of total originations by 2012. Agency RMBS issuance, backed by Fannie Mae, Freddie Mac, and Ginnie Mae, dominated with annual volumes exceeding $2 trillion in recent years, supported by standardized underwriting and implicit government backing that restored investor confidence. Private-label activity saw limited revival, primarily in prime jumbo loans, but regulatory hurdles like risk retention deterred broader recovery, resulting in non-agency MBS outstanding at under $300 billion by 2020 compared to over $7 trillion in agency securities. Fannie Mae and Freddie Mac, placed into federal conservatorship on September 7, 2008, remained under government control through 2025, with the Federal Housing Finance Agency (FHFA) overseeing operations and Treasury providing liquidity support via preferred stock purchase agreements. Multiple reform efforts, including the 2011 PATH Act proposal and subsequent administrative plans, sought to recapitalize and release the GSEs or establish explicit government guarantees for MBS, but legislative gridlock prevented enactment, maintaining the status quo of conservatorship. By October 2025, the incoming Trump administration signaled potential administrative actions, including public offerings or privatization by year-end, to end conservatorship and transition to a sustainable housing finance model, though risks of higher mortgage rates without safeguards persisted. These developments underscored a market evolution prioritizing stability over innovation, with reforms curbing systemic vulnerabilities at the cost of reduced private-sector participation.

Types and Variants

Agency MBS

Agency mortgage-backed securities (MBS) are pass-through securities backed by pools of residential mortgages that meet specific underwriting standards set by government-sponsored enterprises (GSEs), entitling investors to a proportional share of the principal and interest cash flows from the underlying loans. These securities are issued by private entities but guaranteed for timely payment of principal and interest by GSEs such as Fannie Mae, Freddie Mac, or Ginnie Mae, which mitigates credit risk to investors by covering shortfalls from borrower defaults or servicer disruptions. Unlike non-agency MBS, agency variants derive their backing from GSE credit enhancements rather than private credit structures, with Ginnie Mae's guarantees explicitly supported by the full faith and credit of the U.S. government, while Fannie Mae and Freddie Mac rely on their own resources under federal conservatorship since 2008. Fannie Mae and Freddie Mac purchase conforming conventional mortgages—typically fixed-rate loans up to a specified limit (e.g., $766,550 for most areas in 2025)—from originating lenders, primarily commercial banks (Fannie Mae) or smaller thrifts and banks (Freddie Mac), then securitize them into agency MBS. These GSEs do not originate loans but standardize pooling and guarantee payments using their retained servicing fees and capital reserves, fostering liquidity by allowing lenders to offload assets and recycle capital into new originations. In contrast, Ginnie Mae does not purchase or originate mortgages; it guarantees MBS issued by approved private entities backed exclusively by federally insured or guaranteed loans, such as those from the Federal Housing Administration (FHA), Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA). This distinction ensures Ginnie Mae MBS support affordable housing for higher-risk borrowers, while Fannie and Freddie focus on prime conventional markets, with no direct government insurance on individual loans but implicit systemic support. As of August 2025, the outstanding balance of U.S. agency MBS approximates $9 trillion, representing the dominant segment of the mortgage securitization market and providing a benchmark for fixed-income investors due to their liquidity and relative safety. These securities trade actively in the to-be-announced (TBA) forward market, where buyers commit to pools matching generic characteristics (e.g., coupon rate, maturity) without specifying individual loans at trade date, enabling efficient price discovery and hedging. Ginnie Mae offers single-class passthrough products like Ginnie Mae I (for fixed-rate FHA/VA loans) and Ginnie Mae II (allowing multiple issuers and adjustable-rate mortgages), both fully government-backed to attract conservative investors. Fannie Mae and Freddie Mac similarly issue passthrough MBS but incorporate proprietary underwriting (e.g., automated systems for credit assessment) and have aligned standards under the Federal Housing Finance Agency (FHFA) for uniformity, including efforts toward a single securitization platform for interchangeable securities. This structure promotes secondary market depth, with average daily trading volumes exceeding $350 billion in agency MBS as of October 2025.

Non-Agency and Private-Label MBS

Non-agency mortgage-backed securities (MBS), interchangeably termed private-label MBS, consist of pools of residential mortgage loans securitized and issued by private financial institutions rather than government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, or Ginnie Mae. These securities collateralize non-conforming loans, including jumbo mortgages surpassing GSE size thresholds, subprime or Alt-A products with suboptimal borrower credit, and non-qualified mortgages (non-QM) employing flexible underwriting criteria such as interest-only terms or debt-to-income ratios exceeding standard limits. Absent the full faith and credit guarantees inherent to agency MBS, non-agency variants impose direct exposure to borrower defaults and servicer performance on investors, offset via private credit enhancements including subordination of tranches, overcollateralization, reserve funds, and excess interest spreads. This structure yields higher prospective returns but amplifies sensitivity to economic downturns and housing market fluctuations compared to government-backed counterparts. The private-label segment burgeoned in the early 2000s amid deregulatory pressures and surging housing demand, with issuance volumes doubling between 2003 and 2005 to exceed half of all MBS originations by 2005-2006, predominantly through subprime and adjustable-rate mortgage securitizations. This proliferation underpinned the 2007-2008 global financial crisis, wherein cascading defaults on overleveraged subprime loans—stemming from aggressive lending practices, asset price bubbles, and mispriced risk via optimistic credit ratings—inflicted trillions in losses, eroded investor confidence, and precipitated systemic failures including Lehman Brothers' collapse. Regulatory responses, including the Dodd-Frank Wall Street Reform Act of 2010, imposed rigorous risk retention rules, enhanced disclosures, and underwriting standards, curtailing issuance by over 70% in the ensuing years and redirecting focus toward higher-quality jumbo and non-QM collateral. By June 2025, non-agency residential MBS outstanding surpassed $1.7 trillion, dwarfed by the agency market's scale yet sustaining niche liquidity through institutional demand for yield enhancement. Issuance rebounded to $112-132 billion in 2024—more than doubling 2023 levels—and exhibited further growth into 2025, bolstered by a 40% surge in non-agency jumbo originations to $127 billion in the first half of the year amid elevated home prices and constrained agency capacity. Despite this uptick, the market's volatility persists, with delinquencies ticking upward to around 3.8% in early 2025 for non-QM pools, underscoring enduring credit vulnerabilities absent GSE intervention. Participants mitigate these through diversified tranching and empirical modeling of prepayment behaviors, though empirical evidence highlights amplified basis risk relative to agency securities during stress periods.

Structured Products like CMOs

Collateralized mortgage obligations (CMOs) are structured derivatives of mortgage-backed securities (MBS) that reallocate the principal and interest cash flows from a pool of underlying mortgages into distinct tranches, each with prioritized claims, varying maturities, and differentiated exposure to prepayment and interest rate risks. Introduced in 1983 by Freddie Mac, CMOs addressed limitations of pass-through MBS by enabling issuers to customize cash flow predictability, thereby attracting institutional investors such as pension funds and insurance companies seeking better asset-liability matching. The structure typically involves a special purpose vehicle that issues bonds backed by agency-guaranteed MBS collateral, with payments directed according to a predefined waterfall prioritizing senior tranches. The foundational CMO variant is the sequential-pay structure, often termed "plain vanilla," where principal repayments are directed first to the earliest maturing tranche (e.g., Tranche A) until it is fully retired, then sequentially to subsequent tranches (B, C, etc.), with any residual tranche designated as Z (zero-coupon). Z-tranches receive no interim payments but accrue interest compounded until prior tranches are paid off, resulting in longer effective durations and heightened sensitivity to extension risk during low prepayment environments. This sequencing shifts prepayment uncertainty from early tranches to later ones, providing short-term investors with more stable average lives while exposing long-term holders to greater variability. To further mitigate prepayment volatility, planned amortization class (PAC) tranches were developed, embedding principal schedules protected within a specified prepayment collar (e.g., 100-300% of the conditional prepayment rate, or CPR). Support or companion tranches absorb excess or shortfall prepayments outside the collar, buffering PAC stability at the cost of higher risk to supports, which can experience accelerated or extended maturities. Other variants include targeted amortization class (TAC) tranches, which offer partial protection against contraction risk but less against extension, and floating-rate tranches indexed to benchmarks like the London Interbank Offered Rate (LIBOR) plus a spread, hedging interest rate shifts but retaining prepayment exposure. Real estate mortgage investment conduits (REMICs), a tax-advantaged IRS structure enacted under the Tax Reform Act of 1986, encompass most CMOs issued post-1987, allowing pass-through of mortgage interest without entity-level taxation while facilitating complex tranching. By 2010, CMO outstanding volume exceeded $2 trillion, predominantly agency-backed, reflecting their role in enhancing MBS liquidity and investor diversification despite inherent complexities that demand sophisticated modeling for valuation. Empirical analyses indicate that while senior tranches achieve lower yield volatility, subordinate classes amplify risks, particularly in non-agency CMOs where credit enhancements like overcollateralization are critical yet insufficient against systemic defaults, as evidenced in the 2008 crisis.

Market Participants and Uses

Investors and Liquidity Dynamics

Institutional investors, including pension funds, insurance companies, mutual funds, and banks, constitute the primary holders of mortgage-backed securities (MBS), drawn to agency MBS for their yield premium over Treasuries alongside credit protection from government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. The Federal Reserve has been a major investor, accumulating over $2.5 trillion in agency MBS through quantitative easing programs by 2014, though holdings have since declined amid balance sheet normalization efforts. Foreign entities hold approximately $1.2 trillion in agency MBS as of June 2021, with Japan, China, and Taiwan accounting for 64% of that total, reflecting global demand for these relatively safe, dollar-denominated assets. Liquidity in the MBS market is predominantly driven by the To-Be-Announced (TBA) trading system, a forward market where securities are transacted based on generic attributes such as issuer, maturity, and coupon rate rather than specific underlying pools, enabling efficient price discovery and risk hedging for originators. This mechanism accounts for about 90% of agency MBS trades, with average daily volumes reaching $353.6 billion in agency MBS through September 2025, up 16.5% year-over-year, underscoring the market's depth despite periodic stress. Standardization and GSE guarantees enhance liquidity for agency MBS, yielding bid-ask spreads and turnover rates superior to non-agency variants, though the latter experienced severe illiquidity during the 2008 financial crisis due to opaque credit structures and absent backing. Post-2008 reforms, including the Dodd-Frank Act's clearing requirements for certain derivatives and Federal Reserve interventions like the Term Asset-Backed Securities Loan Facility (TALF), have bolstered overall market resilience, yet liquidity remains sensitive to interest rate volatility and dealer balance sheet constraints under Basel III capital rules. Empirical studies indicate that TBA eligibility confers liquidity premiums of 10 to 25 basis points, incentivizing issuers to conform pools to tradable specifications and thereby concentrating trading activity. In contrast, private-label MBS trading volumes have contracted sharply since 2007, remaining 60% below peak levels as of recent data, highlighting persistent challenges in non-agency segments absent systemic support.

Economic Benefits: Lower Costs and Broader Access

Mortgage-backed securities (MBS) enhance liquidity in the primary mortgage market by enabling originators to sell pools of loans to investors, thereby replenishing their capital for new lending without tying up balance sheets in long-term illiquid assets. This secondary market mechanism reduces the funding costs for lenders, as they can access a broader pool of capital from diverse investors seeking fixed-income alternatives, which in turn allows competitive pricing of mortgages at lower interest rates for borrowers. For instance, the development of agency MBS through government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac has historically compressed mortgage spreads over Treasury yields, with estimates indicating that GSE securitization activities contribute to reductions in 30-year fixed mortgage rates by facilitating efficient risk transfer and economies of scale in underwriting. The implicit backing of agency MBS lowers yield requirements to reduced premiums, directly translating to decreased borrowing costs for homebuyers; analyses of post-crisis MBS purchase programs demonstrate that such interventions removed substantial premiums embedded in rates, with effects persisting in market dynamics. also mitigates for originators by converting fixed-rate mortgages into tradable securities, encouraging the of long-term fixed-rate products that would otherwise be cost-prohibitive without a deep . from GSE operations shows that this provision has sustained lower effective costs compared to non-securitized markets, benefiting borrowers through spreads that are typically 20-50 basis points tighter than in less liquid segments. By expanding the investor base beyond traditional banks to include pension funds, insurers, and global entities, MBS broaden mortgage availability, particularly for underserved borrowers, as originators face less geographic or balance-sheet constraints in extending credit. This increased supply of mortgage funding has supported higher homeownership rates, with GSE affordable housing goals and securitization enabling greater volumes of loans to low- and moderate-income households through standardized purchasing and risk-sharing. Historical data indicate that the growth of the MBS market since the 1970s correlated with expanded credit access, allowing lenders to originate loans at scale and stimulating demand in regions with limited local deposit bases, though benefits are most pronounced in conforming loan segments backed by agency guarantees.

Risks and Valuation

Prepayment and Interest Rate Risks

Mortgage-backed securities (MBS) investors face prepayment risk, the possibility that underlying mortgage borrowers repay principal earlier than anticipated, primarily through refinancing or home sales, which disrupts expected cash flows. This risk intensifies when interest rates decline, as lower rates incentivize refinancing to capture cheaper borrowing costs, accelerating principal return to investors who must then reinvest at prevailing lower yields, reducing overall returns. Conversely, extension risk arises when rates rise, slowing prepayments as refinancing becomes uneconomical and borrowers retain higher-rate mortgages longer, extending the MBS duration and locking investors into below-market yields amid higher opportunity costs. Prepayment speeds are commonly benchmarked using the Public Securities Association (PSA) model, where 100% PSA assumes a conditional prepayment rate (CPR) starting at 0.2% in the first month, ramping up by 0.2% monthly for 30 months to reach 6% CPR thereafter, reflecting seasoning effects in new mortgage pools. Empirical data from agency MBS pools show variability; for instance, FHFA monitoring in Q1 2025 indicated prepayment rates influenced by rate environments, with slower speeds in higher-rate periods compared to historical lows during accommodative policy eras. These dynamics embed an embedded call option in MBS, akin to callable bonds, where borrowers exercise prepayment at their discretion, transferring reinvestment risk to investors. Interest rate risk in MBS compounds prepayment effects, as fluctuations alter both discount rates for valuing future cash flows and the likelihood of prepayments, leading to negative convexity where price appreciation lags during rate declines due to contraction risk, while price depreciation exceeds typical bonds during rises owing to extension. Unlike fixed-rate Treasuries, MBS effective duration varies nonlinearly with rates; for example, a 100 basis point rate drop can shorten duration by forcing prepayments, while a rise extends it, amplifying sensitivity beyond Macaulay duration measures. Valuation models thus incorporate option-adjusted spreads (OAS) to isolate credit and liquidity premia from prepayment-driven rate risk, with empirical studies confirming higher OAS for securities prone to macroeconomic prepayment shocks.

Credit and Default Risks

In mortgage-backed securities (MBS), credit risk arises from the potential that borrowers on the underlying pool of mortgages default on principal or interest payments, impairing cash flows to investors. Default risk specifically denotes the outright failure of borrowers to repay, often triggered by economic downturns, rising interest rates, or borrower-specific factors such as unemployment or insufficient income. Unlike prepayment risk, which affects timing but not principal recovery, credit and default risks can lead to permanent capital losses if collateral value—primarily the underlying real estate—does not cover shortfalls after foreclosure. Agency MBS, issued or guaranteed by entities like Ginnie Mae, Fannie Mae, or Freddie Mac, exhibit negligible credit risk due to explicit or implicit government backing that ensures timely payment of principal and interest regardless of borrower defaults. Ginnie Mae provides a full faith and credit guarantee from the U.S. Department of Housing and Urban Development, while Fannie Mae and Freddie Mac offer guarantees backed by their own capital, which proved effective post-2008 conservatorship when the U.S. Treasury provided unlimited support. This structure transfers default risk away from investors, who instead face primarily interest rate and prepayment exposures. In contrast, non-agency or private-label MBS lack such guarantees, exposing investors directly to credit risk, which is heightened in pools of subprime, Alt-A, or jumbo mortgages that do not meet agency conforming standards. Credit enhancements in non-agency deals, such as subordination (senior tranches protected by junior ones), overcollateralization, and excess spread, aim to mitigate losses, but these proved insufficient during periods of widespread defaults. Historical data underscores the severity of default risks in non-agency MBS during the 2007–2009 financial crisis, when lax underwriting standards and housing market collapse amplified borrower failures. Subprime mortgage delinquency rates surged from approximately 6.5% in late 2005 to 17% by mid-2007, with foreclosure initiations rising from 2.5% to 9%; by July 2008, subprime serious delinquency exceeded 21%, compared to an overall single-family delinquency increase from 1.7% to 4.5%. Non-agency MBS backed by 2006–2007 vintage subprime loans experienced cumulative losses averaging 2.3% even for AAA tranches by 2013, with subordinate tranches suffering near-total wipeouts due to negative home price equity and payment shocks from adjustable-rate mortgage resets. Agency MBS, by comparison, maintained near-zero investor losses on principal, as guarantees absorbed defaults without taxpayer bailouts directly impacting MBS holders. Key factors influencing default probabilities in securitized mortgage pools include loan-to-value (LTV) ratios, borrower debt-to-income levels, credit scores, and macroeconomic variables like unemployment and home price declines, which create negative equity and reduce incentives for repayment. High initial LTV ratios—often exceeding 90% in pre-crisis subprime pools—correlate strongly with default, as they leave little borrower skin in the game and heighten losses given default upon foreclosure. Post-crisis reforms, including Dodd-Frank risk retention rules requiring originators to hold 5% of securitized exposure, led to tangible improvements: affected loans showed lower LTVs, higher income-to-debt ratios, and reduced default rates, with overall single-family delinquency falling to 1.79% by Q2 2025. Despite these advances, non-agency MBS remain vulnerable to regional housing downturns or shifts in underwriting, as evidenced by persistent credit risk premiums in their yields relative to agency counterparts.

Pricing Models and Empirical Valuation

The valuation of mortgage-backed securities (MBS) requires accounting for the path-dependent nature of cash flows influenced by borrower prepayments, which are modeled as embedded call options exercisable when interest rates decline or refinancing becomes advantageous. Unlike plain vanilla bonds, standard discounted cash flow methods fail due to this optionality, necessitating stochastic interest rate models combined with prepayment forecasts to generate distributions of future payments under risk-neutral measures. Common frameworks employ Monte Carlo simulations, where thousands of interest rate paths are simulated—often using term structure models like the Hull-White two-factor model—to derive expected cash flows, which are then discounted and averaged to estimate present value. Prepayment modeling forms the core of these approaches, with the Public Securities Association (PSA) standard serving as a benchmark: under 100% PSA, the conditional prepayment rate (CPR) ramps from 0.2% in the first month to 6% by month 30 (increasing 0.2% monthly), remaining constant thereafter, reflecting empirical seasoning patterns in agency pools. More advanced empirical prepayment functions incorporate borrower incentives, burnout effects (reduced sensitivity after prior refinancings), and macroeconomic drivers like unemployment, calibrated from historical loan-level data to predict speeds beyond the PSA baseline. These functions are integrated into simulations, where prepayment probabilities along each path determine principal and interest distributions. The option-adjusted spread (OAS) quantifies relative value by solving for the constant spread over the risk-free curve that equates model-generated prices to observed market prices, isolating compensation for credit, liquidity, and model risks after stripping out embedded option effects via volatility assumptions (typically 20-100 basis points of short-rate volatility). Empirical studies validate these models' pricing efficacy: for instance, a two-factor structural model tested on FNMA pools from 1985-1990 accurately predicted prepayment and default behaviors under varying rates, with pricing errors under 1% of par value in low-volatility regimes. However, during the 2007-2008 crisis, OAS for non-agency MBS widened dramatically (e.g., subprime tranches from 200 bp to over 1,000 bp), revealing model underestimation of tail risks from correlated defaults and liquidity freezes, as static prepayment assumptions failed against systemic housing downturns.

Controversies and Critiques

Moral Hazard from Implicit Guarantees

The perception of implicit government backing for government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac created moral hazard in the market for agency mortgage-backed securities (MBS), as investors treated these securities as virtually risk-free despite underlying credit exposures. This belief stemmed from the GSEs' quasi-public status and historical government interventions, leading markets to price agency MBS with yields only slightly above U.S. Treasuries—often 20-50 basis points higher pre-2008—effectively subsidizing GSE funding costs by an estimated $100-200 billion annually in the years leading to the crisis. Originators and GSEs responded by relaxing underwriting standards, originating and guaranteeing riskier loans, including subprime and Alt-A mortgages that comprised up to 20% of GSE portfolios by 2007, under the assumption that any losses would be socialized via taxpayer support rather than borne privately. This dynamic incentivized excessive leverage and risk-taking: GSEs expanded their combined on- and off-balance-sheet guarantees from $1.5 trillion in 1992 to over $5 trillion by 2008, dominating 50-60% of the U.S. mortgage market, while originators shifted focus from loan quality to volume to capture fees, contributing to a tripling of high-risk lending from 2000-2006. Empirical analyses indicate that the implicit guarantee amplified moral hazard by reducing market discipline; for instance, GSE-affiliated securitizations exhibited higher delinquency rates in downturns compared to private-label MBS without such perceived backstops, as private investors demanded stricter covenants absent government safety nets. Critics, including Federal Reserve economists, argue this setup distorted capital allocation, channeling cheap credit into overvalued housing rather than productive uses, with GSEs prioritizing market share over prudence due to the guarantee's distortion of incentives. The 2008 conservatorship of Fannie Mae and Freddie Mac, involving $187 billion in Treasury infusions (net recovered to $116 billion profit by 2019), validated the implicit guarantee, potentially entrenching future moral hazard by signaling unconditional support. Post-crisis reforms, such as the 2012 capital requirements under conservatorship, aimed to mitigate this by imposing explicit buffers—raising GSE capital from near-zero to targeted 4-5% of assets—but ongoing debates highlight risks of re-privatization without full explicit guarantees, which could revive underpricing of tail risks. Proponents of ending implicit elements contend that true pricing of GSE MBS risks would restore originator incentives for due diligence, though empirical evidence from private-label markets post-2008 shows higher spreads (200-300 basis points over agencies) reflecting genuine risk assessment without backstops.

Incentives for Lax Underwriting

The originate-to-distribute model prevalent in the mortgage industry prior to the 2008 financial crisis created strong incentives for lenders and brokers to prioritize loan volume over rigorous credit assessment. Under this framework, originators issued mortgages primarily to package and sell them into mortgage-backed securities (MBS), earning upfront fees such as origination points and servicing rights while transferring most credit risk to investors. This reduced the originators' "skin in the game," diminishing their motivation to enforce strict underwriting standards like thorough documentation of borrower income, assets, and debt-to-income ratios. Securitization rates for subprime loans rose sharply, from approximately 20% in the late 1990s to over 50% by 2006, amplifying these distortions as lenders competed to feed the secondary market. Empirical studies confirm that higher securitization activity correlated with laxer screening practices. Analysis of subprime loan data from 1997 to 2006, exploiting geographic variation in securitization rates, found that lenders in high-securitization areas exhibited lower loan denial rates and originated mortgages with higher subsequent default probabilities, indicating reduced screening effort. Banks heavily engaged in originate-to-distribute channels during this period systematically produced lower-quality loans compared to those retaining more originations on balance sheets, as measured by post-origination performance metrics like delinquency and foreclosure rates. These findings suggest that the prospect of rapid offloading via MBS undermined traditional underwriting discipline, contributing to the proliferation of no-documentation ("liar") loans and adjustable-rate mortgages with teaser rates that masked repayment risks. Mortgage brokers, often compensated via yield spread premiums (YSP)—additional payments from lenders for delivering higher-interest (riskier) loans—faced parallel incentives to steer borrowers toward subprime products regardless of qualification. YSP structures rewarded brokers for originating loans with elevated yields, which typically involved weaker underwriting, such as minimal income verification or inflated appraisals, fostering a volume-driven culture over sustainability. This agency misalignment extended to non-bank lenders, who lacked deposit bases and regulatory oversight, further eroding standards in pursuit of market share amid rising housing prices from 2000 to 2006. Government-mandated affordable housing goals for government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac indirectly bolstered these private incentives by signaling tolerance for riskier underwriting. Established by the Department of Housing and Urban Development (HUD) in 1993 and expanded in 1995, these goals required GSEs to direct a growing share of purchases—rising from 40% low- and moderate-income mortgages in 1996 to 56% by 2008—toward underserved borrowers, pressuring them to relax criteria via automated systems like Fannie's Desktop Underwriter. To meet escalating targets under administrations from Clinton to Bush, GSEs increasingly acquired loans with features associated with lax origination, such as reduced documentation, which originators interpreted as market validation for broader leniency even in private-label MBS. While GSEs focused more on prime conforming loans, their involvement in Alt-A and subprime segments grew to comply, exemplifying how policy objectives for expanded homeownership distorted risk assessment across the ecosystem.

Causal Role in Financial Instability vs. Policy Distortions

Mortgage-backed securities (MBS) played a role in transmitting financial instability during the 2007-2008 crisis by pooling and redistributing risks from subprime and Alt-A mortgages, whose defaults surged after house prices peaked in mid-2006. Non-agency residential MBS issuance reached $1.3 trillion in 2006, but widespread misrating by agencies like Moody's and overreliance on flawed models led to sharp value declines, triggering liquidity freezes and fire sales among leveraged institutions. Empirical analysis of MBS payoffs through 2013 shows that while securitization dispersed initial credit risks, the underlying mortgage quality deterioration—driven by origination standards collapse—amplified systemic shocks, with cumulative losses exceeding $500 billion on subprime tranches alone. However, securitization mechanisms predated the crisis and had functioned stably for prime loans; the instability arose primarily from the injection of high-risk assets into the pool, not the pooling process itself. Policy distortions, particularly government-mandated affordable housing objectives imposed on GSEs Fannie Mae and Freddie Mac via HUD goals, were the root cause of the subprime expansion that fueled the housing bubble and subsequent MBS vulnerabilities. The 1992 GSE Act and subsequent HUD targets required escalating shares of low- and moderate-income (LMI) loans, rising from 30% in 1993 to 56% by 2008, compelling GSEs to purchase riskier products including $707 billion in subprime MBS and $154 billion in Alt-A MBS from 1997-2007, representing about 30% of total subprime securitizations. These mandates, intended to boost homeownership from 64% in 1994 to 69% by 2004, systematically eroded underwriting standards, with GSE leverage ratios reaching 60:1 and promoting no-down-payment loans that comprised 30% of originations by 2006. Former Fannie Mae chief credit officer Edward Pinto documented how such policies increased non-traditional mortgages to 49% of the 55 million outstanding by June 2008, with 70% linked to government entities, crowding out private prudence and shifting risk to higher-yield but riskier segments. Complementing GSE pressures, 's accommodative post-2001 —holding at 1% through mid-2003—sustained low rates below 6%, inflating and enabling the bubble's growth, with prices doubling from 1997-2006. FCIC dissenter Peter Wallison attributed the core to these housing policies, arguing GSEs' implicit guarantees and goal-driven purchases of high-risk loans (nearly 30% of their direct acquisitions qualifying as subprime under broad definitions) dwarfed private contributions, as evidenced by GSEs' 23% share of Wall Street subprime/ securities by 2007. While some analyses, including studies, contend GSE goals had marginal direct impact on subprime volume, the empirical pattern of policy-induced leverage buildup—evident in 1-in-3 loans with FICO scores under 660 by 2007—supports causal primacy of distortions over inherent MBS flaws, with private securitizers following rather than leading the escalation.

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