Mortgage-backed security (MBS)
Also known as: mortgage-backed securities, mortgage pass-through security
A mortgage-backed security (MBS) is a bond backed by a pool of home mortgages. Investors receive monthly payments of principal and interest as homeowners pay down the underlying loans.
A mortgage-backed security (MBS) is a debt instrument created by pooling hundreds or thousands of individual home mortgages and selling investors a claim on the payments those loans generate. Instead of the semiannual interest most bonds pay, an MBS distributes monthly payments that combine both interest and a portion of principal, mirroring the homeowners' own mortgage payments.
Most MBSs are issued or guaranteed by federal agencies and government-sponsored enterprises. The Government National Mortgage Association (GNMA, or Ginnie Mae) guarantees pass-through certificates issued by approved private lenders, backed by the full faith and credit of the US government, while Fannie Mae (FNMA) and Freddie Mac (FHLMC) issue similar securities carrying an implied, rather than explicit, government backing. Because each investor receives a proportional share of the pool's cash flows, these products are commonly called pass-through certificates.
The defining risk of an MBS is prepayment risk. When interest rates fall, homeowners refinance and pay off their loans early, returning principal to investors sooner than expected — right when reinvestment opportunities are least attractive. When rates rise, prepayments slow and the security's effective life extends, a related problem known as extension risk.
Mortgage-backed securities appear throughout the fixed-income portion of the securities licensing exams. The SIE exam expects you to recognize agency pass-throughs like GNMA certificates, know which carry direct government backing, understand the monthly principal-and-interest payment structure, and connect falling interest rates to prepayment risk.
Key takeaways
- An MBS is a bond backed by a pool of home mortgages, paying investors monthly principal and interest.
- GNMA pass-throughs are backed by the full faith and credit of the US government; FNMA and FHLMC securities carry only implied backing.
- Prepayment risk rises when interest rates fall, because homeowners refinance and return principal early.
- The SIE exam tests agency pass-throughs, their backing, and the risks unique to mortgage securities.