what are mortgage backed securities mbs 
mortgage backed securities mbs are investments like bonds each mbs is a share in of a bundle of home loans and other real estate debt bought from the banks or government entities that issued them investors in mortgage backed securities receive periodic payments like bond coupon payments the mbs market has evolved significantly since the 2007 to 2008 financial crisis which was largely triggered by the collapse of the subprime mortgage market and the complex web of mbs and related derivatives today the mbs market remains a major part of the global financial system albeit with new regulations and increased scrutiny from investors and policymakers by total value over three in five mortgages in the u s are repackaged as mbs 12as investments in them steadily grow again reaching figures last seen before the financial crisis should there be a greater concern that the next recession could set off waves of mortgage defaults that could again wreak havoc on the world economy in what follows we take you through the details of what these investments are why they exist and their place in the markets of the 2020s we ll then leave you better able to decide whether they have a place in your own portfolio and that of the nation julie bang investopediaunderstanding mortgage backed securities mbs mbs are asset backed securities formed by pooling together mortgages the investor who buys a mortgage backed security is essentially lending money to homebuyers an mbs can be bought and sold through a broker the minimum investment varies between issuers as became glaringly obvious in the subprime mortgage meltdown of 2007 to 2008 an mbs was once only as sound as the mortgages that back it up in the 2020s most mbs have the backing of the u s government these are called agency mbs 1to be sold on the markets today an mbs must be issued by a gse or a private financial company and the mbs must have received one of the top two ratings issued by an accredited credit rating agency non agency mbs meanwhile are issued by private financial institutions and are not guaranteed instead securities are grouped by seniority and sold to investors with different appetites for risk 3mortgage backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth 4the best way to understand mbs is to see how they are formed in the first place let s walk you through the steps types of mortgage backed securitiesthese are the two broadest types of mbss pass throughs and collateralized mortgage obligations cmos beneath them is a table with descriptions for other major types within these mbs history of mortgage backed securitiesmortgage backed securities were introduced after the passage of the housing and urban development act in 1968 the act created the government national mortgage association known as ginnie mae which split off from fannie mae the new entity allowed banks to sell their mortgages to third parties so that they would have more capital to lend out and originate new loans this in turn made it possible for institutional funds to buy up and package many loans into an mbs ginnie mae introduced the first mortgage backed securities for the retail housing market in 1970 the first private mbs was introduced by bank of america in 1977 5mortgage backed securities and the financial crisis of 2007 to 2008mortgage backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth bring down lehman brothers and roil the world financial markets 4in retrospect it seems inevitable that the rapid increase in home prices and the growing demand for mbs would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost that was the beginning of the subprime mbs with freddie mac and fannie mae supporting the mortgage market the quality of all mortgage backed securities declined and their ratings became meaningless then in 2006 housing prices peaked 6subprime borrowers started to default which is the failure to repay a loan as a result the housing market began its prolonged collapse more people began walking away from their mortgages because their homes were worth less than their loans even the conventional mortgages underpinning the mbs market had steep declines in value the avalanche of nonpayments meant that many mbss and collateralized debt obligations cdos based on pools of mortgages were soon vastly overvalued the losses piled up as institutional investors and banks tried and failed to unload their bad mbs investments credit tightened causing many banks and financial institutions to teeter on the brink of insolvency lending was disrupted to the point that the entire economy was at risk of collapse the u s congress authorized a 700 billion financial system bailout to ease the credit crunch also the u s federal reserve bought 4 5 trillion in mbs over several years while the troubled asset relief program tarp injected capital directly into banks some of the measures of the bailout included the following in 2010 tarp ended also that year the dodd frank wall street reform and consumer protection act was passed the dodd frank law reduced the initial 700 billion authorized for tarp to 475 billion 7advantages and disadvantages of mortgage backed securitiesfixed interest rates and monthly payoutsmore diversification than single loansrelatively low correlation with corporate bonds or the stock marketreturns may be affected by borrowers refinancing or paying off their loans early if interest rates increase the price of an mbs may drop advantagesfor investors mortgage backed securities have some advantages over other securities they pay a fixed interest rate that is usually higher than u s government bonds moreover they typically offer monthly payouts while bonds offer a single lump sum payout at maturity mortgage backed securities are also considered relatively low risk given the government backing for most of them if an mbs is guaranteed by the federal government investors do not have to absorb the costs of a borrower s default moreover they offer diversification from the markets of corporate and government securities 8disadvantagesprepayments can be either voluntary such as when borrowers refinance or relocate or involuntary from defaults refinancing is the most significant source of prepayment as borrowers can pay off their remaining balance at par without penalty when market interest rates decline this makes mbs callable securities limiting their price appreciation potential and resulting in negative convexity the weighted average coupon wac can estimate the prepayment characteristics of a pool of underlying mortgages the wac will change periodically as mortgages are paid off 9this is related to duration risk which arises from the sensitivity of mbs prices to changes in interest rates mbs typically have extended maturities and pay fixed coupons resulting in high duration and significant price sensitivity to interest rate movements however unlike traditional fixed income securities the duration of mbs is not fixed but remains uncertain because of the potential for borrowers to prepay their loans at any time mbss are also sensitive to changes in interest rates on loans and mortgages if interest rates rise fewer people will take out mortgages causing the housing market to decline liquidity varies significantly across different types of mbs with agency mbs benefiting from the highly liquid to be announced or tba forward market and the ability to execute dollar rolls for funding in contrast private label mbs have much more limited liquidity 9mortgage backed securities todayin the u s the mbs market is massive with over 11 trillion in outstanding securities and almost 300 billion in average daily trading volume according to the federal reserve bank of new york 3 the market is divided into two main categories agency mbs which are issued by government sponsored entities like the federal national mortgage association fannie mae and federal home loan mortgage corporation freddie mac and non agency mbs which are issued by private financial institutions agency mbs are considered less risky because they are backed by fannie mae and freddie mac guarantees which promise to pay investors even if homeowners default on their loans this guarantee is ultimately backed by the u s government making agency mbs attractive to investors looking for stable fixed income returns in may 2024 agency mbs s average daily trading volume reached 292 9 billion a 19 4 increase over may 2023 3non agency mbs meanwhile do not have explicit government guarantees and typically carry higher credit risk investors in non agency mbs face potential losses if homeowners default on their mortgages non agency mbs often have higher yields than agency mbs to compensate for this increased risk in may 2024 non agency mbs s average daily trading volume was around 1 62 billion a 6 8 increase over may 2023 but only a tiny fraction of agency mbs 1the growth of the mbs market can be attributed to increasing demand for these securities global economic expansion and ongoing efforts to stimulate economic growth through monetary policy these are not the only assets the u s federal reserve has been working to get off its balance sheet however the market also faces challenges such as interest rate risk 