Mortgage backed securities (MBS) are a type of asset backed security. As should be obvious from the name, the asset that they are backed with are mortgages: more precisely the pooled cash flows from mortgages.
The simplest mortgage backed security is a pass-through MBS which simply distributes received interest and repayments of principal to the holders of the security, with a deduction for a servicing fee. This usually goes to the originator.
The sequence of events is:
- The originator lends money on mortgages.
- Mortgages are selected to go into a pool whose cash flows are to be securitised.
- The cash flows then go to the holders of the securities.
Apart from the simple pass through type, there are other types of MBS. These include CMOs which issue several securities against the same pool of mortgages, giving investors a choice of exposures to risk, and returns. This is similar to the difference between the different classes of shares of a split capital investment trust.
As with split capital investment trusts, but with more far reaching consequences, these structures have proven to make it more difficult for investors to assess the risk of any given security issued against the pool of assets.
Another way in which the cash flows from an MBS can be divided up differently ("segregated") is by stripping them, separating interest from repayments of principal.
In some countries it is common for the originators to keep retain ownership of the mortgages, issuing corporate bonds secured by a portion of a mortgage book. The vital difference between this and an MBS is that there is no transfer of risk.
In the US, the main issuers of MBS were government sponsored corporations (Fannie Mae, Freddie Mac and Ginne Mae) with an implicit or actual government guarantee. This made them extremely safe investments, needing to offer only a small spread over the risk free rate. This is not true for other issuers. The US market is also notable for the additional risk that comes from the early payment of fixed rate mortgages if interest rates fall. This effectively gives borrowers a put option that they will exercise if rates fall.
The pool backing an MBS commonly contain either only residential mortgages, or only commercial mortgages. The two types are distinguished by the use of the terms CMBS (commercial mortgage backed security) and RMBS (residential mortgage backed security)