Mortgage- and Asset-Backed SecuritiesMBS
Mortgage-backed securities pool home loans and pass the borrowers’ payments to investors. Asset-backed securities do the same with other loans, such as car loans, credit cards or student loans. Early repayment by borrowers is a key risk.
Banks make loans; investors want income. Securitisation connects the two: loans are bundled into a pool, and securities backed by that pool are sold to investors. Mortgage-backed securities are one of the largest bond markets in the US. This entry explains how they work, how asset-backed securities differ, and why prepayments make them behave differently from ordinary bonds.
- Category
- Bonds and Interest Rates
- Reading time
- 4 min
- Also called
- Mortgage-backed security, Asset-backed security, Securitisation
- Updated
MBS and ABS in plain words
Mortgage loans are bought from lenders, pooled, and turned into securities that pay investors the borrowers’ principal and interest — a process called securitisation.1
Asset-backed securities pay returns from a pool of other debts, such as car loans or credit card balances; mortgage-backed securities are one type of ABS.2
How securitisation works, step by step
Lenders make loans
Mortgages, car loans or card balances.
Loans are pooled
An agency or private entity buys and pools them.1
Securities are issued
Investors buy claims on the pool’s cash flows.
Payments pass through
Borrowers’ payments flow to investors.
Tranches may split risk
Some structures pay classes in a set priority.1
Borrowers may prepay
Early repayment returns principal sooner than expected.
Worked examples
Example 1 — A pass-through share
Monthly incomeAn investor owns 1% of a mortgage pool. This month borrowers pay $800,000 in principal and interest.
| Investor’s share | $800,000 × 1% = $8,000 |
A pass-through gives each holder a pro-rata share of the pool’s payments.1
Example 2 — Prepayment risk
Lower incomeRates fall and borrowers refinance. $10,000 of principal earning 6% comes back early and can only be reinvested at 4%.
| Income before | $10,000 × 6% = $600 a year |
| Income after | $10,000 × 4% = $400 a year |
Principal returns just when reinvestment options are worse.1
Example 3 — Extension risk
Longer lifeRates rise instead. Fewer borrowers refinance, so the expected life of the security stretches from 7 to 10 years.
| Effect | Money stays locked in at the old, lower rate |
MBS tend to shorten when you want them long and lengthen when you want them short. See Convexity.
MBS vs. ABS
| Aspect | MBS | ABS |
|---|---|---|
| Backed by | Home and other real estate loans | Car loans, card balances, student loans and more |
| Main risk | Prepayment and extension | Borrower defaults and prepayment |
| Typical issuers | Ginnie Mae, Fannie Mae, Freddie Mac, private firms | Banks, lenders, finance companies |
| Relationship | A type of ABS | The broader group |
Why MBS and ABS matter
Income investing
Regular monthly payments.
Housing finance
Securitisation lets lenders make more loans.
Bond funds
Many core bond funds hold agency MBS.
Financial stability
Poor-quality pools can spread losses widely.
Advantages and disadvantages
Advantages
- Monthly income from many underlying loans.
- Agency MBS carry government or agency guarantees.
- Diversification across thousands of borrowers.
Disadvantages
- Prepayment risk when rates fall.
- Extension risk when rates rise.
- Complex structures can be hard to analyse.
- Private-label pools carry real credit risk. See Default Risk.
Going deeper
Read as far as you need. Each level builds on the one before it.
Who guarantees agency MBS
Beginner
Ginnie Mae is backed by the full faith and credit of the US government. Fannie Mae and Freddie Mac give their own guarantees but are not backed in the same way.1
Tranches
Intermediate
Collateralised mortgage obligations divide pool payments into tranches with different principal balances, coupons, prepayment risks and maturities.1
Negative convexity
Advanced
Because borrowers refinance when rates fall, MBS prices rise less than comparable bonds in rallies but still fall when rates rise — the hallmark of negative convexity. See Duration.
Common mistakes
Treating MBS like Treasuries
Cash flows are uncertain because of prepayments.
Ignoring who stands behind the pool
Agency and private-label risks differ greatly.
Looking only at yield
Higher yield often pays for prepayment or credit risk.
Forgetting extension risk
Rising rates can lengthen the bond.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Securitisation turns pools of loans into tradable securities.
- MBS are backed by mortgages; ABS by other loans.
- Investors receive borrowers’ principal and interest.
- Prepayment and extension risk drive MBS behaviour.
- Guarantees differ between agency and private-label pools.
Frequently asked questions
Are mortgage-backed securities safe?
What is a pass-through?
How do individuals usually invest in MBS?
Further learning
- Convexity
Why MBS prices behave unusually.
- Callable and Putable Bonds
Prepayment works like an issuer call.
- Duration
Rate sensitivity of bonds.
- Default Risk
Credit risk in private-label pools.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Mortgage-Backed Securities and Collateralized Mortgage Obligations (opens in a new tab) Checked .
- FINRA. Bonds (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.