Mortgage-Backed Securities

How it works

Lenders originate mortgages and sell them into a pool. The pool issues securities, and each buyer receives a pro-rata share of the monthly principal and interest that the underlying borrowers pay. A servicer sits between the borrower and the security holder: it collects payments, manages escrow accounts, and handles delinquencies, keeping a servicing strip out of the interest before anything is passed through. On agency deals, the guarantor also takes a guarantee fee out of that same interest stream.

The guarantees differ by issuer. Ginnie Mae pools carry the explicit full faith and credit of the United States on timely payment of principal and interest. Fannie Mae and Freddie Mac guarantee their own pools, backed by the implied federal support those enterprises carry rather than a statutory guarantee. Non-agency, or private-label, MBS carry no such backing. They are credit-tranched instead, with junior classes absorbing losses before senior classes are touched — the structure that sat at the center of the 2008 crisis.

Collateralized mortgage obligations rearrange a pool's cash flows by timing rather than credit, sending principal to tranches in a set sequence and sometimes splitting cash flow into interest-only and principal-only strips. Every payment a holder receives is part interest and part return of principal, so the security's outstanding balance amortizes down over its life. That remaining balance is tracked publicly through a monthly factor.

What it pays

An MBS is quoted as a yield to maturity under an assumed prepayment speed, and different securities are compared using option-adjusted spread, a measure that prices the value of the borrower's right to prepay. Prepayment speed itself is expressed as a constant prepayment rate or against the PSA benchmark curve, and small changes in the assumed speed can move the quoted yield substantially — the same pool can look very different depending on the assumption used.

The underlying driver is simple: where current mortgage rates sit relative to the pool's weighted average coupon. When new mortgage rates fall below a pool's coupon, refinancing accelerates and prepayments surge, returning principal faster than expected. That asymmetry produces negative convexity — an MBS gains less in price when rates fall than it loses when rates rise, the opposite of a plain bond's behavior.

Because that prepayment option is a cost borrowers hold and security holders bear, agency MBS typically yield more than comparable Treasuries even though the credit guarantee is the same. The extra spread compensates for cash-flow timing risk, not default risk. Monthly rather than semiannual payments smooth the income stream, but every check blends taxable interest with a return of the holder's own capital.

Costs and taxes

Servicing and guarantee fees are deducted before the pass-through reaches the security holder, so the quoted coupon is already net of those costs. Individual investors rarely buy whole pools directly; dealer markups on retail-size pool trades are meaningful, and most access to the asset class comes through an MBS ETF or mutual fund carrying a stated expense ratio.

For US federal tax purposes, the interest portion of each monthly payment is ordinary income, while the principal portion is a return of capital and is not taxable income. That split means the cash received each month is larger than the taxable income reported, and the holder's cost basis declines every month as principal is returned — a reconciliation that is easy to get wrong on a tax return.

Agency MBS interest is generally not exempt from state income tax the way direct Treasury interest is, though the treatment of Ginnie Mae paper varies by state. Non-agency deals are frequently structured as REMICs, and their tax reporting can include original issue discount and market discount accruals on top of the basic interest-versus-principal split.

Liquidity and time commitment

Agency MBS trade in one of the largest, deepest fixed-income markets in the world, most of it through the TBA, or to-be-announced, forward market where generic pools are bought and sold before specific loans are even assigned. That headline liquidity, however, lives at institutional size. A retail-size lot of a specific seasoned pool is far harder to move at a tight spread, and non-agency and older seasoned pools can be genuinely difficult to sell, especially during periods of market stress.

There is no fixed maturity in practice. A pool's stated final maturity may run thirty years, but its average life is typically much shorter and shifts constantly with prepayment speeds. Holding a fund or ETF keeps effort low, since the manager handles factor tracking and reinvestment. Holding individual pools directly requires tracking monthly factors, reinvesting returned principal, and reconciling the interest-versus-principal split by hand.

How it goes wrong

Prepayment risk shows up when rates fall: borrowers refinance, a high-coupon pool is repaid at par, and the holder gets cash back exactly when reinvesting it at a similar yield is hardest. Extension risk is the mirror image and often worse — rates rise, refinancing stops, and a security expected to return principal within a few years stretches out for many more while its market price falls. Negative convexity is the structural label for this: the price behaves poorly at both ends of a rate move, the cost of owning the borrower's prepayment option.

Credit risk is concentrated in non-agency deals and, within them, in junior tranches. The 2007–2009 period showed how quickly a subordinated class can be written down to zero when defaults exceed the assumptions built into the tranche structure. A more mundane failure mode is behavioral: investors regularly mistake the size of the monthly check for yield, when a substantial part of it is simply their own principal being returned.

Cash-flow timing can also be disrupted by forces outside any prepayment model — servicer operational problems, government forbearance programs, and foreclosure moratoria have all changed the pace of principal return in ways that standard prepayment assumptions did not anticipate.