Agency-backed mortgage-backed securities (MBS) are financial instruments secured by a pool of mortgages that have been guaranteed by a government-sponsored enterprise (GSE). The four major GSEs in the United States are Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Housing Administration (FHA).
MBS are created when a bank or other financial institution originates mortgages and then sells them to a GSE. The GSE pools the mortgages together and issues securities that are backed by the full faith and credit of the U.S. government. This makes MBS one of the safest and most liquid investments in the world.
MBS are typically sold to institutional investors, such as pension funds, mutual funds, and insurance companies. These investors purchase MBS because they offer a relatively high yield compared to other fixed-income instruments. However, MBS are also subject to interest rate risk, which means that their value can decline if interest rates rise.
There are two main types of MBS:
- Pass-through MBS: In a pass-through MBS, the investor receives a portion of the principal and interest payments from each mortgage in the pool.
- Collateralized mortgage obligations (CMOs): In a CMO, the pool of mortgages is divided into tranches with different priorities. The holders of tranches with higher priorities receive payments first, while the holders of tranches with lower priorities receive payments last.
MBS are an important part of the U.S. housing market. They provide a way for banks to originate mortgages without having to hold them on their balance sheets . This allows banks to recycle their capital and originate more mortgages. MBS also make it easier for investors to invest in mortgages, which helps to increase the supply of mortgage capital.
As of 2022, there are over $10 trillion worth of MBS outstanding. MBS are one of the largest asset classes in the world, and they play a vital role in the U.S. economy.
Here are some of the benefits of investing in MBS:
- High yield: MBS typically offer a higher yield than other fixed-income investments.
- Liquidity: MBS are one of the most liquid investments in the world.
- Diversification: MBS can help to diversify an investment portfolio.
- Government backing: MBS are backed by the full faith and credit of the U.S. government.
However, there are also some risks associated with investing in MBS:
- Interest rate risk: The value of MBS can decline if interest rates rise.
- Prepayment risk: borrowers may prepay their mortgages, which can reduce the cash flow to MBS investors.
- Credit risk: The borrowers in an MBS pool may default on their mortgages, which can cause losses to MBS investors.