A Guide to Understanding Mortgage-Backed Securities

People tend to think of mortgage-backed securities (MBS) in relation to the 2007 U.S. housing market crash and the subsequent financial crisis of 2008. But what exactly are MBS, and how has the market for these securities changed since then?

Since the 1980s, banks and other lenders have increasingly bundled and sold their mortgage loans to government-sponsored enterprises and private financial institutions. These enterprises and institutions in turn sell MBS (as agency MBS and nonagency MBS, respectively) in the form of securities to investors. The securitization of mortgages allows banks to free up capital for lending and enables the decoupling of mortgage lending from mortgage investing.

For their paper, “Mortgage-Backed Securities,” James Vickery of the Philadelphia Fed, David Lucca of Jane Street, and Andreas Fuster of the École Polytechnique Fédérale de Lausanne, Swiss Finance Institute, and Center for Economic Policy Research, review this securities market in detail.¹ MBS, they write, “lie at the heart of housing finance and the U.S. financial system and also play a significant role in monetary policy and monetary transmission.” They focus on the large residential agency MBS market in the United States but also discuss other types of MBS in the United States and globally. Below are some of their key observations and insights.

The market for residential MBS expanded rapidly between the 1980s and the mid-2000s, the authors explain, with the volume of these traded securities equaling close to a hefty 50 percent of gross domestic product around the time of the housing crisis. However, a big decline in U.S. home prices in the late-2000s, coupled with banks’ lax mortgage-lending standards, contributed to a huge wave of mortgage defaults in the subprime lending market.² When financial institutions suffered massive losses on their MBS investments, the crisis widened and resulted in the Great Recession of 2007–2009.

Postcrisis regulations were put in place to prevent a repeat of the housing and financial market crash. These regulations include the Dodd–Frank Act’s risk retention requirements, more stringent bank liquidity regulations, and reforms to the government-sponsored enterprises Fannie Mae and Freddie Mac.

The market for agency MBS has since recovered, the authors write, and is very active. However, the riskier nonagency MBS market, which lacks a government-backed guarantee for investors, remains far below precrisis levels. The majority of MBS issued today are composed of residential mortgages, with pooled commercial mortgages playing a significantly smaller role. And the residential MBS market is enormous. About two-thirds of all residential mortgages have been repackaged as MBS in recent years, nearly all of them as agency MBS.

The most straightforward design of agency MBS is a “pass-through,” where scheduled principal and interest, as well as any prepayments, are paid to investors after subtracting a fee to the loan servicer and a fee for a credit guarantee. Other agency MBS designs appeal to investors with different risk appetites and duration needs — for example, life insurers favor long-duration assets to match their policy liabilities.

Because MBS can be risky, yields on them are significantly greater than on “risk-free” assets such as government bonds. These risks come in four main categories. Borrowers can prepay their mortgage loans at any time, so the duration of MBS is not fixed, creating interest rate risk and prepayment risk.³ Investors also face credit risk because borrowers can default on their loans. This is primarily a concern for investors in nonagency MBS because these securities lack a government-backed guarantee.⁴ Another risk for investors is uncertainty about the ease with which MBS can be traded — in other words, liquidity risk.

Today’s U.S. market for MBS, the authors write, is one of the largest and most liquid global fixed-income markets, with trading volumes averaging about $300 billion daily and with over $11 trillion of securities outstanding.⁵ Who invests in the MBS market? Mid-2021 data of mostly agency MBS show that the largest class of investors is banks and other depository institutions (32 percent), followed by the Federal Reserve (23 percent) and international investors (11 percent). The remaining shares cover a wide range of other investor types.⁶

The Federal Reserve is the single largest agency MBS investor through its large-scale asset purchase program, with holdings equaling $2.5 trillion as of October 2021.⁷ To stimulate economic growth during and after the 2008 financial crisis, the Fed bought securities, including large amounts of MBS. This increased the money supply and reduced interest rates. As a matter of policy, the Fed has recently worked to draw down its holdings of MBS and other securities from its balance sheet.

As is widely cited in the literature, a key benefit of the MBS market is that it makes mortgages more liquid thanks to the high marketability and tradability of these securities. One of the downsides of the MBS market, as historical experience shows, is that loan originators may have a weaker incentive to screen borrowers, thus increasing the default risk on these securities. The authors are confident that “this important market will remain a vibrant topic for research in the years to come.”