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L.6 · INTERMEDIATE · 3 MIN

Mortgage-Backed Securities

Mortgage-backed securities are bonds backed by pools of home mortgages. At roughly $10 trillion outstanding, they form the largest segment of the US bond market.

Quiz · 5 questions ↓

Step through

How MBS work: A bank makes 1,000 mortgages, pools them together, and sells bonds backed by those monthly payments. Investors receive principal and interest as homeowners pay.

Prepayment risk: When rates drop, homeowners refinance. MBS investors get their principal back early, just when they want to reinvest at now-lower rates.

2008 lesson: MBS backed by subprime mortgages (borrowers with weak credit) were rated AAA by agencies that did not understand the risk. When housing prices fell, defaults cascaded, and the global financial system nearly collapsed.

Key insight

MBS are safe when backed by quality mortgages and honestly rated. The 2008 crisis was not about securitization itself but about the quality of the underlying loans and the failure of rating agencies.

Check-in

An MBS (mortgage-backed security) paid yield 5.5% when rates were 6.5%. Rates fall to 4%. The MBS yield falls to 3.8%. Why does the yield fall FASTER than the rate decline?
Check your understanding

Sit with the ideas.

You hold an MBS with a 5.5% coupon when market mortgage rates drop from 6% to 4%. What happens to your investment and why?

Why:
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Other lessons in this course.

  1. 01Treasury Securities Essentials
  2. 02Understanding Yield Curves
  3. 03Corporate Bonds & Credit Risk
  4. 04Introduction to Derivatives
  5. 05Repo Markets & Money Markets
  6. 06Mortgage-Backed Securities— reading now
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