Definition
Mortgage-backed securities are investment securities secured by pools of mortgages. Lenders sell mortgages into the secondary market where they're packaged and sold to investors. When borrowers make payments, investors receive principal and interest returns.
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Mortgage-backed securities transform illiquid individual mortgages into liquid securities that can be traded on financial markets. When a borrower makes a monthly payment, it flows through the servicer to MBS investors as their return. MBS pricing fluctuates based on interest rate expectations, economic conditions, and prepayment risk. The market for MBS is enormous and critical to the U.S. mortgage market's functioning.
Pro Tip
Interest rate movements affect MBS values; when mortgage rates rise, existing MBS become more valuable, which can improve mortgage availability and lower rates.
Example
A bank sells 100 mortgages averaging $300,000 each to an investment firm, which bundles them and sells $30 million in MBS to pension funds and insurance companies that collect the monthly payments.