Mortgage-Backed Security (MBS)
A bond-like investment backed by a pool of mortgages, passing homeowners' monthly payments to investors.
What is Mortgage-Backed Security?
A mortgage-backed security (MBS) is a type of asset-backed security collateralized by a pool of home mortgages. When homeowners make monthly mortgage payments, those payments flow through to MBS investors as interest and principal. MBS are created through securitization: a lender pools thousands of mortgages and sells claims on the cash flows to investors. Agency MBS are issued by Fannie Mae, Freddie Mac, or Ginnie Mae and carry an implicit or explicit government guarantee; non-agency MBS are issued by private institutions and carry credit risk. MBS are subject to prepayment risk — homeowners may refinance when rates fall, returning principal to investors who must then reinvest at lower rates.
Example
Fannie Mae pools 5,000 mortgages with a total balance of $1 billion and issues MBS backed by that pool. Investors receive monthly payments representing each borrower's interest and principal. When interest rates fall sharply and homeowners refinance en masse, the MBS pays off faster than expected — investors receive their principal back but must reinvest at lower prevailing rates (prepayment risk).
Source: Fannie Mae — MBS Overview