Decoding Mortgage-Backed Securities (MBS)

Feb 13, 2025

145 million—that's the total number of housing units in the U.S., serving 334 million residents. For many, buying a home is one of the biggest financial decisions of their lives. It’s a choice that comes with the highest level of accountability for a resource that’s inherently scarce—capital. And with scarcity comes risk.

When someone purchases a home, they usually secure a mortgage—a loan used to buy the property, which they repay over time with interest. But what many don’t realize is that these mortgages don’t just stay with their bank. Instead, they are bundled together and sold in secondary markets. This means banks profit not only from the interest you pay but also by converting your loan into financial securities and selling them to investors around the globe—think pension funds, insurance companies, and more.

You might ask: How does this system work? How are mortgages transformed into securities? And most importantly—why should you care?

Honestly, I didn’t bother to explore this question myself until last year when a prospect who operates in this space wanted us to help them modernize their technology infrastructure. This research led me to decode this sector and only then did I realize the significance of both mortgages and mortgage-backed securities and the role they play in our economy. 

Whether you're a founder, executive, or an engineer looking to build a product or service in this space, and need a 101 guide on mortgage-backed securities, I have simplified this sector down in this article and this should serve as a good starting point and will save you a lot of time. 

So why should you care about mortgage-backed securities? 

You should care because the interest you pay on your mortgage doesn’t just benefit your bank—it supports a network of financial institutions. But that’s only one side of the story. While this system may seem lucrative to the average consumer, history has shown that it carries significant risks that have the potential to disrupt the entire economy.  Before we dive into these risks, it's important to understand what mortgage-backed securities are, who issues them, how they are created, who benefits from them, and—most importantly—what they mean for our economy and the interest you pay to your bank.

Macro View - Mortgage-Backed Securities

To understand mortgage-backed securities, let's start at the core of our economic pyramid. Economy is a system that allows people to produce, distribute and consume goods and services. For example, when we purchase groceries, they are produced by farmers and sold by vendors. This exchange happens through capital—money. The system that facilitates the movement of capital is known as the financial system.  It not only enables transactions but also allows people to convert their capital (savings) into productive instruments—or in simpler terms, to generate wealth.

This conversion is made possible through an array of platforms also known as financial markets. 

There are a wide range of financial markets. For instance, when you invest in a company, you’re essentially purchasing a stake in it—commonly known as stock. These stocks are traded in equity markets and this is where investors buy and sell fractional ownership in companies. But beyond stocks, individuals and businesses invest in a variety of other assets—such as oil, gold, treasury bills, and mortgage-backed securities. This has given rise to a series of markets beyond equity markets.

Core Financial Markets

To begin with, first we have the fixed income markets. When you think about fixed-income markets, think about investments that offer low but steady returns—1%, 5%, and so on. These markets enable governments and corporations to raise funds by offering steady returns to investors. Treasury bills, notes, and mortgage-backed securities fall under this category. It’s important to note that steady returns should not be confused with low risk or safety. 

When consumers help governments and corporations raise funds through fixed-income markets, it allows for the inception of new businesses in the economy. New businesses lead to the exchange of goods and services between countries, which, in turn, drives the flow of capital, and this is where the next major financial market comes into picture — foreign-exchange markets (Forex).

These markets supply the foreign currencies that are often needed to enable cross-border trade and transactions. For example, if you are Apple Inc., you are likely sourcing rare earth minerals from Mongolia, display panels and chipsets from Korea, Japan, and Taiwan, and assembling them in China. To facilitate this flow of goods and services, you as Apple Inc. would need access to the local currencies of these countries and that’s the liquidity that is provided by the Forex markets.

Make no mistake, the global demand for these currencies has significant implications for their prices, which is why foreign exchange markets play a critical role in cross-border trade and transactions. In fact, they are often considered the lifeblood of global economies.

Now you may ask—beyond currencies, we humans need food, clothing, and shelter to survive. How are they traded? That’s where the commodity markets come into play.

Commodity markets are a critical component of the economy, allowing us to trade essential physical goods such as oil, gold, and agricultural products. These markets enable businesses to invest and hedge against price fluctuations and inflation in these sectors. Essentially, commodity markets allow businesses and consumers to invest in the vital physical goods that play an important role in our daily lives.

You might wonder—what if you run a business that relies heavily on a commodity with volatile prices? Take airlines, for example, and consider fuel prices. If the price of fuel suddenly increases by 40%, would you be able to raise your ticket prices by the same percentage? Would the market even support that? Probably not. So, how can businesses manage this risk?

That’s where airlines typically mitigate such risks by locking in fuel prices for months, and in some cases, years, with their suppliers using derivatives markets. Derivatives are financial contracts that allow businesses to secure the purchase price of underlying assets—such as gold, oil, wheat, currencies, and bonds—for a fixed period. By stabilizing costs, they help businesses manage market volatility and reduce the risk of sudden price fluctuations in raw materials. This stability minimizes the need for frequent adjustments in the pricing of final products, ensuring consistency for consumers and operational resilience for businesses. 

Now that we have a clear overview of different types of financial markets, given the scope of this article, the one that truly matters to us is the Fixed-Income Market.  This is where consumers and businesses exchange fixed-income instruments such as treasury bills, notes, and mortgage-backed securities (MBS). The primary goal of this market is to provide stable, fixed returns to investors—ranging from as low as 1% to double-digit yields, depending on the risk and duration of the investment.

Now, you might be wondering—what exactly are mortgage-backed securities? 

What is a Mortgage-Backed Security (MBS)?

A Mortgage-Backed Security (MBS) is a type of financial investment that represents a share in a pool of home loans. Simply put, when people take out mortgages to buy homes, banks and financial institutions group these loans together and sell them to investors. This allows investors to earn fixed returns based on the monthly mortgage payments made by homeowners.

So, mortgage-backed securities are fixed-income investments that allow individuals and institutions around the globe to invest in the U.S. housing market in exchange for a fixed percentage return on their investment. For the U.S. economy, this means that national mortgage debt is effectively converted into tradable securities and sold globally as an investment instrument. In simple terms you are essentially running an economy as a corporate entity. 

MBS play an important role in the financial system by allowing banks to free up capital and issue more loans. Think about it—when loans are converted into investment assets and sold, the money that was originally loaned out becomes available again, enabling banks to provide more loans to borrowers. While this might seem like a flywheel or an infinite cycle, it’s exactly this effect that can lead to economic downturns. The 2008 financial crisis exemplifies this phenomenon. A core lesson learned here is that when debt is sold as an asset, whether through MBS or other forms, it carries significant risks. You may ask, so how does it matter in 2025?

It does matter. 

In 2024, the total issuance of mortgage-backed securities hit a record $1,592.2 billion, reflecting a 21.4% increase from 2023. That's essentially a reasonable KPI of heightened risk.  Now, given the volume of capital involved and the demand for MBS in this market, you might be wondering who buys these securities?

Who buys these securities and where do they originate? 

A wide range of organizations across the globe invest in MBS, with international pension funds being among the most prominent buyers due to their need for stable, long-term returns. Countries like Japan, Taiwan, and China have traditionally been the largest investors in U.S. mortgage-backed securities. While the U.S. has been learning in this space for a long time now, there are other countries that are entering this space. Saudi Arabia recently announced that it is partnering with BlackRock to develop mortgage-backed securities and enable the flow of foreign investments in the housing markets in the Middle East. 

A question that people often ask at this point is: How are these mortgage-backed securities created, and who is involved in the process? Let’s take a closer look.

The MBS Development Process: Step by Step

The development of Mortgage-Backed Securities (MBS) follows a structured process that transforms individual mortgage loans into investable financial instruments. Each step plays a crucial role in ensuring that mortgage loans are efficiently pooled, packaged, and traded in financial markets. Here's how it works:

Step 1: Loan Origination

The process begins when borrowers apply for home loans. When you apply for a home loan, lenders—such as traditional banks like Wells Fargo, J.P. Morgan Chase, Bank of America, credit unions, or digital equivalents like Rocket Mortgage—evaluate your credit score and accordingly issue a mortgage. These loans are then added to the lender’s portfolio that includes a series of mortgages that they may have issued to 1000s of borrowers like you.

Step 2: Loan Aggregation

Once a sufficient number of loans have been issued, lenders sell them to aggregators such as Wells Fargo, U.S. Bank, and PNC Financial Services. Aggregators pool thousands of similar loans together, grouping them based on factors like interest rates and loan types. This aggregation process allows for the development of larger and high-value mortgage portfolios  that are easier to package and sell.

Step 3: Securitization

The aggregated loans are then converted into securities. Government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae, along with private investment banks such as Goldman Sachs and Morgan Stanley, package these loans into mortgage-backed securities (MBS). These securities are structured into different categories based on risk and return, making them attractive to different types of investors.

Step 4: Credit Enhancement

To attract investors and reduce perceived risks, issuers apply credit enhancement measures. Credit rating agencies such as Moody’s, S&P Global Ratings, and Fitch Ratings, assess and rate these securities, while insurers such as AIG and Arch Capital offer insurance coverage to minimize the risk of default on MBS.  These measures bolsters investor confidence.

Step 5: Issuance and Sale

Once structured and rated, the newly created MBS are introduced to the primary market. Institutional investors—including pension funds, hedge funds, and individual investors—purchase these securities. Investment banks and financial intermediaries such as Barclays, Deutsche Bank, and Citigroup facilitate the sale, catering to investors seeking stable returns.

Step 6: Servicing and Payments

After the MBS are sold in primary markets, loan servicing companies such as Wells Fargo, Mr. Cooper, and PennyMac take over the responsibility of collecting monthly mortgage payments from borrowers. They then distribute these payments to MBS investors, deducting fees for their services. This ensures a steady cash flow to investors throughout the life of the mortgage.

Step 7: Secondary Market Trading

Finally, MBS are actively traded in the secondary market, where institutional investors such as BlackRock, Vanguard, and PIMCO participate. Trading platforms like Bloomberg and ICE Mortgage Technology facilitate these transactions. The value of MBS in the secondary market fluctuates based on interest rates, economic conditions, and investor demand, offering liquidity and further investment opportunities.

Through these steps, mortgage loans—once considered illiquid assets—are transformed into tradable securities, enhancing liquidity in the financial system and providing investors with a steady stream of income.

While MBS have played a significant role in the financial system, they have also contributed to some of the most severe financial crises in history. I have summarized a few notable examples in the following section.

Historic Risks and Failures Related to MBS

The 2008 Global Financial Crisis was one of the most devastating financial collapses caused by MBS. A subset of banks aggressively issued subprime mortgages—home loans to borrowers with poor credit scores—expecting rising housing prices to offset default risks. These subprime loans were bundled into MBS and sold as low-risk investments. When housing prices started to fall, borrowers defaulted on their loans in large numbers, leading to a collapse in the demand and value of MBS . Major financial institutions like Lehman Brothers filed for bankruptcy, triggering a global economic recession and leading to government bailouts worth billions of dollars to stabilize the economy.

Another significant failure occurred during the Savings and Loan Crisis (1980s-90s) when deregulation allowed financial institutions to take on riskier investments, including MBS. Poor oversight and high-interest rate volatility led to the collapse of over 1,000 banks that offered fixed-rate mortgage investments, requiring a massive government intervention to restore stability to the financial system. Long-story short, a total of $125 billion went from taxpayers' pockets to repair the damage done to our financial system in this process. This unfortunately was not the last failure in this sector. 

In 1998, the collapse of Long-Term Capital Management (LTCM), a hedge fund heavily invested in MBS, demonstrated how market disruptions and high leverage could create systemic risks. The Federal Reserve had to coordinate with 14 other banks in the U.S at the time to secure a bailout for LTCM that came at a hefty price tag of $3.6 billion at the time to prevent further market destabilization.

These historical incidents highlight the importance of proper regulation, risk management, and transparency in the MBS market to prevent future economic disruptions.

Now that we have a good understanding of MBS, you’ve probably heard of Fannie Mae, Freddie Mac, and Ginnie Mae. And you might be wondering—why do we need all three, and what exactly do they do in the context of MBS? Let's cover each of these.

The Role of Fannie Mae, Freddie Mac, and Ginnie Mae

When it comes to mortgage-backed securities (MBS), three key institutions play a crucial role in ensuring liquidity and stability in the U.S. housing market: Fannie Mae, Freddie Mac, and Ginnie Mae. While they may seem similar, each serves a distinct purpose.

Fannie Mae (Federal National Mortgage Association) works mainly with big banks and financial institutions, buying mortgages that meet specific credit and size requirements. It bundles these loans into MBS and sells them to investors, which helps free up bank capital so they can issue more home loans.

Freddie Mac (Federal Home Loan Mortgage Corporation) does something similar but focuses on smaller lenders like credit unions and community banks. By purchasing their mortgages and turning them into MBS, Freddie Mac helps ensure that home loans are available in local markets across the country.

Both Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs), meaning they are privately owned but operate under government oversight to promote stability and affordability in the housing market.

Then there’s Ginnie Mae (Government National Mortgage Association), which takes a different approach. Unlike Fannie and Freddie, Ginnie Mae doesn’t buy or sell mortgages. Instead, it guarantees MBS that are backed by government agencies like the FHA, VA, and USDA. This government guarantee makes Ginnie Mae securities a relatively safer investment for those looking for lower risk.

Each of these institutions plays a key role in making homeownership more accessible and keeping the mortgage market stable and efficient.

Thus, mortgage-backed securities (MBS) essentially allow countries to convert their debt into assets, sell them in international markets, and generate revenue. For foreign investors, MBS provide an opportunity to invest in overseas markets, while for sellers, they help offload risk, generate stable returns, and free up capital previously tied up in mortgages—allowing it to be used for issuing new loans.

However, MBS can create a flywheel effect and, if not managed properly, pose significant risks that have contributed to major economic collapses in the past. Institutions involved in the MBS business are now exploring how technology can help mitigate these risks. Several technology partners are actively working in this space to help institutions better manage this risk through emerging technologies.

We will cover some of these in detail in one of our future posts.

Cheers,

Prathamesh

Disclaimer: This blog is for educational purposes only and does not constitute financial, business, or legal advice. The experiences shared are based on past events. All opinions expressed are those of the author and do not represent the views of any mentioned companies. Readers are solely responsible for conducting their own due diligence and should seek professional legal or financial advice tailored to their specific circumstances. The author and publisher make no representations or warranties regarding the accuracy of the content and expressly disclaim any liability for decisions made or actions taken based on this blog.