What it means
A bank that lends someone $300,000 for thirty years has tied up its money for a very long time. Rather than wait, it can sell that loan to an issuer who pools it with thousands of similar loans and issues securities backed by the pooled repayments.
The bank gets its cash back to lend again, and investors get a stream of income. For businesses and investors outside banking, this matters because mortgage-backed securities are one of the largest slices of the global bond market.
Pension funds, insurers and corporate treasury teams hold them because they typically pay more than government bonds while still being backed by real property. That extra yield is not free, and understanding what you are paid for is the whole point.
The simplest structure is a pass-through, where every investor owns an equal share of all the interest and principal the pool collects. More complex structures, often called collateralised mortgage obligations, carve the pool into tranches with different levels of priority.
Senior tranches get paid first and accept a lower return, while junior tranches absorb the first losses in exchange for a higher one. The distinctive risk here is prepayment.
Homeowners can remortgage or sell at any time, so when interest rates fall, borrowers repay early and investors get their capital back exactly when there is nowhere good to reinvest it. When rates rise, the opposite happens: borrowers stay put and the investor is stuck holding a below-market yield for longer.
A useful distinction is between agency and non-agency issues. Agency securities carry a guarantee from a government-sponsored body, so credit risk is small and prepayment is the main variable.
Non-agency issues carry no such guarantee, which is why the loosely underwritten pools of the mid-2000s caused so much damage when borrowers defaulted in large numbers.
In practice
Real-world examples
Example 1
A regional insurance company needs income to match claims it expects to pay over the next decade. It buys $40,000,000 of agency mortgage-backed securities yielding 5.50% instead of government bonds yielding 4.20%, accepting prepayment risk in exchange for roughly $520,000 more income a year.
Example 2
A savings bank has lent out almost all of its deposits and cannot write new loans. It sells $180,000,000 of completed mortgages to a securitisation issuer, receives the cash within weeks, and reopens its lending desk while continuing to collect a servicing fee on the loans it sold.
Example 3
A corporate treasury team parks surplus cash in a short-dated mortgage bond fund. When central bank rates fall sharply, borrowers remortgage in large numbers, the fund's holdings repay early, and the team has to reinvest at a materially lower yield than it had planned for.
Think of it
Think of a mortgage-backed security like a giant basket of apples collected from hundreds of different trees. Instead of selling each apple individually, the farmer bundles them all together and sells slices of the basket, so everyone shares the good and bad fruit.
Formula
Calculation
Pass-through rate = weighted average coupon on the pool - servicing fee - guarantee fee
Investor annual interest = face value held x pass-through rate
Take an illustrative pool of 1,000 mortgages with an average balance of $250,000, so the pool totals $250,000,000. The weighted average coupon paid by borrowers is 6.00%. The servicer keeps 0.25% for collecting payments and the guarantor keeps 0.25% for insuring credit losses, so the pass-through rate is 6.00% - 0.50% = 5.50%.
Interest passed to all investors in year one = $250,000,000 x 5.50% = $13,750,000.
An investor holding $500,000 of face value receives $500,000 x 5.50% = $27,500 of interest a year, or $27,500 / 12 = $2,291.67 a month. On top of that the investor receives a share of any principal the borrowers repay, which reduces the face value on which future interest is calculated.Case study
Seen in the real world
Harborline Building Society is an illustrative, entirely fictional lender used here to show how the mechanics work. Harborline has written $500,000,000 of residential mortgages at an average rate of 6.00% and has run out of deposit funding to write more. It sells the whole book to an issuer, keeps a 0.25% servicing fee, and receives the sale proceeds in cash.
Investors buy the resulting securities at a 5.50% pass-through rate. For the first two years everything behaves as modelled, then market rates drop by more than a percentage point and a third of Harborline's borrowers remortgage elsewhere within twelve months. Investors get large slugs of principal back far earlier than expected and can only reinvest at 4.30%.
Nobody defaulted and no one behaved badly, yet the investors still earned less than they had planned. In this fictional case the lesson is that with mortgage-backed securities the timing risk can matter as much as the credit risk.
Watch out
Common mistakes
- Treating the quoted yield as a promise. The yield assumes a prepayment speed, and if borrowers repay faster or slower than assumed, the realised return will differ.
- Assuming a government-sponsored guarantee covers market losses. It covers credit losses on the underlying loans, not the price fall if you have to sell early.
- Confusing the stated maturity with how long your money is actually invested. Most pools repay far sooner than their thirty-year legal maturity because of moves and remortgages.
Questions
People also ask
Are mortgage-backed securities risky?
Agency issues carry little credit risk but real interest rate and prepayment risk, while non-agency issues add genuine borrower default risk on top.
What is the difference between a pass-through and a tranche?
A pass-through gives every holder the same proportional share of the pool, while a tranched structure ranks holders so some get paid before others.
Can an ordinary business hold these?
Yes, usually through a bond fund rather than directly, since individual issues trade in large sizes and need specialist analysis.