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A '''mortgage backed security''' is a financial instrument whose payments are backed by a pool of mortgages. Investors in the security receive payments derived from the interest and principal paid by the borrowers whose mortgages are in the pool, and the security is therefore a claim on the cash flows of the underlying loans. Mortgage backed securities allow the risks and the funding of mortgage lending to be shared among many investors, and they are a major source of finance for housing in several countries.

== Structure ==

The creation of a mortgage backed security begins with the origination of mortgages by lenders. The mortgages are then pooled, and the pool is transferred to a separate legal entity, which issues securities to investors. The entity uses the proceeds to pay the originator for the mortgages, and the payments from the borrowers are passed through to the investors, after deducting fees for servicing and administration.

Securities may be issued as pass-through certificates, in which investors receive a pro rata share of the payments from the pool, or as structured instruments, in which the cash flows are divided into tranches with different priorities. In a structured security, senior tranches are paid first and bear less risk, while junior tranches absorb losses first and offer higher returns. This structuring allows the risk of the underlying mortgages to be redistributed among investors with different preferences.

== Types ==

Agency mortgage backed securities are issued or guaranteed by government-sponsored or government agencies, which guarantee timely payment of principal and interest. This guarantee reduces credit risk for investors and lowers the cost of mortgage finance, but it transfers the risk to the guarantor and ultimately, in some cases, to the taxpayer. Non-agency or private-label securities are issued without such guarantees, and investors bear the credit risk of the underlying mortgages.

Securities may also be distinguished by the type of mortgage, including fixed-rate and adjustable-rate loans, by the credit quality of the borrowers, and by the size of the loans. Commercial mortgage backed securities are backed by loans on commercial property rather than on residential housing, and they have different risk characteristics and market conventions.

== Benefits ==

Mortgage backed securities provide several benefits. By allowing mortgages to be pooled and sold, they increase the supply of funds available for mortgage lending, and they reduce the cost of borrowing for homebuyers. They allow lenders to specialise in origination and servicing, while investors bear and manage the interest rate and credit risk, which can improve the efficiency of the mortgage market.

The securities also offer investors a range of risk and return profiles, and they broaden the set of assets available for portfolio diversification. By connecting the housing market to capital markets, they can reduce the dependence of mortgage lending on the deposit base of banks and on the availability of local funds, and they can channel saving from a wide range of investors into housing finance.

== Risks ==

Mortgage backed securities also carry risks. Prepayment risk arises because borrowers may repay their mortgages early, particularly when interest rates fall, which shortens the life of the security and changes its return. Extension risk arises when rates rise and borrowers repay slowly, lengthening the security's life. These risks make the securities sensitive to interest rates in complex ways.

Credit risk arises from the possibility that borrowers default, and it is concentrated in the junior tranches. The complexity of structured securities, and the reliance on assumptions about the correlation of defaults, can obscure the extent of this risk. The experience of the global financial crisis showed that the risks of mortgage backed securities had been underestimated, that the assumptions underlying ratings and models were unreliable, and that the securities had become widely held by institutions whose exposure was not well understood.

== Market and policy ==

Mortgage backed securities markets are large, and they are important for the transmission of monetary policy, since purchases and sales of these securities by central banks affect mortgage rates and housing finance. Central banks have used large-scale purchases of mortgage backed securities as an instrument of policy when interest rates are near their lower bound, on the view that this lowers mortgage rates and supports housing demand.

The regulation of the market has been strengthened after the crisis. Requirements for risk retention, so that originators retain an interest in the loans they sell, aim to align incentives. Disclosure and reporting requirements improve transparency, and capital and liquidity rules for investors ensure that the risks are borne with adequate buffers. Supervision of the institutions that originate, securitise, and hold these securities addresses the concentrations and interconnections that contributed to the crisis.

== The role in the financial crisis ==

Mortgage backed securities were at the centre of the global financial crisis. Securities backed by subprime mortgages, which had been originated during a period of rapid house price growth and lax underwriting, suffered large losses when house prices fell and borrowers defaulted. The losses were amplified by the structure of the securities, in which junior tranches absorbed the first losses, and by the use of leverage and short-term funding by the institutions that held them.

The crisis revealed weaknesses in the assessment of risk. Ratings agencies had assigned high ratings to securities whose underlying loans were riskier than assumed, and the models used to assess the securities relied on assumptions about the correlation of defaults that proved too optimistic. The complexity of the instruments, and the difficulty of valuing them in stressed conditions, contributed to a loss of confidence and to a freeze in funding markets, which spread through the financial system.

== Reforms after the crisis ==

Reforms after the crisis sought to address these weaknesses. Risk retention requirements oblige originators to retain a portion of the credit risk of the loans they securitise, aligning their incentives with those of investors. Disclosure requirements improve transparency about the underlying loans and the structure of the securities, and they allow investors to conduct their own analysis rather than relying solely on ratings.

Capital and liquidity rules for banks and other investors ensure that the risks of holding these securities are borne with adequate buffers. Restrictions on the use of ratings in regulation reduce reliance on a single measure of risk, and requirements for central clearing and margin for derivatives linked to mortgages reduce counterparty risk. Supervision of the institutions that originate, securitise, and hold the securities addresses the concentrations and interconnections that contributed to the crisis.

== Current market structure ==

The market for mortgage backed securities has changed since the crisis. Agency securities, which carry a government or government-sponsored guarantee, account for a larger share of the market, reflecting the withdrawal of private issuers and the continued role of public institutions in housing finance. Issuance of private-label securities has recovered only partially, and the market remains concentrated among a few large issuers and investors.

The role of central banks has also increased. Large-scale purchases of mortgage backed securities have been used as an instrument of monetary policy, and central bank holdings of these securities are substantial in some economies. The presence of the central bank as a major holder affects the market and the pricing of these instruments, and the eventual reduction of these holdings will affect conditions in the market and the cost of mortgage finance.

== See also ==

* [[Securitisation]]
* [[Asset Backed Security]]
* [[Housing Finance]]
* [[Financial Crisis]]
* [[Credit Risk]]

== References ==


<ref name="r1">Bank for International Settlements work on securitisation.</ref>
<ref name="r2">International Monetary Fund global financial stability reports.</ref>
<ref name="r3">Central bank research on mortgage markets.</ref>
<ref name="r4">Journal literature on mortgage backed securities.</ref>

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