Mortgage-backed securities (MBS)

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A mortgage-backed security is a claim on interest and principal payments from a pool of mortgage loans.

After a borrower makes a mortgage loan, banks, mortgage companies, and other originators would usually combine the loan with other mortgage loans and sell it to governmental, quasi-governmental, or private entities like the Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac).

Then, in a process called securitization, these entities would “pool” similar loans with almost the same rates and credit risk and issue securities representing claims on the interest and principal payments from the pool of mortgage loans.

MBS are attractive because its yields are usually higher than government bonds, and credit risk is minimal for securities backed by federal agencies. On the other hand, MBS that are not backed by agencies still present default risk, and holders of MBS also face the risk of borrowers paying off more than their required mortgage payments (which would shorten the average life of the security).

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