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A mortgage-backed security (MBS) is an asset-backed security or debt obligation
that represents a claim on the cash flows from mortgage loans, most commonly on
residential property.
First, mortgage loans are purchased from banks, mortgage companies, and other
originators. Then, these loans are assembled into pools. This is done by
government agencies, government-sponsored enterprises, and private entities.
Mortgage-backed securities represent claims on the principal and payments on
the loans in the pool, through a process known as Securitization. These
securities are usually sold as bonds, but financial innovation has created a
variety of securities that derive their ultimate value from mortgage pools.
Most MBSs are issued by the Government National Mortgage Association (Ginnie
Mae), a U.S. government agency, or the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S.
government-sponsored enterprises. Ginnie Mae, backed by the full faith and
credit of the U.S. government, guarantees that investors receive timely
payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while
not backed by the full faith and credit of the U.S. government, have special
authority to borrow from the U.S. Treasury. Some private institutions, such as
brokerage firms, banks, and homebuilders, also securitize mortgages, known as
"private-label" mortgage securities.
Residential mortgages in the United States have the option to pay more than the
required monthly payment (curtailment) or to pay off the loan in its entirety
(prepayment). Because curtailment and prepayment affect the remaining loan
principal, the monthly cash flow of an MBS is not known in advance, and
therefore presents an additional risk to MBS investors.