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Mortgage-backed security

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.