Mortgage-backed securities: How they impact the housing market and interest rates

Your home — or, more specifically, your home loan — could be part of someone’s investment strategy. That’s because of something called mortgage-backed securities (MBS).

In fact, your mortgage loan could end up as part of several different kinds of investment tools. At some point, after you closed on your house, that mortgage likely took on a new life somewhere far beyond the walls of the mortgage lender that issued the loan.

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Mortgage-backed securities are bundles of home loans, just like yours, that are packaged as an investment. Hundreds, if not thousands, of loans are all wrapped into one giant collection that can be sold off in pieces — called shares — to investors.

Your monthly payment, along with those made by other homeowners, generates income for the holders of those shares.

In many ways, an MBS is similar to a mutual fund, which has hundreds of stocks wrapped inside one investment.

Your mortgage. Now part of a big-time investment for some savvy financial fat cat drawing pass-through income off your monthly payment. And thousands of others. Who knew?

The most common (and simple) type of mortgage-backed securities are called pass-throughs. You make a monthly mortgage payment on your principal and interest, and your payment amount is “passed through” to the owner of the mortgage and allocated to investors.

Mortgage-backed securities can come in hybrid forms with varying structures based on things like risk, maturities, and interest payments. These investments are called collateralized mortgage obligations, or CMOs. There are other versions with even more exotic names that are best left to be discussed by finance majors and investment bankers.

Commercial mortgage-backed securities are issued on loans for other types of real estate, such as multifamily housing and business properties.

Learn more: How to invest in real estate

Mortgage-backed securities are part of a massive money machine that fuels the housing market, and they’re just one form by which lenders sell their loans. Here’s a quick summary of why and how lenders sell the loans they issue to borrowers.

So that they can make more loans. Only a small number of loans are kept on lenders’ books. Often, high-value jumbo loans remain in a financial institution’s portfolio. However, most lenders sell their loans so they have more money to lend.

Loans are sold to middlemen companies that package the mortgages into mortgage-backed securities. These go-betweens are often government-sponsored companies authorized to guarantee these investments, such as Freddie Mac, Fannie Mae, or Ginnie Mae (which is actually a government agency).

Private issuers, such as investment or retail banks and other financial institutions, can also buy and package mortgages for sale.

When you make payments toward your mortgage principal and interest, the payments are passed on to the mortgage owner and ultimately distributed to investors. That’s why the most common MBS are called pass-throughs.

Dig deeper: What determines mortgage rates? It’s complicated.

In the years leading up to the financial crisis of 2008, the mortgage industry began making loans that were especially risky. They could do this because they knew they wouldn’t be holding the loans but selling them (as described above).

The mortgage resellers packaged these risky loans, which had often been extended to borrowers with poor credit histories. Because so many were bundled together, the risk was thought to be minimized. Middlemen sold the pools of mortgages as high-quality, low-risk investments.

That definitely did not end up being the case.

As the housing market collapsed, millions of homeowners defaulted on their home loans, and the so-called subprime mortgage-backed securities sold as “safe” investments became worthless.

The U.S. government had to step in to save financial institutions and prop up a failing economy.

Read more: When will the housing market crash again?

Mortgage-backed securities are a major component of the home loan industry’s overall liquidity and, as such, share in the influence of mortgage rates. As an element in the bond market, MBS prices react to economic conditions, capital market moves, and investor sentiment. So, mortgage-backed securities don’t directly determine mortgage market rates but are essential to the overall interest rate ecosystem.

MBS are part of an income investment strategy. Investors will use them in a bond portfolio to enhance the yield of interest-driven returns. While many investors are financial institutions — and the U.S. government — individuals can buy mortgage-backed securities as part of a mutual fund or exchange-traded fund investment.

A particular risk of MBS is prepayment. If interest rates fall, homeowners may refinance their mortgages. MBS investors would see returns fall at a time (of lower interest rates) when alternative fixed-income securities are scarce.

This article was edited by Laura Grace Tarpley.