What Are Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are investment products based on groups of mortgage loans, which play a significant role in determining mortgage rates.

A Longer Definition: Mortgage-Backed Securities

Mortgage-backed securities (MBS) are investment products created by bundling mortgages from homeowners and then selling shares of the bundle to investors worldwide. Also known as mortgage-backed bonds, mortgage-backed securities directly influence current mortgage rates through their relationship with the supply and demand of mortgage funds.

When lenders make mortgages for home buyers and refinancing homeowners, they often sell them to government-backed agencies like Fannie Mae and Freddie Mac, who pay cash to the lenders for the loans. When lenders get paid, it re-supplies their reserves, which allows them to make more mortgages to first-time home buyers and others.

Meanwhile, Fannie Mae, Freddie Mac, and other buyers of mortgages group the loans they buy into bonds that are backed by the mortgages and sold to institutional investors, including pension funds, large companies, and parts of governments.

MBS investors are buying bonds. A given bond’s interest rate is the average of the mortgage rates inside them. In this way, mortgage-backed securities affect U.S. mortgage rates.

Interest rates must increase when demand for mortgage-backed bonds is low, or investors will stop investing in mortgage-backed bonds. Conversely, interest rates can drop when demand for mortgage-backed bonds is high.

This is part of how the Federal Reserve and mortgage rates are linked, if only indirectly.

Mortgage-Backed Securities: A Real-World Example

Imagine a scenario where inflation pressures are falling, spurring high demand for mortgage bonds from worldwide investors, including pension funds and insurance companies. As demand for mortgage bonds rises, the price of mortgage-backed bonds rises because demand is growing faster than supply.

Bond prices and bond yields move in opposite directions, so as prices rise, mortgage rates fall, which makes homeownership more affordable for first-time home buyers and others.

Frequently Asked Questions About Mortgage-Backed Securities

How do mortgage-backed securities affect mortgage rates?

Mortgage-backed securities affect mortgage rates through their impact on the supply and demand of mortgage funds. High demand for mortgage-backed securities lowers their yield, lowering mortgage rates.

Why are mortgage-backed securities important for the housing market?

Mortgage-backed securities are important because they provide liquidity to the housing market, allowing banks to issue more mortgages. They also influence mortgage rates, which directly impact homebuying and refinancing activities.

Can changes in mortgage-backed securities prices impact the economy?

Yes, changes in mortgage-backed securities prices can significantly impact the economy, mainly through their influence on mortgage rates and, consequently, the housing market.

Who benefits from lower mortgage rates due to high demand for mortgage-backed securities?

Homebuyers and homeowners looking to refinance benefit from lower mortgage rates resulting from high demand for mortgage-backed securities, making borrowing more affordable.

What role did mortgage-backed securities play in the economic crisis of 2008?

The economic crisis of 2008 was partly fueled by the proliferation of mortgage-backed securities backed by higher-risk mortgages. When these mortgages defaulted at a higher-than-expected rate, it led to significant losses for MBS investors and contributed to the collapse of major financial institutions.

Why does the Federal Reserve buy mortgage-backed securities sometimes?

The Federal Reserve buys mortgage-backed securities to wield influence on the economy. By purchasing MBS, the Fed helps to lower mortgage interest rates, which supports the housing market and the broader U.S. economy.