Legal Definitions - mortgage-backed security

A mortgage-backed security (MBS) is an investment product that represents a share in a large group, or "pool," of mortgage loans. Instead of holding individual mortgages until they are paid off, lenders (like banks) can gather many similar mortgage loans together – for example, hundreds or thousands of home loans – and then sell slices of this combined pool to investors.

When an investor buys an MBS, they are essentially buying a right to receive a portion of the principal and interest payments made by the homeowners whose mortgages are part of that pool. This process allows banks to free up capital to issue new loans, while providing investors with a way to earn returns from the housing market. These securities are often issued by government-sponsored enterprises or other financial institutions.

• Example 1: A Regional Bank's Capital Strategy
  Imagine "Community First Bank," a regional lender, has issued thousands of home mortgages over the past year. While these loans generate interest, they also tie up a significant amount of the bank's capital. To free up funds so it can offer new loans to more customers and expand its business, Community First Bank decides to package 1,000 of its existing 30-year fixed-rate home mortgages into a single investment product. This package, now a mortgage-backed security, is then sold to institutional investors.

  Explanation: This illustrates how a bank uses an MBS to convert illiquid assets (individual mortgage loans) into cash. Investors who buy this MBS are now entitled to a share of the monthly principal and interest payments from those 1,000 homeowners, while Community First Bank has fresh capital to lend out again.

• Example 2: A University Endowment's Investment
  The endowment fund for "Evergreen University" seeks stable, long-term income to support scholarships and research. Its financial advisors recommend investing in a mortgage-backed security that is backed by a diversified pool of residential mortgages from across the country. The endowment purchases a significant portion of this MBS.

  Explanation: In this scenario, Evergreen University's endowment fund becomes an investor in the MBS. Each month, as homeowners in the underlying pool make their mortgage payments, the endowment receives its proportional share of those payments, providing a predictable income stream for the university's operations.

• Example 3: Funding for New Housing Developments
  "Green Valley Developers" is planning a large new residential community with hundreds of homes. To make the project financially viable and attract more capital for future phases, they work with a financial institution. As homes are sold and mortgages are originated for the new homeowners, these mortgages are systematically grouped together. Once a substantial pool of these new home loans is formed, a mortgage-backed security is created and offered to the broader investment market.

  Explanation: This example shows how MBS can be linked to new development. The financial institution bundles the mortgages from the new homes into an MBS. Investors buying this MBS provide capital, which indirectly helps Green Valley Developers secure funding or manage risk, while the investors themselves gain exposure to the performance of the mortgages from the new community.