A mortgage-backed security (MBS) is a bond type security in which the collateral is provided by a pool of mortgages. For example, A borrows money from Bank ‘B’ mortgaging his house to Bank ‘B’. The Bank ‘B’ sells the mortgage to a company ‘C’ (which may be a government agency or investment bank or private entity). The company ‘C’ groups similar mortgages ((i.e., similar interest rates, maturities, etc.) already bought by it. This system of grouping mortgages is known as pooling the mortgages. This way the companies like ‘C’ can purchase more mortgages and create MBS which will be sold to investors in a package similar to bonds in the open market. For investors an MBS is much like a bond which offers monthly, quarterly or half yearly income along with the principal.
How MBS works?
When ‘A’ repays the loan to Bank ‘B’ in installments, Bank ‘B’ keeps its fee or spread and sends the balance amount to Company ‘C’. The company ‘C’ in turn keeps its margin and passes the principal and interest payment received to the investors who hold the MBS.