Mortgage backed securities are interests in a pool of mortgages which entitle the bearers to payments from the pool. One could think of them like shares in a home loan; whenever the borrower makes a payment on his or her mortgage, a portion of that payment ends up in the hands of a bearer of mortgage backed securities. This type of security is known as a “debt security,” meaning that the bearer has an interest in a form of debt.
Usually, the way mortgage backed securities work is that an investment firm or government entity buys a large number of mortgages from the issuing bank, creating a pool of mortgages. Investors can buy into that pool for a set amount per share, and as payments are made, they get returns which vary in size, depending on how many shares they own and the rating of their shares. The idea is that by spreading the risk, the investors are guaranteed a certain level of return, since if one homebuyer in a pool of 1,000 defaults on his or her mortgage, this will not have a huge impact on the shareholders.
The pool of mortgages is divided into different classes known as tranches. Each tranche is given a credit rating, from AAA to unrated. When investors buy into the pool, they can specify the tranche they would like to buy into, with highest-rated sections of the pool receiving payments first. This means that if people start to default on their mortgages, investors with AAA-rated mortgage backed securities will continue to receive payments, while investors who chose lower-rated segments may not get any payments at all.
From the point of view of banks, especially small banks, mortgage backed securities are an excellent arrangement, because they receive payment in full when the mortgages are purchased. This means that the risk of offering those mortgages has been eliminated, and that they have available capital to invest or lend. For investors, sharing the risk in a large pool is supposed to make mortgage backed securities a reasonably safe place to invest, although the cash flow can be irregular, since some borrowers like to prepay their mortgages, with the goal of paying off the loan before its maturity date.
As investors learned rather explosively in 2008, mortgage backed securities can be extremely dangerous if large numbers of borrowers start to default on their loans all at once. A security may be packed with so-called “sub prime” loans which are prone to default, leading to a collapse in revenue for investors, and a snowball effect can occur as more and more borrowers fail to make their mortgage payments. For investors with limited diversification, loss of income from a mortgage backed security can be a serious problem.