Mortgage-Backed Securities (MBS): Explained

Mortgage-Backed Securities (MBS) are one of the most important yet least understood financial instruments in the global housing market.

While they might sound like a complex Wall Street concept, they directly influence mortgage rates, lending availability, and even economic stability in Australia. 

So, understanding how MBS work isn’t just for finance professionals. It’s a valuable piece of information for any Aussie looking to buy home, invest, or simply grasp the forces that shape our housing market.

What Are Mortgage-Backed Securities (MBS)?

A Mortgage-Backed Security (MBS) is a type of investment where a large pool of mortgages (home loans) are bundled together and sold to investors. 

Instead of a bank holding onto all the mortgages it issues for decades, it can package them into an MBS and sell them to free up cash for more lending. You can think of it as a giant basket filled with hundreds (or even thousands) of home loans.

Instead of one person owning the loans, that basket is sliced into pieces and sold to investors. 

When you buy an MBS, you’re essentially buying the right to receive a share of the regular payments that homeowners make on their mortgages. This includes both interest and principal repayments.

Mortgage-Backed Securities (MBS): How They Work

Here’s a step-by-step breakdown of the process:

1. Origination: Lenders issue mortgages to homebuyers (or commercial borrowers). These loans are secured by the properties being bought.

2. Selection & due diligence: A group of similar loans is chosen for securitisation (e.g., owner-occupier variable loans).

3. Transfer to SPV: Loans are transferred into a bankruptcy-remote trust or SPV to isolate them from the originator.

4. Structure & credit enhancement: The SPV arranges the cashflows and adds protections (subordination, overcollateralisation, excess spread, LMI, etc.) to make tranches attractive to different investor types.

5. Issuance: The SPV issues notes (tranches) to investors and proceeds flow to the originator (or pay down existing funding).

6. Servicing & payments: Borrowers repay loans to the servicer and the servicer passes interest and principal to noteholders according to tranche rules (after fees).

7. Ongoing reporting & monitoring: Issuers/servicers provide monthly loan-by-loan data to investors and regulators.

Types of Mortgage-Backed Securities (MBS)

1. Commercial MBS (CMBS)

These are securities backed by loans on commercial real estate (office buildings, retail spaces, etc.) 

They possess higher risk due to economic sensitivity.

2. Residential MBS (RMBS)

Securities backed by home loans taken out by individual borrowers (for example, owner-occupied properties). They are dominant in Australia due to the high demand for housing finance. 

And in Australia’s MBS market, residential mortgage-backed securities (RMBS) are often grouped into conforming and non-conforming categories.

Conforming MBS:

• Backed by prime home loans that meet the lending standards of major banks or government guidelines.

• Borrowers in this category usually have strong credit histories, steady incomes, and low loan-to-value ratios (meaning they’ve put down a healthy deposit).

• Considered lower-risk, these securities tend to offer more predictable and stable returns for investors.

Non-Conforming MBS:

• Backed by specialist or non-prime loans that don’t quite fit the standard lending rules of big banks.

• This could include borrowers with less-than-perfect credit history, irregular income (such as self-employed people), or higher loan-to-value ratios.

• They generally offer higher returns to compensate for the extra risk, but there’s also a greater chance of borrower default.

In Australia, non-conforming MBS make up a smaller slice of the market compared to some overseas economies. 

They’re often issued by non-bank lenders, and while they may carry more risk, they play a crucial role in making finance accessible to borrowers who don’t meet the strict criteria of mainstream banks.

The Australian Landscape of MBS

Mortgage-backed securities have been part of Australia’s financial system since the late 1980s, but our market operates a little differently from the U.S. or Europe.

• Dominated by Residential MBS (RMBS): Most Australian MBS are backed by home loans rather than commercial mortgages.

  • Within RMBS, conforming loans (prime borrowers) make up the bulk of issuance, while non-conforming loans are a smaller but important segment.

• Non-Bank Lenders Play a Key Role: Unlike the big four banks, non-bank lenders don’t have large deposit bases to fund their loans. 

  • MBS allow them to raise capital from investors and compete in the mortgage market, offering products that can be more flexible than traditional bank loans.

• Government Support via the AOFM: The Australian Office of Financial Management has stepped in during times of market stress (such as the Global Financial Crisis and early COVID-19) to buy RMBS and keep funding channels open, especially for smaller lenders.

• Strong Regulatory Oversight: Regulators like APRA, ASIC, and the RBA keep a close watch on lending standards and the stability of the MBS market. 

  • Australian RMBS are generally considered to have lower default rates compared to many overseas markets, thanks to full-recourse lending and conservative underwriting.

• Global and Domestic Investor Base: Australian RMBS are bought not just by local institutions but also by overseas investors attracted to the country’s historically low mortgage default rates and transparent reporting standards.

The Benefits of Mortgage-Backed Securities (MBS)

Benefits for Lenders

1. Freeing Up Capital (Boosting Lending Capacity)

When a lender writes a mortgage, the loan sits on its balance sheet and ties up capital for the next 20–20 years. 

But by selling the mortgages into an MBS, the lenders gets most of the money back straight away. They can then recylce that “freed-up” cash into writing new loans.

For banks, this helps meet capital adequacy requirements. And for non-banks, it’s often their main way to scale without needing a huge deposit base.

2. Managing Risk

Mortgages come with the risk that some borrowers may default. But the loans are passed to a Special Purpose Vehicle (SPV) before they’re sold into an MBS.

This way, the credit risk largely shifts from the lender to the investors who buy the MBS, helping lenders:

• Originating new loans without being overly concentrated in long-term housing risk.

• Smooth out earnings and remain more resilient in downturns.

• Shift risk exposure off their books.

Benefits for Investors

1. Steady Income Stream

MBS are designed to pass through the regular principal and interest payments that homeowners make on their mortgages. For investors, that means a predictable cash flow.

2. Diversification

An MBS pools hundreds or thousands of mortgages, reducing the impact of any single borrower defaulting.

For institutional investors like super funds or insurers, RMBS offers a way to diversify beyond equities and government bonds.

3. Choice of Risk & Return

Each MBS is sliced into layers, or tranches. This lets investors pick between safer, lower-yield options or higher-risk, higher-yield ones.

Benefits for Borrowers

While we may not see the word MBS on a loan contract, the presence (or absence) of strong MBS demand directly affects the mortgage products available for Aussie borrowers. Here’s how:

1. Lower Mortgage Rates Through Global Demand

When global investors buy up Australian RMBS, they inject billions of dollars into the local housing finance system. This deep pool of capital reduces lenders’ cost of funding.

The cheaper it is for banks and non-banks to access money, the sharper the rate they can pass on to borrowers. So, this global appetite can keep your mortgage rate lower than it would be otherwise.

2. More Competition Beyond the Big Four

Non-bank lenders may not have large deposit bases to fund loans. In that case, they rely heavily on RMBS markets.

Thanks to securitisation, they can raise money competitively and offer borrowers alternatives to traditional bank loans. 

This competition often results in better fixed and variable-rate mortgages, and more flexible credit policies.

Key Players in the MBS Market

Lenders (Banks & Non-Bank Lenders)

These are the starting points of every MBS. 

Banks, credit unions, and non-bank lenders (like mortgage finance companies) issue home loans to borrowers that end up in the MBS pools.

Special Purpose Vehicles (SPVs) or Trusts

Once a group of mortgages is ready, it’s transferred to a legally separate entity known as a Special Purpose Vehicle (SPV) or trust. 

This entity holds the loans and issues the MBS to investors, ensuring the assets are kept separate from the lender’s own balance sheet.

Arrangers/Underwriters

These are often large investment banks or specialist financial firms that structure the MBS, set its terms, and arrange for its sale to investors. 

Investors

These are the buyers of the MBS, ranging from Australian superannuation funds and insurance companies to overseas pension funds and asset managers. 

They purchase MBS to earn a steady income stream from the underlying mortgage repayments.

Credit Rating Agencies

These companies assess the credit quality of an MBS, assigning ratings that help investors gauge the level of risk. 

A higher credit rating generally means a lower perceived risk of default.

Regulators

In Australia, several bodies oversee the MBS market:

• APRA (Australian Prudential Regulation Authority) – monitors the financial health of banks and non-bank lenders.

• ASIC (Australian Securities and Investments Commission) – regulates financial markets and securities offerings.

• RBA (Reserve Bank of Australia) – keeps an eye on overall financial system stability and can purchase MBS as part of monetary policy if needed.

Key Features of Mortgage-Backed Securities (MBS)

Tranches (the common slice model)

MBS are divided into ‘tranches’ or layers, each identified by letters (e.g. the Class A, Class B, Class C notes) with different rights. 

So, Tranches are packages or bundles of home loans that are sold to institutional investors. Investors can then target a package or bundle of home loans (a tranche) based on their investment goals and the risk of a tranche. 

The risk, or credit rating, of each tranche is usually determined by an accredited credit rating agency.

• Senior (top): Lowest risk, lowest yield; first to receive payments.

• Mezzanine: Middle risk/reward.

• Subordinated/equity: Last to receive payments and first to absorb losses; highest yield.

This “waterfall” structure protects senior holders but concentrates losses in the lower tranches.

Credit Enhancement Mechanisms

To make the securities safer and more attractive to investors, issuers often add safeguards such as:

• Overcollateralisation (OC): Assets exceed liabilities, so extra principal sits in the deal.

• Excess Spread: Using leftover interest after investor payments as a protective buffer.

• Lenders’ Mortgage Insurance (LMI): Covers some loss on high-LTV loans.

• Reserve Accounts: Holding cash to cover temporary shortfalls in payments.

Payment Flow Structure

This is the method of how returns are paid out to the investors. There are two ways the payments are processed:

• Pass-through: Investor payments come directly from borrower repayments.

• Pay-through: Funds are pooled and paid out according to a set schedule, sometimes with reinvestment in between.

Metrics for Evaluating Mortgage-Backed Securities (MBS)

When it comes to assessing mortgage-backed securities, investors (and even curious homebuyers) can look at a few key numbers and ratings to understand risk, return, and stability.

Credit Ratings

Ratings, provided by various agencies, range from AAA (highest quality, lowest risk) down to sub-investment grades. 

Higher-rated MBS are generally safer but offer lower yields.

Yield

The annual income an investor earns from the MBS is expressed as a percentage of the investment.

Higher yields often mean higher risk, especially in non-conforming RMBS.

Average Life/Weighted Average Life (WAL)

This means the average time it takes for the principal to be repaid. It’s influenced by the history of how quickly borrowers have made their mortgage repayments in the past.

Prepayment Speed

Measures how quickly homeowners are paying off or refinancing their mortgages. High prepayment speeds can reduce the expected interest income for investors.

Default Rate

This is the percentage of loans in the pool that have gone into default. A higher default rate means higher risk for the MBS.

Credit Enhancement Levels

Refers to any extra protections like reserve accounts or subordination that help shield investors from losses if borrowers default.

It’s common in non-conforming RMBS to make them more attractive to investors.

Loan-to-Value Ratio (LVR) Profile

It shows how much equity borrowers have in their homes. Lower LVRs generally mean less risk, as borrowers are less likely to walk away from their loans.

Mortgage-Backed Securities (MBS): Risks & Considerations

• Prepayment Risk: If homeowners refinance or pay off loans early (due to lower interest rates), MBS investors may get their money back sooner than expected, reducing long-term returns.

• Credit/Default Risk: If too many borrowers stop paying their mortgages (e.g., during an economic downturn), MBS investors could lose money.

• Interest Rate Risk: If interest rates rise, fixed-rate MBS may lose value. If rates fall, prepayments may increase, cutting into returns.

• Liquidity Risk: Some MBS, especially from smaller issuers, can be harder to sell quickly without taking a price hit.

• Complexity Risk: Understanding tranche structures, credit enhancements, and repayment schedules requires expertise. Misjudging these can lead to poor investment decisions.

• Systemic Risk (Lessons from 2008): While Australia’s lending standards helped avoid the worst of the Global Financial Crisis in 2008, overseas experience showed that excessive reliance on poorly underwritten mortgages can cause major market instability.

Risk Management Tools for Mortgage-Backed Securities (MBS)

• Credit Default Swaps (CDS): It is a form of insurance against borrower defaults. An MBS investor pays a premium to a CDS seller, who agrees to cover losses if defaults reach a certain level. 

• Credit Enhancement: Using features like reserve funds, excess spread, or over-collateralisation provides an extra buffer for investors if borrowers default.

• Diversification of the Mortgage Pool: Mixing loans from different regions, borrower profiles, and property types can potentially help reduce exposure to localised downturns.

• Interest Rate Hedging: Using derivatives such as interest rate swaps or futures may help against rate changes that could reduce the value of an MBS.

• Tranche Selection: Choose MBS tranches that align with your risk tolerance and investment horizon.

Conclusion

Mortgage-backed security (MBS) is a key part of Australia’s financial system, quietly linking homeowners, lenders, and investors in a cycle that keeps the housing market running. 

For the average borrower, strong demand for MBS can mean more choice, competitive rates, and greater access to finance, even if you never see the term “MBS” on your loan documents.

Note: This information is of a general nature only and does not constitute financial advice. Kindly consider seeking independent, licenced credit advice before acting.

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