Mortgage-backed securities (MBS) are batches of residential mortgages, packaged in pools with similar interest rates and terms, and sold as securities in the secondary mortgage market. The MBS program was launched in 1968, to increase the supply of funds available for mortgage lending. This is accomplished when banks and other mortgage lenders sell portfolios of their existing home mortgage loans as mortgage-backed securities. The sellers recover the underlying value of the mortgage pools, allowing them to expand mortgage lending in their communities. In addition to receiving monthly principle passed-through from mortgagors to the buyers, MBSs are popular because buyers also receive a sure rate of interest (based on the pools of mortgages that make up the security).
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities.
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution (i.e. one you could write it down) are widely known. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions
MBSs are highly-regarded investment vehicles. Large institutional investors often purchase one of more pools of mortgage-backed securities, and many small investors buy shares of popular Ginnie Mae MBS mutual funds.
This section is written with the subprime lending crisis of 2007-2008 as its focus; as such it is framed as "winners" and "losers" from the subprime crisis and the companies that invested heavily in sub-prime MBS.
Many large investment firms have seen their stock prices plummet as a result of their heavy exposure to mortgage-backed securities, as they took heavy write downs in the wake of the subprime bust.
When it's easy to buy homes, rental prices drop. When financing for mortgages dries up, people rent instead of buying. As a result, Apartment REITs, which own and operate rental apartments, benefit in some areas from the subprime fallout as the decreased availability of mortgages makes rental apartments more attractive.
Other potential winners are the few hedge funds that have bet against the subprime market recently, by shorting subprime-heavy firms' stocks and securities backed by subprime mortgages.
Commercial Real Estate Investment Trusts (REITs)
Commercial REITs have faired well relative to REITs with significant holdings in residential property, as the subprime lending crisis has primarily affected home mortgages.
The creation of these securities is credited to the Government National Mortgage Association  (Ginnie Mae), a wholly-owned federal corporation within the U.S. Department of Housing and Urban Development (HUD) . The MBS program was designed to increase the supply of funds available for home mortgages.
MBSs made a small splash in 1968 when they first were issued, and today are at the heart of a billion dollar securitization industry. MBSs are called "pass-through" certificates. The monthly principal and interest payment from each of the underlying mortgage loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. By selling a pool of mortgage loans to an MBS servicer, the lender receives funds equal to the underlying value of the pool, which will be used to make more home mortgage loans.
MBS have garnered controversy for their role in subprime lending. MBS allow originating banks to offload their exposures to homeowners to the bond market, recycling their capital so they can originate more mortgages. Investors count on the investment banks and, crucially, the rating agencies to rate and then monitor the credit quality of the resulting MBS. Apparently compromised by their reliance on this flow of business, however, the agencies and investment banks failed to spot (or, say some, deliberately ignored) the deteriorating underwriting standards of the originating banks, and rated as triple-A (AAA to Standard & Poor's and Fitch, Aaa to Moody's Corporation) some MBS that were, in fact, much riskier. This mistake was compounded by the emergence of CDO's (Collateralized Debt Obligations) that invested in these MBS on the basis of their ratings, and got their own AAA/Aaa ratings on their bonds as a result.
Whether the resulting meltdown was the result of corruption, or simply incompetence, is still under debate. The rating agencies, not without some reason, can claim to have been duped alongside the investors -- to have lost 'reputation capital' just as the investors lost money capital. Many observers, though, point to the enormous growth in their business on the back of the securitization phenomenon.
While highly visible and distressing, subprime MBS and CDOs are only a fraction of the securitization market; many MBS are still considered high-grade either because of the high credit quality of the mortgage pools that back them, or because of the guarantee of the federal housing agencies. Securitization remains a pillar of all modern capital markets because of its ability to move risk onto the balance sheets of investors and creditors who are better able to bear that risk than the originating institutions.
See especially Government National Mortgage Association (also known as Ginnie Mae, or GNMA).