A mortgage-backed security (MBS) is an financial instrument that is similar to a bond and is composed of a collection of mortgage loans that have been acquired from the banks that issued them and sold as a ‘bundle’ to individual investors. The investors of MBS earn periodic interest payments on these instruments payable by the borrowers.
You approach a bank to ask for a mortgage loan when you want to buy a house. Home loans are secured loans in which the house you’re buying serves as the collateral.
The bank will provide you a loan if it determines that you are creditworthy.
Once the loan is disbursed, you have to make principal and interest payments to the bank on a regular basis in accordance with your loan arrangement.
Once a loan has been issued, the issuer bank has two options: it can decide to retain the loan in its books and earn interest on the same, or sell the mortgage to another bank or financial institution.
In case it chooses to sell the mortgage to another financial institution, the bank might use the sale proceeds to expand its loan portfolio
The purchasing financial institution would typically acquire similar mortgage loans from various lenders and then pool loans with comparable features into a security that can be traded in the open market.
Such securities, known as Mortgage-Backed Securities (MBS) are then sold to individual investors who earn interest on the MBS similar to any other debt instrument.