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A mortgage-backed security represents an ownership interest in mortgage loans made by financial institutions to finance a borrower’s purchase of a home or other real estate. Mortgage-backed securities are created when mortgage loans are packaged, or “pooled,” by issuers or servicers, and securities are issued for sale to investors. As the underlying mortgage loans are paid off by the borrowers, the investors in the securities receive payments of interest and principal.

Mortgage-backed securities play a crucial role in the availability and cost of housing in the United States. The ability to securitize mortgage loans enables mortgage lenders and mortgage bankers to access a larger reservoir of capital, which makes financing available to home buyers at lower costs and spreads the flow of funds to areas of the country where capital may be scarce.

Asset securitization began when the first mortgage pass-through security was issued in 1970, with a guarantee by the Government National Mortgage Association (“GNMA” or “Ginnie Mae”). The most basic mortgage-backed securities, known as pass-throughs or participation certificates (“PCs”), represent a direct ownership interest in a pool of mortgage loans. Shortly after this issuance, both the Federal Home Loan Mortgage Corporation (“FHMLC” or “Freddie Mac”) and Federal National Mortgage Association (“FNMA” or “Fannie Mae”) began issuing mortgage-backed securities.

Although mortgage-backed securities are fixed-income securities that entitle investors to payments of principal and interest, they differ from corporate and Treasury securities in significant ways. With a mortgage-backed security, the ultimate borrower is the homeowner who takes on a mortgage loan. Because the homeowner’s monthly payments include both interest and principal, the mortgage-backed security investor’s principal is returned over the life of the security, or amortized, rather than repaid in a single lump sum at maturity.

Mortgage-backed securities provide payments to investors that include varying amounts of both principal and interest, due to the flexibility that the homeowner has in being able to pay more than the minimum payment required by the loan agreement. As the principal is repaid, or prepaid, interest payments become smaller because the payments are based on a lower amount of outstanding principal. In addition, while most bonds pay interest semiannually, mortgage-backed securities may pay interest and principal monthly, quarterly or semiannually, depending on the structure and terms of the issue. Most mortgage pass-through securities are based on fixed-rate mortgage loans with an original maturity of 30 years, but typically most of these loans will be paid off much earlier.

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