Here is a simple explanation of Mortgage Backed Securities, so you can understand the concept. Mortgage Backed Securities can certainly vary from and be more complex than this...
1) Someone buys a house, and to obtain the money to purchase the house, they get a mortgage loan from a bank. So over the next 30 or so years, they will owe the bank the total loan amount (principle) PLUS interest payments.
2) This bank gives out a lot of mortgage loans to different people. Let's say 1,000 mortgage loans.
3) The bank then sells these 1,000 loans to an Investment Bank. So now all the interest and principle payments will go to the Investment Bank.
4) The Investment Bank creates a separate company, specifically a corporation. They transfer the 1000 loans to this new corporation. So now all the interest and principle payments will go to this new corporation.
5) The Investment Bank issues shares of ownership in the corporation (which are called securities…i.e. stocks). These securities are then sold in the free market.
6) Each owner of one of these securities will get a part of the cash flow from the loan payments that are now being paid to this corporation.
7) These securities are called Mortgage Backed Securities. They are securities which are backed by mortgage payments. Hence the wikipedia definition: "A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property."
The SEC's explanation of Mortgage Backed Securities
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