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The issuer pools together many of these individual mortgages. By combining many mortgages, the issuer creates a diversified pool. This diversification reduces the risk for investors because it's unlikely that all homeowners in the pool will default on their mortgages simultaneously. This is a very important concept. The issuer then slices up the cash flows from the pool of mortgages into different 'tranches' or slices. Each tranche has a different risk profile and a different expected return. Some tranches are considered safer (and therefore pay a lower interest rate), while others are riskier (and pay a higher interest rate). The safer tranches typically have a higher priority in receiving payments, meaning they're paid first. The riskier tranches are paid last and absorb the losses if some homeowners default on their mortgages. The payment structure of MBS can get pretty complex. The issuer, for example, might divide an MBS into different tranches, each with a different risk profile. Some tranches might be senior, meaning they have a higher priority in receiving payments. Others might be junior, meaning they absorb the losses first if the underlying mortgages default. This is where things get interesting and sophisticated. MBS is used by investors as a means to make money.
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