Mortgage Bonds

mortgage bondsMortgage bonds are bonds secured by a mortgage or pool of mortgages. These bonds are typically backed by real estate holdings and/or real property such as equipment. In a default situation, mortgage bondholders have a claim to the underlying property and could sell it off to compensate for the default. Mortgage bonds can pay interest in either monthly, quarterly or semiannual periods.

Mortgage bonds offer the investor a great deal of protection in that the principal is secured by a valuable asset that could theoretically be sold off to cover the debt. However, because of this inherent safety, the average mortgage bond tends to yield a lower rate of return than traditional corporate bonds that are backed only by the corporation’s promise and ability to pay.

How Mortgage Bonds Work

When a person buys a home and finances the purchase with a mortgage, the lender rarely retains ownership of the mortgage. Instead, it sells the mortgage on the secondary market to another entity, such as an investment bank or government-sponsored enterprise (GSE). This entity packages the mortgage with a pool of other loans and issues bonds, with these mortgages as backing.

When homeowners make their mortgage payments, the interest portion of their payments are used to pay the yield on these mortgage bonds. As long as most of the homeowners in the mortgage pool keep up with their payments, a mortgage bond is a safe and reliable income-producing security.

Mortgage bond yields tend to be lower than corporate bond yields, as the securitization of mortgages makes such bonds safer investments. If a homeowner defaults on a mortgage, the bondholders have a claim on the value of the homeowner’s property. The property can be liquidated with the proceeds used to compensate bondholders. By contrast, investors in corporate bonds have little to no recourse if the corporation becomes unable to pay. As a result, when corporations issue bonds, they must offer higher yields to entice investors to shoulder the risk of unsecured debt.

Mortgage-Backed Security (MBS)

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. This security must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pays periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.

When an investor invests in a mortgage-backed security, he is essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment market participants.

This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS.

Types of Mortgage-Backed Securities

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations, also known as CMOs. Pass-throughs are structured as a trust in which mortgage payments are collected and passed through to investors. Pass-throughs typically have stated maturities of five, 15, and 30 years. Adjustable-rate mortgages (ARM), fixed-rate mortgages and other types of loans are pooled to create pass-throughs. The average life of pass-throughs may be less than the stated maturity, depending on the principal payments of the pool of mortgages.

Collateralized mortgage obligations (CMO) consist of multiple pools of securities, which are known as slices, or tranches. The tranches are given credit ratings, and the rates that are returned to investors depend on the tranches. For example, pools of securities in the senior secured tranche typically have lower interest rates than those in the unsecured tranche, due to the low degree of risk assumed in the senior secured tranche.

When Mortgage Bonds Go Bad

One major exception to the general rule that mortgage bonds represent a safe investment occurred during the financial crisis of the late 2000s. Leading up to this period, investors realized they could earn bigger yields purchasing bonds backed by subprime mortgages — mortgages offered to buyers with poor credit or unverifiable income—while still enjoying the supposed security of investing in collateralized debt. Unfortunately, enough of these subprime mortgages defaulted to cause a crisis, amid which many mortgage bonds defaulted, costing investors millions of dollars. Since the crisis, there has been heightened scrutiny over such securities. Nevertheless, the Fed still holds a sizable amount of mortgage-backed securities (MBSs) such as mortgage bonds.

Mortgage Backed Securities Today

MBSs are still bought and sold today. There will always be a market for them simply because people generally pay their mortgages if they can. The Fed is still holding that trillion plus chunk of the market for U.S. originated MBSs, but it has announced that it will start selling off its MBS holdings starting in 2017. Even CDOs have returned after falling out of favor for a few years post crisis. So two of the main culprits in the financial crisis are still in session, but the assumption is that Wall Street has learned its lesson and will question the value of MBSs frequently rather than just blindly buying them. Time will tell, however, and you know what they say about assumptions.

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