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Mortgage bonds for newbies

By Holden Lewis · Bankrate.com
Friday, March 26, 2010
Posted: 5 pm ET

When you get a mortgage, your home loan is in the middle of a long chain of transactions that determine the rate you pay. Here's a brief, oversimplified explanation of how your rate is set.

Most mortgages are sold in bulk to financial institutions. The financial institution -- it could be Fannie Mae or Freddie Mac, or a big bank -- bundles several dozen or even a few hundred mortgages together to create an investment vehicle. This investment vehicle is spun off, and legally is a corporation.

OK, so you have a bag of loans that is a corporate entity unto itself. This company then securitizes the loans. When it securitizes the loans, it sells investors the right to receive income from the monthly payments. That right -- the thing that investors buy -- is like a bond, and it's called a mortgage-backed security. You'll often read articles that say that mortgage investors own the mortgages. That's not the case. They own the right to collect a portion of the monthly interest and principal payments, and the corporate entity owns the loans themselves.

The rates on mortgages have a distant relationship to the yields on 10-year Treasury notes. Lately, coupon yields on mortgage-backed securities have been a little less than 1 percent over the equivalent Treasury yields. For example, on March 17 the 10-year Treasury yielded 3.65 percent, and the dominant coupon on 30-year, fixed-rate, mortgage-backed securities was 4.5 percent. Essentially, the 10-year Treasury yield is the starting point for mortgage rates, but the journey to your final mortgage rate is long and winding.

Now, when a mortgage loan pool sells a mortgage bond with a coupon of, say, 4.5 percent, that's not necessarily what the investor will collect. A bond is an IOU, and when the price of that IOU goes up, the yield goes down. That sounds complicated, but it's pretty straightforward. Here's how to think about it:

Let's say you lend a friend $100 and she gives you a piece of paper promising to give you $105 a year from now. That piece of paper is a bond, and you just bought it for $100 (the $100 that you lent). A year from now, the holder of the bond is supposed to get $105, which means that the bond has a coupon of 5 percent.

Let's say that, a month after you lent the $100, you sell that piece of paper to another friend for $101. Your friend just paid $101 to receive $105 in a little less than a year, for an annual yield of about 4 percent. See what happened? The price went up $1, and the yield went down about 1 percentage point. When people say that bond prices move inversely to yields, this is the phenomenon that they're describing.

The prices of mortgage-backed securities fluctuate. When prices go up, rates tend to go down, and vice versa. Prices rise and fall in response to what's happening to yields on other types of bonds, as well as investors' perception of credit risk (mortgage-backed security prices fall if investors believe borrowers are going to start to default in greater-than-forecast numbers), and prepayment risk (the mortgage bond gains value if overall interest rates rise and borrowers become less likely to refinance).

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