What is a mortgage bond?
A mortgage bond is a bond in which holders have a claim on the real estate assets put up as its collateral. A lender might sell a collection of mortgage bonds to an investor, who then collects the interest payments on each mortgage until it’s paid off. If the mortgage owner defaults, the bondholder gets her house.
Banks often have a huge number of mortgages on their books. However, they don’t always want to wait for the mortgages to turn profitable for them. Sometimes, they’ll package many mortgages into a bond and sell that to make a short-term profit instead.
The investor who purchases the mortgage bond has the right to collect interest payments on the mortgages as well as payments toward the principal. If the borrower defaults, the investor can also foreclose on her house. On the other hand, if the mortgagee happens to pay off her mortgage early, the investor could lose money on future interest payments.
Mortgage bonds are different than traditional bonds, like those sold by the government. The interest on a mortgage bond may fluctuate, depending on the type of mortgages included, but traditional bonds have a fixed-interest coupon that stays the same. Mortgage bonds also have what’s called an average life estimate. When they mature, the investor doesn’t receive a principal payment because it was included with the monthly interest coupon.
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Mortgage bond example
Mortgage bonds developed a negative reputation in the wake of Great Recession. One factor in the financial crisis was the buying and selling of subprime loans; essentially, mortgage bonds filled with mortgages that banks didn’t think homeowners would be able to pay off. The banks made a significant profit on the sales of those subprime loans, and sold so many of them they there was an abundance of them to package and resell to investors.
At the time, it looked like everyone would profit. However, the borrowers, especially those whose interest rates started increasing, started defaulting en masse, and investors quickly stopped buying mortgage-backed securities. What followed was a quick depletion of cash in the banks and investors who collectively found themselves out billions of dollars.