Mortgage bonds are highly secure debt instruments collateralized by mortgages or pools of mortgages. These bonds are secured by real estate or property. If the borrower defaults, the bondholder can sell off the secured property to compensate his losses. Lenders rarely retain the mortgages and usually sell them to investment banks or government-sponsored entities (GSE’s). They, in turn, bundle it up with other loans and issue mortgage bonds. Interested investors purchase these bonds. The interest on the mortgage payments made by homeowners is used to pay the yield on these bonds.
Let us closely examine some of the features that make these bonds so attractive.
Liquid assets
The ability to sell an asset at the prevailing market price allows entities to redistribute their assets and earn high returns. The GSE or bank provides cash to the lender who originates the bond in exchange for the mortgage. The lender can then advance loans again. Investors who purchase these bonds again infuse liquid cash into the system. This way the securitization cycle runs like a well-oiled machine and the government uses a share of the proceeds from the sale of mortgage bonds to subsidize the housing of lower income families.
Safety
A mortgage bond offers a great deal of security because it’s backed by an underlying asset namely real estate or property. If there is a default, the asset can simply be sold to cover the losses. Due to the highly secure nature of these instruments, they yield a lower rate of interest than corporate bonds that have no underlying security.
Transfer of risk
When the bank sells the mortgage to the GSE, it receives cash on its books in place of the mortgage and thus lowers its risk profile. GSE’s with a much bigger risk appetite take over these mortgages.
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Benefits of mortgage bonds
The debt that comes with a mortgage bond is cheaper to own as compared to lines of credit or bank loans. There are lower rates of interest on these bonds as they are collateralized as compared to non-secured bonds such as corporate bonds which are riskier.
A stable rate of interest
Lenders typically try not to overcharge or undercharge for the mortgage. The lender resells the mortgage to a bank or GSE. If the rate is too low, the bank will refrain from taking it on because it can get a better deal at the prevailing market rates and these will offer lower returns. If the rate of interest is too high, the bank or GSE will assume it’s a riskier investment. This way the mortgage rates don’t fluctuate much.
2008 subprime mortgage crisis
Investors realized they could get higher dividends by purchasing bonds backed by subprime mortgages. These mortgages were given to buyers who had very bad credit and income that could not be verified. The people who purchased the bond believed they would earn a higher yield on supposedly collateralized debt. However, too many people defaulted on their mortgages causing huge losses to investors.
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