Mortgage Bond

A bond backed by real estate or property.

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Last Updated:November 2, 2023

What is a Mortgage Bond?

A mortgage enables home buyers to own property through borrowed finances from financial institutions such as banks. The banks rarely hold mortgages; instead, they are sold on the secondary mortgage market to aggregators. 

Aggregators purchase many mortgages from the secondary mortgage market to categorize mortgages with similar characteristics into a mortgage-backed security (MBS) to sell to investors.

Investors prefer the type of returns they aim to achieve, with lower returns typically being the safest, as mortgage providers reward high credit-worthy individuals with low mortgage rates.

High creditworthiness ensures the borrower displays a low chance of defaulting on their payments. 

Conversely, larger returns come with high risk as borrowers with low credit are charged high interest rates for the contingencies of defaulting on their loans.

The ownership of the bond entitles them to receive all interest and principal payments instead of the primary lender; however, the bank could still be actively servicing the payments.

Mortgage bonds are considered safe bonds as the underlying asset, the property, protects them. If the borrower were to default on their mortgage payments, the property could be sold to reimburse the investor.

Corporate bonds are not associated with an underlying real asset and are based on trust that the investor will be paid back. For this reason, the interest rate is substantially higher for the added risk. 

However, professionals must properly assess and regulate mortgage bonds because they also have risks that were felt in the 2008 Financial Crisis.

Factors Influencing Mortgage Rates

The primary mortgage market comprises banks and other mortgage providers who lend money to help consumers finance the purchase of a high-value property. The creation of new credit means the borrower is obligated to pay back the principal and interest over a term of 15 to 30 years to the lender.

The mortgage rate is the interest borrowers pay to the lender that can be passed to investors. The rate is determined through several factors, which include:

Benchmark/Reference rate

Benchmark/reference rates are factored into the mortgage rate to provide a standard of the risks associated with crediting money in the current market economy.

Common rates used include the Fed Funds rate and US Treasury Yields, as they are critical when measuring inflation as its primary risk.

The Fed Fund Rate is the rate the Federal Reserve pays banks for holding a reserve deposit. Subsequently, this sets the rate banks use when borrowing from each other to compensate for a shortfall in a bank's Federal reserve deposit.

For example, if the Fed Fund rate is 1%, banks could charge other banks a 3% rate for borrowing funds to accumulate more interest that would otherwise receive 1% from the central bank.

US Treasury securities are considered the most stable, risk-free bonds; therefore, the yields associated with the longevity of the bond provide an accurate representation of the applied risk when lending money in the current economy.

Credit Score

A consumer's creditworthiness is determined by their credit score, a number between 300–850 that is subject to change depending on credit history, such as repayment history and total debt obligations. 

A high score would provide borrowers with a better outcome as banks would service a loan with a low-interest rate as it shows evidence of committed scheduled debt payments with a low risk of default.

Fair Isaac Corporation (FICO) created the most commonly used credit scoring system adopted by financial institutions.

Credit scores can significantly affect a person's financial credibility and hence the prospects of being accepted to withdraw a mortgage.

Subprime borrowers are classed as individuals with a credit score below 640. Lending institutions conscientiously charge higher rates for subprime mortgages for the unpredictable nature of the borrower to make consistent payments.

More frequent scheduled repayments or a co-signer may be added to the conditions of the mortgage to mitigate risk.

Lower interest rates are awarded to borrowers with a credit score of 700 and above, which is advantageous as they will pay less money throughout the full term of the mortgage in comparison to subprime borrowers.

Down payment

The initial payment made when purchasing a property is known as the down payment. In other words, it is the capital you have contributed to buying a house. It represents a percentage of the property's price, while the remainder of the money is borrowed from the bank as a mortgage.

The standard percentage for a down payment in the United States is 20%, although it can vary depending on the financial circumstance of the home buyer. 

The more you contribute to the house purchase, the more money you save on interest payments over the mortgage, as you would not have to borrow as much from the bank.

For example, if you place a down payment of $20,000 for a $100,000 property, you will borrow $80,000 from a bank. Say the interest is 5% for a fixed term of 20 years; you would be paying interest of $4,000 annually.

However, a down payment of $30,000 under the same conditions will require an interest payment of $3,500 annually, saving you a total of $10,000 over the full term of the mortgage.

A larger down payment usually reduces the mortgage rate, adding to the amount of money saved in the example above, as it poses less risk to the bank if payments are missed for a smaller loan.

Mortgage Bonds and Mortgage-Backed Securities

Mortgage-backed securities are formed by pooling together mortgages exclusively. When investors buy into an MBS, they essentially take ownership of the mortgage loan issued, entitling them to loan payments from the home buyer.

MBS enables the bank to act as an intermediary between homebuyers and the investment industry. The bank can sell mortgages to financial institutions for them to be securitized as MBS to be sold to investors. 

This replenished the bank's account to be able to lend to more consumers without overloading risk. If an MBS defaults, the bank loses little to nothing on its balance sheet.

Credit rating agencies assess the credit risk of the MBS and assign it a credit rating according to the underlying borrowers. This groups mortgages with similar characteristics, allowing them to be easily presented to investors and their investment criteria.

The demand for MBS plays an integral role in mortgage rates. High demand requires banks to issue more mortgages to accommodate. In turn, the mortgage rate lowers to stimulate demand for more consumers to apply for a mortgage by promoting attractive rates.

Interest rates can supersede this demand as increased interest rates will be reflected in the mortgage rates; therefore, the government can control the demand for mortgages and MBS if they believe it to be concerning.

The pandemic resulted in the Federal Reserve purchasing MBS, valued at $2.1 trillion in 2022. 

The measure was used to stimulate the property market and the overall economy, which was feared would become stagnant. Lowering mortgage rates created favorable conditions for spending and growth.

New regulations since the financial crisis have altered how MBS are sold, such as MBS can only be issued by a government-sponsored enterprise (GSE) or a private financial company. 

The financial institution must be authorized and follow strict regulations to securitize MBS, and the MBS must receive one of the two highest credit ratings from a licensed credit rating agency.

Types of MBS

Some of the types include:

1. Pass-through MBS

It allows principal and interest payments to be collected and directly transferred to the investor acting as a trust.

  • The MBS comprises a pool of mortgages that investors can contribute to proportions of different mortgages and therefore have a right to its derived payments. 

  • The risk of default is limited as it is composed of many different mortgages; therefore, investors can only lose a small percentage of return if it occurs.

  • The bonds maturity may last between 15 to 30 years and is paid to the investor depending on the agreed debt payment schedule.

  • A fall in interest rates may cause lower returns as mortgage owners refinance their higher interest mortgage. 

  • Prepayment risks would result in early mortgage payment, losing potential returns which could have generated more interest over the expected mortgage term.

2. Collateralized Mortgage Obligations (CMO)

It is a pool of mortgages organized into separate groups, known as tranches, within the security.

  • Each tranche comprises bonds with similar principal balances, maturity dates, mortgage rates, and potential of repayment defaults. 

  • Investors are exposed to various returns, with high-risk tranches diversifying the portfolio and low-risk tranches mitigating risk. 

Advantages and Disadvantages of Mortgage Bonds

The advantages of mortgage bonds are that they provide liquidity to the housing market while spreading risk through investors so that banks are not susceptible to any overloaded risk. 

They allow low-credit individuals a chance to obtain a mortgage with less stringent conditions.

Payments are made monthly as a fixed-income security. They can be structured so that principle and interest payments are transferred to the investor in one payment creating a separate income stream.

The bond is secured by an underlying asset which alleviates heavy financial losses that can be easily compensated when selling the underlying asset. This makes them a relatively safe investment vehicle.

On the contrary, depending on circumstances, the real asset may be sold at a lower price than its expected market value. If there is little demand, it could take years for the asset to be sold; therefore, your funds could take some time to be retrieved with little return on investment.

They generate lower returns than corporate bonds as they pose less risk; therefore, investors looking to make a larger return on investments over a smaller period may look to invest elsewhere, such as the stock market.

Subprime mortgage crisis

The crisis had been developing years before the visible crash in 2007 and led to the 2008 financial crisis as money was vanishing. The prices of homes began to drop, and the debt used to purchase these properties became overvalued and unmaintainable.

It was fueled when mortgage providers began issuing loans to subprime borrowers using different mortgage structures, including adjustable-rate mortgages (ARMs), which they believed would limit the risk of defaulting on payments.

MBS were in great demand, which drove the forefront of banks to issue more mortgages, gradually increasing the prevalence of subprime bonds incorporated in MBS and CMO.

High-risk MBS were not discouraged as they provided greater returns for investors looking to capitalize on the thriving property market. The bonds were also perceived as being secure as the underlying assets were used as collateral.

Therefore, if the borrowers had defaulted, the asset could be liquidated to pay back investors.

The property market was booming during this cycle; therefore, the value of homes was constantly appreciating, reassuring home buyers that they would be making an easy profit if they purchased homes.

Methods of buying homes to be sold after they had appreciated were adopted, with home buyers and bondholders profiting from the transaction.

Eventually, the housing market began to cool when the Federal Reserve decided to raise interest rates between 2004 and 2006 to contain the overheated market.

Mortgage rates simultaneously increased, resulting in larger loan payments, especially for individuals exposed to ARMs. This triggered a cascade of defaults in the US.

Demand for houses fell, pushing down the price of houses, with the sales prices dropping by 1.7% in a year. This was the largest decline seen in 11 years since the recession in 1990. 

Many owners now owned mortgages valued higher than their underlying property.

The situation had become problematic as the rate of default was accelerating with the abundance of subprime borrowers and hefty monthly payments. 

This impacted MBS as many junk bonds infiltrated the security. Many investors were losing money as the monthly payments were not made, while the underlying collateralized assets were losing value.

Researched and Authored by Rohan Hirani | Linkedin

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