Mortgage Bond Meaning Example How Does It Work

Mortgage Bond Meaning

The investors receive a monthly payment that includes interest as well as the principal amount when the borrower pays interest and repayment of debt to the person who borrowed money by keeping some real estate assets as collateral. In case the borrower defaults, the asset can be sold to pay off bondholders secured by those assets.

How does Mortgage Bond Works?

When a person purchases a home and finances it by keeping it as a mortgage, the lender gets the ownership of that mortgage until the loan is fully paid. The lender includes banks and mortgage companies that give a loan on such real estate assets. Banks then club these mortgages and sell them to an investment bank or any government entity at a discount. This way, banks get money instantly that they originally would get over the term of a loan, and they also manage to shift the risk of any default from themselves to investment banksInvestment BanksInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more.

An investment bank then transfers that bundle to an SPV (special purpose vehicleSpecial Purpose VehicleA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company’s bankruptcy-remote and has its own assets and liabilities.read more) and issues bondsIssues BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more on those loans backed by the mortgage. The cash flow from these loans is in the form of interest, plus principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more is passed every month to mortgage bondholders. This process of pooling mortgages and passing cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more is passed every month to mortgage bondholders. An investment bank keeps its share in the interest component of a loan and passes on the rest of the interest plus the principal component to bondholders. This process of pooling mortgages and passing cash flow on debt to bondholders is called securitization.

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Types

There are various types of MBS (mortgage-backed security)-

#1 – Mortgage Passthrough Securities

Under this type of MBS, payments are made proportionally among bondholders as they are received. If the total bonds issued are 1000 $1000 each and ten investors are holding 100 bonds each, then each investor would receive 1/10th of the payment passed on to them. Each investor would get its share of payment according to its holding. If there are prepayments, they will be passed on to bondholders proportionally. No bondholder would get more or less than his proportion of total bond holding in those mortgages. In the case of default, every investor would bear the loss (if the asset value falls below the face value of bonds) to their bond proportion.

So the MPS investors or bondholders face prepayment and extension risks equal to their holdings.

#2 – CMBS (Collateralized Mortgage Backed Security)

We have seen above how MPS investors face prepayment riskPrepayment RiskPrepayment Risks refers to the risk of losing all the interest payments due on a mortgage loan or fixed income security due to early repayment of principal by the Borrower. This Risk is most relevant in Mortgage Borrowing which is normally obtained for longer periods of 15-30 years.read more and in the eventuality of prepayment, how every investor receives it irrespective of whether they need or prefer it at that time. Many investors are concerned with prepayment and default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more.

CMBS helps mitigate these problems by directing the cash flows from mortgages to different classes or tranchesTranchesTranches refer to the segmentation of a pool of securities with varying degrees of risks, rewards, and maturities to appeal to investors.read more so that every class has different exposure to both risks. CMBS is structured so that each class of bond would retire serially in order. Each tranche is governed by different rules on how the payment will be distributed. Every tranche receives interest payments every month, but the principal and prepayment amounts are paid sequentially.

If there are four tranches, then the rule for monthly principal and prepayment to the tranches would be as follows –

Tranche 1 – Would receive all the principal amount and prepayments until the principal balance is zero.Tranche 2 – After tranche one is fully paid, it will receive all the principal amount and prepayments until the principal balance is zero.Tranche 3 – After tranche two is fully paid, it will receive all the principal amount and prepayments until the principal balance is zero.Tranche 4 – After tranche three is fully paid, it will receive the principal amount and prepayments until the principal balance is zero.

So this way, prepayment risk is distributed among tranches. The highest prepayment risk is in Tranche 1, whereas lower tranches act as shock absorbers if the borrower defaults. In the above example, Tranche 4 has the highest default risk and lowest prepayment risk as it gets prepayment after the above three tranches are fully paid and absorb losses in case of default.

Example

Suppose ten people took out a loan of $100,000 at 6%each by keeping the house as collateral in ABC bank, totaling a mortgage of $1,000,000. Bank would then sell this pool of mortgage amounts to an investment bank XYZ and use that money to make new loans. XYZ would sell bonds of $1,000,000 (1000 bonds of $1000 each) at 5% backed by these mortgages. ABC bank would pass on the interest received ($5,000) plus the payment component in 1st month to XYZ after keeping a margin or fee. Let’s say the fee kept is 0.6% (0.05% monthly) of the loan amount, so the amount passed on 1st month to XYZ is $4500 plus the repayment amount. XYZ would also keep its spread of 0.6% (0.05% monthly)on the loan amount and pass on the rest of the interest of the $4000plus repayment amount the first month to mortgage bondholders.

This way, the investment bank can purchase more mortgages from a bank through money received from selling bonds, and the banks can also use money received from selling mortgages to make new loans. In case of default by homeowners, the mortgage could be sold to pay off investors.

Mortgage vs. Debenture Bond

The main difference between a debenture and a mortgage bond is that the bond is not secured and is backed only by the full faith and credit of the issuing company. In contrast, the mortgage bond is backed by collateral, which can be sold if the borrower defaults. Therefore the interest rate of MBS is lower than debenture bonds due to lower risk.

The other difference lies in the payment and frequency of payment. Mortgage bonds are paid monthly and include interest as well as a principal component. Debenture bondsDebenture BondsDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, on the other hand, are paid annually or semiannually, which includes only the interest component, and the principal amount is paid at maturity.

Advantages

Mortgage-backed securities offer a higher return than Treasury securities.It offers higher risk-adjusted returnsRisk-adjusted ReturnsRisk-adjusted return is a strategy for measuring and analyzing investment returns in which financial, market, credit, and operational risks are evaluated and adjusted so that an individual may decide whether the investment is worthwhile given all of the risks to the capital invested.read more than other debenture bonds due to the backing of mortgaged assets, which reduces its risk.They provide asset diversification as they have a low correlation with other asset classes. It provides regular and frequent income as compared to other fixed-income products. MBS has monthly payments, whereas corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more offer annual or semiannual payments.A mortgage-backed security is a safer investment than debenture bonds in case of default, and the collateral can be sold to pay off bondholders.MBS does not have tail riskTail RiskTail Risk is defined as the risk of occurrence of an event that has a very low probability and is calculated as three times the standard deviation from the average normal distribution return.read more as there is no lump sum principal payment on maturity because monthly payment involves interest plus principal component, which is spread over the life of a bond. In other bonds, there is a high tail risk because of the lump-sum principal payment at maturity, which increases the risk to bondholders.

Disadvantages

Mortgage-backed security offers a lower yield than debenture bonds.Mortgage-backed securityMortgage-backed SecurityA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more, often touted as a safe investment, attracted negative publicity due to its role in the 2008 subprime mortgage crisis. Banks, due to high profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more, became complacent and issued loans to people having low creditworthiness. When subprime mortgagesSubprime MortgagesA subprime mortgage is a loan against property offered to borrowers with a weak or no credit history. Since the risk of recovering is high, the interest rate charged on such mortgages is higher so that the lender can recover a maximum amount at the beginning of the loan.read more defaulted, it resulted in the loss of millions of dollars of investors’ money and the bankruptcy of many large investment banks like the Lehman brothers. So these bonds are as good as the asset, and people borrow money from those assets.Such bondholders face the risk of prepayment in case of a lowering of interest rate in the market. Moreover, the money received by them will have to be invested at a lower rate, which reduces their return.

Conclusion

Mortgage bonds as an asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more offer diversification and offer the investor a higher yield than the treasury and lower risk than debenture bonds. Moreover, they provide money to investment banks to purchase more mortgages and lend more money, which helps keep mortgage rates competitive and markets liquid.