How Does a Mortgage Bond Make Money?

An investor gets principal and interest in a single monthly payment when a borrower pays back a loan using specific real estate assets as security. In the event of a default by the borrower, the asset may be auctioned off to repay bondholders.

To what end do mortgage bonds serve?

Lenders retain title to mortgages until the loan is paid in full. This happens when a person buys a home using a mortgage. Financial institutions and mortgage companies are two examples of potential lenders for such property loans.

The mortgages are pooled by the banks. The bundles are then sold to investment firms or government entities at a discounted rate. By shifting the risk of loan default to investment banks, lending institutions get access to the funds they would have earned throughout the life of the loan upfront.

Bonds for mortgage-backed loans are often issued by an investment bank after a bundle of loans is sold to an SPV (special purpose company). Bondholders in mortgage loans get regular interest and principal payments each month.

Mortgage bondholders get a monthly distribution of funds generated by the mortgage pooling process. An investment bank keeps some of the interest on a loan and gives the rest, along with the principal, to bondholders. Mortgages are securitized when their cash flows are transferred to bondholders.

Types

There are a variety of mortgage-backed securities (MBS), including securities with a passthrough to mortgage

• When interest or principal is paid on these MBS bonds, the proceeds are divided among bondholders according to their respective ownership percentages. If ten people invested $1,000 apiece and 1,000 bonds were created, each person would get $1,000. Each investor would get a dividend proportional to their portfolio holdings. Any prepayments will be shared equally among bondholders. Payments on mortgage bonds would never exceed a bondholder’s proportionate share of bond proceeds. In the case of default, the loss would be distributed to investors according to their bond holdings (if the asset value drops below the face value of the bonds). Therefore, bondholders and MPS investors face similar prepayment and extension risks. Many financiers fret about the risks of prepayment and default.

• CMBS helps reduce these problems. They do this by segmenting mortgage cash flows into many classes or tranches. Each of these is exposed to a different set of risks. Under the CMBS structure, the retirement of each bond type would occur in a predetermined order. Each portion of the money has its own set of rules for how it may be used. In addition to the monthly interest payments, each tranche (a portion of money) also receives payments toward the principal and any prepayment amounts. This method of dividing up prepayment risk among tranches is common in the financial industry. The risk of prepayment is greatest for Tranche 1, whereas the lesser tranches act as shock absorbers in the event of borrower default. Tranche 4 gets prepayment only after the previous three tranches have been paid in full. So it can afford losses in the event of a default. It faces the highest default risk and the lowest prepayment risk in the aforementioned scenario.

Example

Let’s say ten people took out $100,000 in loans from ABC Bank, using the property as collateral, at a rate of 6% apiece, for a total of $1,000,000. The bank would sell XYZ a pool of mortgage amounts, and XYZ would issue bonds for $1,000,000 (one thousand bonds of $1,000 each) using this pool of mortgages as collateral at a rate of 5%.

From there, XYZ would make new loans out of the collected funds. ABC Bank would send XYZ $5,000 in interest and the first month’s payment component, less any applicable margin or fee.

For the first month, XYZ will get $4,500 plus the repayment amount if the fee retained is 0.6% (0.05% each month). In addition, XYZ would continue to pay mortgage bondholders the remaining interest on the $4000+ repayment amount for the first month at a spread of 0.6% (0.05% monthly).

To implement this strategy, the investment bank may acquire mortgages from other banks using bond sale revenues. And the other banks can make loans with the proceeds of mortgage sales. If the homeowners default on their mortgage, the loan might be sold at auction to compensate the lenders.

Home loan vs. financial responsibilities

In contrast to a debenture, a mortgage bond is not backed by any collateral. It is backed by the full faith and credit of the issuing business alone. In contrast, in the case of borrower default, the mortgage bond is backed by real estate. This real estate may be liquidated to repay the bond. MBS have a lower interest rate than debenture bonds. This is because they are a lower-risk investment.

There are also variations in payment schedules and procedures. Mortgage bonds are debt instruments that pay interest and principal every month. However, the principle on debenture bonds is not paid until the bond matures. The interest is paid semiannually or annually.

Advantages

• Mortgage-backed securities have a higher rate of return than Treasury bonds.
• Mortgage-backed debentures provide higher risk-adjusted returns than other types of debenture bonds. This is because of the security provided by the underlying mortgages.
• They contribute to a diversified portfolio because of the low degree of correlation between them and other investment options.
• It provides regular and reliable income, especially in comparison to other fixed-income products. Interest on corporate bonds is paid annually or semiannually, whereas MBS payments are made monthly.
• Mortgage-backed securities are preferable to debenture bonds in the case of insolvency since the collateral may be liquidated to repay bondholders.
• Unlike traditional bonds, MBS do not have tail risk because their monthly payments include both interest and principal, the latter of which is amortised over the life of the bond. The risk to bondholders is elevated because of the single, large payment of principal at maturity seen in certain other bonds.

Disadvantages

• Mortgage-backed securities have a lower yield than debenture bonds.
• Mortgage-backed securities, formerly seen as safe investments, were blamed for contributing to the subprime mortgage crisis of 2008. As a consequence of higher profits, some banks became complacent and extended credit to people who weren’t good risks. Several large investment banks, notably the Lehman brothers, had significant investor losses as a result of the subprime mortgage default crisis. Loans are secured by assets. So these bonds are essentially equivalent to the asset.
• If the market interest rate drops, these bondholders might be pre-paid. To make matters worse, they’ll have to invest the money they get at a lesser rate. This reduces their overall return.

Conclusion

Mortgage bonds are a diversified investment option that outperform Treasury bonds and debenture bonds. They carry much less risk. To keep mortgage rates low and the market functioning, these financial institutions also provide loans to investment banks.

Visit Piramal Finance to learn more.