Mortgage Backed Bonds and Securitization

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So MBS's are bonds! Where do they come from?

Grossly oversimplified and leaving out numerous items that are not germane to rate analysis, MBS are the bonds that mortgage loans are turned into when they are bought or sold. That's a tough one to grasp your first time around. I know it was for me.

Basically, Big Bank will write a check for your mortgage, say it's $100,000. Big Bank A then has a promissory note saying that you will pay them a certain interest rate over time (sound familiar?). But Big Bank A needs some more money to lend other people... Where to get it? I know! They can sell your mortgage note to someone else in the form of a bond! Hopefully, that investor is willing to pay something like $102,000 for the right to collect interest on your $100,000 loan. Big Bank A just made $2000, and the investor has something that will hopefully pay them interest over time. Remember price vs. yield? The higher your interest rate, the more the investor would be willing to pay Big Bank A. That's YSP Baby! And if the investor is only going to pay $97,000 for the loan, that means Big Bank has to pay them a discount to buy it, which was probably passed on to you on line 802 of the GFE! Now YSP starts to become clear I hope!

But there's a big problem! The investor doesn't want all of their risk riding on one loan, so we have to find a way to spread out the risk. Because even if you only have a 3% chance of defaulting, in the event that you do, the investor would lose his hat. So to spread out the risk, Big Bank A combines your loan with 10's to hundreds of other similar loans with similar rates and similar credit quality.

Then either by selling them directly to Fannie Mae and Freddie Mac or by utilizing Fannie and Freddies Protocols and doing it themselves, Big Bank A accomplished what is known as SECURITIZATION. Now the "pool" (collective of all the bundled loans which will now be in the millions of dollars) can be broken up into bond-sized chunks. Now instead of buying one loan for $100,000 dollars (give or take), and investor can buy a portion of 10's to hundred's of loans for the same amount of money, with the same rate of return, with the same risk of default. BUT NOW, if you apply the 3% rate of default, the investor only loses 3%! Brilliant! And it's a concept that has allowed a significantly larger amount of money to be available for home loans than ever before.

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