A mortgage bond is a bond that is backed by a mortgage/pool of mortgages such as real estate property or other tangible assets. The assets are considered as collaterals of the bond. The mortgage bondholders have the right to stake claims over these collaterals. When a borrower fails to repay the debt, the bondholders can opt to sell the said assets to recover the payments that they must receive as per the contract terms.Summary
Frequently Asked Questions
Mortgage bonds involve less risk for an investor because a valuable asset in these bonds backs the principal amount. In default cases, the bondholder can sell off the underlying assets to adjust for the default and ensure dividends since mortgage assets provide greater protection to the bondholder as compared to the corporate bonds, they tend to yield a lower return. Traditional corporate bonds offer high yields and involve higher risks because they are backed only by the bond issuers promise and ability to pay.
When a person buys a home and backs the purchase with a mortgage, there are very few chances that the lender retains the said mortgage. Instead, the lender sells the mortgage to another entity, which can be an investment bank or government-sponsored enterprise in the secondary market. These entities then compile the mortgage with a bundle of other loans and issues bonds with mortgages as backing. The interest paid by the mortgagee is paid in the form of yield to the bondholders by the banks. However, bondholders may lose money on future interest payments if the mortgagor pays their mortgages early.
Thus, a mortgage bond is safe and is a source of reliable income-generating security until most of the homeowners in the mortgage pool continue to pay their payments.
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A major drawback of mortgage bonds is that they offer lower yields to the bondholders as securitisation of mortgages makes mortgage bonds safer investments. Yields from corporate bonds are higher than mortgage bonds. On the positive side, if a mortgagor defaults on a mortgage, then the investor can stake a claim over the mortgaged property. Furthermore, if required, the property in question can be liquidated with the proceeds to compensate the bondholders/investors.
Yet another positive side of mortgage bonds is that they are a safer investment option than stocks.
For example, corporate bondholders have little to no recourse in case of default i..e if the corporation fails to make payment. This is one important reason why corporations issue bonds with a promise to pay higher yields to lure investors into sharing the risk of unsecured debt. Besides, mortgage bonds also provide regular and frequent income to the bondholders.
An important exception to the golden rule that mortgage bonds are relatively safer investment options became evident during the great recession that occurred between 2007-2009. Noticeably, an important factor contributing to the financial crisis was the sale and purchase of subprime loans. The investors believed that they would receive higher yields if they would invest in bonds backed by subprime mortgages. Subprime mortgages are the mortgages that provide the purchasers with poor quality and unverifiable income. Besides, subprime mortgages charge higher interest rates to compensate for carrying high risk. As a result, subprime mortgages are often blamed for fueling a great recession.
What led to the crisis was when a significant number of subprime mortgages defaulted, resulting in massive losses for the investors. This had cost the investors who had invested in mortgage-backed securities millions of dollars. The banks at that time accumulated a large number of subprime mortgages hoping to make a profit from the sale of subprime loans. However, as soon as the interest rates increased, borrowers started defaulting en masse, and soon the investors stopped buying mortgage-backed securities. This led to the depletion of cash in the banks and as a result the investors had to bear the loss of billions of dollars.
Post this crisis; there has been a drastic increase in scrutiny over such securities. However, the Federal Reserve still owns a considerable number of mortgage-backed securities like mortgage bonds. According to the Federal Reserve Bank of St. Louis, till February 2021, the Federal Reserve held around $2.1 trillion in mortgage-backed securities.
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Mortgage bonds are generally seen as a safe investment option because they are backed by real property. For example, if a homeowner who has borrowed money from a bank or any other financial institution defaults on loan or cannot repay the borrowed amount, the property which is kept as a mortgage with the bank can be sold to recover the loan debt. The ability to sell off the property to compensate for the default makes mortgage bonds a low-risk investment.
Mortgage bonds carry less risk as the US government also backs them. This makes them appealing to those investors who are looking for sustainable growth in their income. Usually, the bondholders seek a steady source of income which can be in the form of regular interest payments made by the homeowners. Moreover, investors mainly prefer safe and reliable investments which have consistent growth over time. As such, investment in mortgage bonds and mortgage-based securities are best suited to the needs of these kinds of investors.
What do you mean by subprime mortgage?
Subprime mortgage is a type of home loan granted to individuals with a poor or non-existent credit score who are less likely to repay the loan than other individuals. Subprime mortgages charge higher interest rates because the borrowers, in this case, involve a higher risk for lenders.
Basically, “Subprime” reflects the borrower's less than average credit score taking out the mortgage. Typically, it is believed that those borrowers often stuck with subprime mortgages who have a Fair Isaac Corporation (FICO) credit score below 640. The over-abundance of subprime mortgages led to the global financial crisis in 2008.;