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Mortgage-Backed Bonds and Mortgage Pools

Student Question:

Course: Investment Planning
Lesson 9: Fixed Income Securities

I don’t clearly understand how money is made in the mortgage-backed bond process.  What are mortgage pools? Does the investor make money from the interest of the pooled mortgages? What if the mortgages default?

Thanks,
Kevin

Instructor Response:

Great question.  Here’s a quick example:

  1. John Doe takes out a mortgage from a bank to buy a home.
  2. The bank sells that loan to a federal agency such as GNMA.
  3. A pool of mortgages is simply a number of loans from borrowers such as John Doe.
  4. GNMA issues bonds in order to generate the liquidity to pay the bank when the bank sells the mortgage to GNMA.
  5. The investor in a GNMA bond is secured by the collateral of the mortgage bonds (homes) AND the sovereign guarantee of the United States of America; only GNMA bonds carry the sovereign guarantee.

GNMA and other federal agencies are a vital part of the capital market cycle that allows John to take out a loan. GNMA is part of a broader group of federal agencies that issues Mortgage-Backed Securities (MBS). MBS also allows an investor to invest in low default risk fixed income securities; the investor receives payments from agencies such as GNMA consisting of both principal and interest as homeowners pay their mortgages.

FYI – Only certain types of loans, called conforming loans, may be sold to GNMA and other federal agencies.

Bruce