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?
Great question. Here’s a quick example:
- John Doe takes out a mortgage from a bank to buy a home.
- The bank sells that loan to a federal agency such as GNMA.
- A pool of mortgages is simply a number of loans from borrowers such as John Doe.
- GNMA issues bonds in order to generate the liquidity to pay the bank when the bank sells the mortgage to GNMA.
- 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.