I am watching the Big Short and the opening scene is that banker talking about individual mortgages being low yield and boring. Then he goes on to say their yield is higher when bundled to an MBS.
How could that be possible?
If I combine two debts with 1% interest, wouldn’t the combined interest be 1% again?
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One way that MBS can have higher yield than the individual mortgages is by trading at a discount to their face value in the market. This can happen when interest rates rise, making the existing mortgages less attractive to investors who can get higher rates elsewhere. When MBS trade at a discount, investors can buy them at a lower price and receive a higher yield than the interest rate of the mortgages.
Another way that MBS can have higher yield than the individual mortgages is by having different prepayment assumptions than the actual prepayment behavior of the borrowers. Prepayment assumptions are estimates of how fast borrowers will pay off their mortgages, based on historical data and market conditions. They affect the yield of an MBS because they determine how much and how long investors will receive cash flows from the MBS.
If borrowers prepay slower than expected, investors will receive more cash flows over a longer period of time than they anticipated. This will increase the yield of the MBS compared to the interest rate of the mortgages. Conversely, if borrowers prepay faster than expected, investors will receive less cash flows over a shorter period of time than they anticipated. This will decrease the yield of the MBS compared to the interest rate of the mortgages.
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