I just can’t wrap my mind around this.
In: 8
What is a mortgage?
A mortgage is an agreement between a person buying a house and someone else (usually a bank).
The person buying the house doesn’t have the money to buy it completely, so they promise to give the bank money over time. And if they fail to do that, they have to give the bank the house.
So, a mortgage is a promise of “I will, over time, pay you $X – or if I fail to do that, I’ll give you this house.” This is a promise with collateral; the collateral is the house. A mortgage is kind of like a “house-backed security”.
The bank can sell that promise. The home-buyer still pays the same $X, but pays it to a different bank or other entity.
The next step is that the bank can use the mortgage as collateral. The bank now tells someone else, “I will pay you $Y – or if I fail to do that, I’ll give you this mortgage.” This is a “mortgage-backed security”.
I loan you $100 million dollars and expect to be paid back $125 million in 5 years. You’re a big commercial bank so you own thousands of mortgages for people’s homes. As collateral for this big loan I’m giving you, you put up some of the mortgages, so that if you fail to pay me back your loan, you give up the mortgages and I get to keep them. So this loan is “backed” by mortgages.
So now (after giving you $100 million) I’ve got an IOU that says you owe me $125 million or a thousand mortgages. If I wanted to, I can sell this IOU to whoever wants to buy it from me. So instead of owing me, you’ll owe *them* $125 million or a thousand mortgages. This little IOU is a security, it’s a tradeable financial product that can be bought or sold.
A mortgage backed security is a share of a bundle of mortgages. The cash flows are assigned to a series of tranches. Institutional investors like them because they can buy the short cashflows or the long cashflows or default protected cashflows and tune their investments better. Tranche 1 might get the first 20% of principal payments, the next tranche gets the next 20% of payments. Etc. They all earn interest on their tranche until it gets fully redeemed. The disadvantage of MBS is that people tend to refinance and pay off their old, higher interest mortgage for a new one when interest rates drop.
Looks like I need to start saving up for my own mortgage-backed security! Thanks for the ELI5.
A bond is an investment where some entity (like a company, government agency) borrows money by selling the bonds, paying interest on the money and re-paying the principal at the maturity date. For the investor, they collect interest on their money and get the initial amount back at the end.
A mortgage backed security works like a bond, only instead of one borrower getting the proceeds of the bond sale, the investor is buying into a basket of 1000’s of mortgages. Instead of $200m going to fund a large public works project, it’s $200m worth of mortgages bundled together.
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