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So MBS's are bonds! Where do they come from?
Grossly oversimplified and leaving out numerous items that are not germane
to rate analysis, MBS are the bonds that mortgage
loans are turned into when they are bought or sold.
That's a tough one to grasp your first time around. I know
it was for me.
Basically, Big Bank will write a check for your mortgage,
say it's $100,000. Big Bank A then has
a promissory note saying that you will pay them a certain
interest rate over time (sound familiar?). But Big Bank
A needs some more money to lend other people... Where to
get it? I know! They can sell your mortgage note to someone
else in the form of a bond! Hopefully, that investor is
willing to pay something like $102,000 for the right to
collect interest on your $100,000 loan. Big Bank A just
made $2000, and the investor has something that will hopefully
pay them interest over time. Remember price vs. yield? The
higher your interest rate, the more the investor would be
willing to pay Big Bank A. That's YSP Baby! And if the investor
is only going to pay $97,000 for the loan, that means Big
Bank has to pay them a discount to buy it, which was probably
passed on to you on line 802 of the GFE! Now YSP starts
to become clear I hope!
But there's a big problem! The investor doesn't want all
of their risk riding on one loan, so we have to find a way
to spread out the risk. Because even if
you only have a 3% chance of defaulting, in the event that
you do, the investor would lose his hat. So to spread out
the risk, Big Bank A combines your loan with 10's to hundreds
of other similar loans with similar rates and similar credit
Then either by selling them directly to Fannie Mae and
Freddie Mac or by utilizing Fannie and Freddies Protocols
and doing it themselves, Big Bank A accomplished what is
known as SECURITIZATION. Now the "pool"
(collective of all the bundled loans which will now be in
the millions of dollars) can be broken up into bond-sized
chunks. Now instead of buying one loan for $100,000 dollars
(give or take), and investor can buy a portion of 10's to
hundred's of loans for the same amount of money, with the
same rate of return, with the same risk of default. BUT
NOW, if you apply the 3% rate of default, the investor only
loses 3%! Brilliant! And it's a concept that has allowed
a significantly larger amount of money to be available for
home loans than ever before.