Bonds are just loans that are so big that the institutions that create them divide them into standardized securities and slice them up into affordable units. That is what Fannie Mae and Freddie Mac do with residential mortgages; they bundle home loans together so that many small streams of income become giant securitized cash flows, this is the mortgage-backed securities (MBS) market.
For government debt and corporate bonds, the units usually are $1,000 each. For more technical bonds like MBSs, the units usually sell for $25,000 each initially. Once on the market, they can trade at a discount or premium to face value, depending on market sentiment.
The Market For Mortgage Backed Securities
Mortgage-backed securities give investors income from a small share in a wide range of borrowers. The MBS market helps you buy your home because they bring institutional money into the residential lending market and create a cycle of lending and investing that helps everyone. For most conforming loans, Fannie Mae and Freddie Mac do the work of putting MBSs together.
You take out a home loan, and the bank or mortgage company that sold it to you goes to the market and sells your loan for cash; the money they gave to you they recuperate from the MBS markets. The market makers then collect these loans and add them to new MBSs, which they sell to investors. The lender still services your loan, but they pass on most of your payment to the market, which distributes it to the investors who hold the bonds.
There has been a lot of talk in the financial press in the last decade about the MBS market; most of the chatter has put these bonds in a very negative light. However, there was a good philosophical concept behind MBSs, one that reflects the values of this country and its market-based culture of self-help. It is true that as the lending market overheated that financial markets made the situation worse and then suffered a collapse in 2008. Sub-prime loans were misidentified as triple-A rated debt and collapsed overnight, taking the markets down with them.
3 Reasons Mortgage Backed Securities Mean Easier Lending
They keep the funds liquid – Real estate is an investment that makes it difficult to withdraw funds; you cannot just cash out part of the value the way that you might sell off stocks or withdraw funds from a savings account. By taking loans and bundling them into securities the cash comes from the size of the market makes the best use of cash.
They replenish your local lender – More people can own homes because of the liquidity mentioned above. The cycles of cash that flow from institutional investors replace the funds for finance companies and banks, which can then create more loans.
They help to preserve standards in lending – As long as the agencies create the bonds correctly, and the ratings represent the actual quality of the underlying home loans, MBSs are stable assets that deliver income to investors. Although lenders do not have to follow the FHA rules for conforming loans, access to the secondary markets makes the terms appealing as part of successful lending business models, giving lenders a stake in maintaining high standards.