A mortgage bond is a type of bond secured by mortgages that is typically real estate or other real assets. The assets are also known as the collateral of the bonds.
Holders of mortgage bonds can make claims on the collateral. If borrowers cannot repay their debts, bondholders can sell the underlying assets to cover the payments that they should receive according to the contract terms.
Mortgage bonds are secured by a valuable real asset or a set of assets, which protect bondholders. If the borrower defaults, the mortgage bondholders are entitled to sell the collateral assets to get the principal paid.
When and how the bondholders can sell the assets, as well as how the money from the sale is distributed, are determined by the contract terms. As a result of a lower level of risk, mortgage bonds usually carry lower interest rates than typical corporate bonds that are not secured by real assets.
For example, a company borrowed $1 million from a bank and put its equipment up as collateral. The bank is the holder of the mortgage bond and owns a claim on the company’s equipment. The company pays interest and the principal back to the bank through periodic coupon payments.
If the company meets all the payments, it can retain its ownership of the equipment. If it cannot fully repay the bank, the bank is entitled to sell the equipment to recover the money lent.
Pros and Cons of Mortgage Bonds
Mortgage bonds provide several advantages to both borrowers and lenders. Holding a claim on real assets, the lenders of such bonds bear lower potential losses in the case of default. Mortgage bonds also allow less creditworthy borrowers to access larger amounts of capital at lower borrowing costs.
Mortgage bonds can be securitized into financial derivatives and sold to investors, which provides more liquidity in the capital market and allows the transfer of risks.
One of the drawbacks of mortgage bonds is the risk of losing the collateral if the borrowers fail to make the payments. Although the lender obtains ownership of the underlying collateral, it is not always the case that the lender can sell the collateral for an amount that can fully cover the loss. Collaterals are usually sold at prices lower than the fair market values of comparable assets.
Mortgage Bonds and Mortgage-Backed Securities
Lenders of mortgage bonds and loans, such as banks, do not usually retain the ownership of mortgages. Instead, they securitize the mortgages into financial products that can be sold in the secondary market. Such a type of financial product is known as a mortgage-backed security (MBS).
A special purpose vehicle (SPV) – the originator of the MBS – gathers mortgages from a bank into a pool and sells small packages of the mortgages to investors. The originator gathers interest payments from the mortgage borrowers and then distributes the payments to the MBS investors. Hence, the default risk is transferred to the MBS investors.
Subprime Mortgages
Despite providing liquidity and investment opportunities in the capital market, MBS investments can lead to a moral hazard. Banks, as the lenders of mortgage bonds, are expected to carefully evaluate the credit risks of the bonds and only lend to borrowers that meet the standards.
However, as banks can transfer the credit risks to investors through MBS, they tend to lower their standards and lend to borrowers with low credit ratings. Such a moral hazard may lead to an increasing number of subprime mortgages. The 2008 Global Financial Crisis is attributable to the overabundance of subprime mortgages and widespread defaults on these mortgages.
Corporate Finance Institute
