The Pitfall Created by Mortgage Bonds

Mortgage bonds are quite different from government and corporate bonds. It’s not a single big loan for a defined fixed term. Instead, it’s a claim on the cash flows from thousands of home mortgages pooled together. Mortgage bonds were at the heart of the subprime housing crisis.

According to Michael Lewis, the author of ‘the Big Short’, the cash flows were problematic because the mortgage borrowers could pay off the loan as fast as they pleased. Investors in these bonds didn’t know when they were getting their money back, often times when they least wanted to.

So to fix this problem the payments made by homeowners were cut into pieces called tranches. The buyer of the first tranche got the first wave of mortgage repayments but was paid a higher interest rate to make up for it. The second buyer received the second wave and less interest payment and so forth… The last buyer received the least interest but for the longest period of time.

These mortgage loans were backed with guarantees by the government agencies: Freddie Mac, Fannie Mae and Ginnie Mae (And we all now know what later happened to these agencies…) so if the borrower defaulted, the government paid off the debt.

So there was no risk for the originator of the loan and no need to be sure they were lending to reliable borrowers. If there had been no government guarantees, allowing free market forces to work, no banks would ever risk giving out these types of loans.