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Charles J. Corrado_Fundamentals of Investments - Chapter 13

CHAPTER 13 Mortgage-Backed Securities The development of mortgage-backed securities represents an important innovation in the way that capital is raised to finance purchases in housing markets. The basic concept is simple. Collect a portfolio of mortgages into a mortgage pool. | CHAPTER 13 Mortgage-Backed Securities The development of mortgage-backed securities represents an important innovation in the way that capital is raised to finance purchases in housing markets. The basic concept is simple. Collect a portfolio of mortgages into a mortgage pool. Then issue securities with pro rata claims on mortgage pool cash flows. These mortgage-backed securities have the attraction to investors that they represent a claim on a diversified portfolio of mortgages and therefore are considerably less risky than individual mortgage contracts. Owning your own home is a big part of the American dream. But few Americans can actually afford to buy a home outright. What makes home ownership possible for so many is a well-developed system of home mortgage financing. With mortgage financing a home buyer makes only a down payment and borrows the remaining cost of a home with a mortgage loan. The mortgage loan is obtained from a mortgage originator usually a local bank or other mortgage broker. Describing this financial transaction we can say that a home buyer issues a mortgage and an originator writes a mortgage. The mortgage loan distinguishes itself from other loan contracts by a pledge of real estate as collateral for the loan. This system has undergone many changes in recent decades. In this chapter we carefully examine the basic investment characterisitcs of mortgage-backed securities. 2 Chapter 13 13.1 A Brief History of Mortgage-Backed Securities Traditionally savings banks and savings and loans S Ls wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets. This changed radically during the 1970s and 1980s when market interest rates ascended to their highest levels in American history. Entering this financially turbulent period savings banks and S Ls held large portfolios of mortgages written at low pre-1970s interest rates. These portfolios were financed from customers savings deposits. When market interest .