I am trying to know secure bonds and I know mortgage bonds are secured bonds,if that is the case,even if they default ,the shareholder should get the prinicipal back.Can someone give an explanation of this works.
If Mortgage Bonds Are Secured Corporate Bonds Then How Did the Subprime Bubble Happen?
I’ll try to clarify this clearly, because it can be confusing:
Person Z buys a house using a mortgage from Bank Z. Bank Z takes Person Z’s mortgage and packages it up with many other mortgages. Bank Z then sells the mortgages to Company R.
Company R issues bonds using the mortgages as guarantee. In effect, they are saying “Even if our corporate credit isn’t enough to convince you to buy our bonds, we’re backing them up with these mortgages for extra protection.” Because the bond is secured, they can offer a lower coupon rate (the bond is less risky). Person A, seeing this fantastic secured bond, buys a lot of them.
Now, interest rates rise and Person Z’s flexible-rate, interest-only jumbo loan goes from $800/month to $3500/month. Person Z can’t pay and defaults on the loan.
The bonds that Person A bought have had their security defaulted on by Person Z. They are still backed by the homes themselves, but since EVERYONE is defaulting property values are plummeting. Even worse, the mortgage company is incurring huge costs to buy the house at auction and carry it on their books until they can sell it and get their money back. The bonds issued by Company R are much more risky now.
In order to compensate for the extra risk, investors refuse to buy Company R’s bonds until they can get them at a very steep discount. This means that Company R won’t raise as much money as they need. If Company R doesn’t raise much money, they likely won’t buy mortgages from Person Z’s lender any more. If the lender can’t sell it’s mortgages in the secondary market, it won’t have as much money to lend. Without much money to lend, the price of money goes up. If money is more expensive, other people have difficulty borrowing money. If everyone has distress borrowing money, none can meet the deprivation of to buy the foreclosed homes and the downward spiral continues.
They are secured only by the mortgage loans within them. If those loans perform poorly, the bond becomes riskier and its market value declines. There is no guarantee that a bondholder will get his/her principal back for any type of bond. Default risk is always present.