25 - Asset-backed bonds I: Mortgage-backed securities

Abstract

This chapter considers mortgage-backed securities, the largest of the asset-backed bond markets, while dealing with the other asset-backed instruments available. A mortgage is a loan made for the purpose of purchasing property, which in turn is used as the security for the loan itself. It is defined as a debt instrument giving conditional ownership of an asset and secured by the asset that is being financed. A lending institution may have many hundreds of thousands of individual residential and commercial mortgages on its book. If the total loan book is pooled together and used as collateral for the issue of a bond, the resulting instrument is a mortgage-backed security. In the US market, the terms of a conventional mortgage, known as a level-payment fixed-rate mortgage, will state the interest rate payable on the loan, the term of the loan, and the frequency of payment. Another type of mortgage in the US market is the adjustable-rate mortgage or ARM, which is a loan in which the interest rate payable is set in line with an external reference rate. The re-sets are at periodic intervals depending on the terms of the loan, and can be on a monthly, six-monthly or annual basis, or even longer.