A bond is similar to an IOU. An investor purchases a bond from a financial institution for a fixed amount of money. The financial institution then promises to give the money back years from that day with a small percentage of interest added to the original value.
When a person purchases a house, he or she generally must borrow money from a bank or mortgage lending company. To borrow this money, the person must sign a promissory note stating he or she will pay back the value of the loan, plus a percentage of interest, which is accrued each month. Usually, a mortgage payment spans fifteen to thirty years and is paid back in monthly installations.
To issues these loans, the mortgage lending company may need to "borrow" a large sum of cash from a larger financial institution. The mortgage lender offers a number of mortgage agreements in one lump-sum package to a financial institution, which issues a mortgage bond in return. In this situation, the larger financial institution "purchases" the mortgage agreement from the mortgage lender and receives the borrower's monthly payment in exchange. The mortgage bond process helps the mortgage lender get the money it needs, while the larger financial institution earns extra money by receiving the monthly payment from the borrower.
In most cases, a mortgage bond is a win-win situation for both financial institutions. The recent increase in the value of homes, however, has caused some difficulty with this arrangement. Because homes were increasing in value, mortgage lenders issued loans to people who were not the ideal candidates. As such homeowners default on more loans, and the value of housing levels out, the bond may be worth more than the value of the house.
If the borrower defaults on the mortgage loan, the loss is passed on to the financial institution that issued the mortgage bond. To regain the money, the financial institution that issued the mortgage bond can resell the house. This can still result in a loss of money if the bond is worth more than the home.