Mortgage Bond Questions

[CzechItOut]

Trebles all round Gents, OK, now back to work.

At the start of the Big Short they are describing Lewis Ranieri's mortgage bond:

"Here’s how it works. You’ve got
your average person’s mortgage.
Fixed rate, 30 years...
Boring, safe, small pay off...
Right? But when you have thousands
of them all bundled together...
Suddenly the yield goes up and the
risk is still low cause it’s a
mortgage and who the hell doesn’t
pay their mortgage?"

I'm confused about how bundling thousands of mortgages together cause the yield to go up?

[mfmman]

Larger amount of money you borrow (to divide up and lend to others), the lower the rate you can borrow it at?

[anonymous-user]

CzechItOut said:

I'm confused about how bundling thousands of mortgages together cause the yield to go up?

Presumably you were working as a CEO in the banking sector in 2007.

The answer is that it reflects a fundamental misunderstanding of risk. Taking the same small risk many times simultaneously may be thought to reduce risk (hence increased yield) but if some external factor affects all of those risks in the same way at the same time then you're in exactly the same position as if you'd taken one big risk.

[NickCQ]

CzechItOut said:

I'm confused about how bundling thousands of mortgages together cause the yield to go up?

The missing element is leverage. If you can sell AAA-rated bonds cheaper than the coupon on the mortgages, then you are left with a residual spread which will be higher than the spread on the underlying. The trick is convincing (i) rating agencies and (ii) rated note buyers that your AAA bonds are extremely high quality and will never default.