This article is intended to help the reader understand the cryptic sounding term mortgage backed securities or MBSs and how they affect mortgage rates. To begin with let us look into what mortgage backed securities are all about.

Mortgage Backed Securities

Mortgage backed securities are simply bundles of mortgages with similar terms, such as interest rates. In other words, when a bank makes a loan it bundles all of the mortgage loans with similar interest rates and sells them to quasi governmental agencies such as Fannie Mea and Freddie Mac or to investment banks or the large insurance companies. These bundles of mortgages or groups of similar mortgages are held and traded by large institutions, in way that is somewhat similar to bonds, stocks or mutual funds.

When the FHA set up its home loan guarantee program the problem of holding on to all of those low down payment mortgages was solved by collecting them into large bundles and holding them as investments under the supervision of what was to become Fannie Mae. Homeowners will pay their principal and interest to the company responsible for servicing the debt. The servicer passes on the income from the loan to the institution after subtracting their management fee.

Big Boys Of The Bond Market

Like all other fixed income securities, the price of one of these MBS bonds is set based on the value of the income stream. Because they have traditionally been seen as safe investments, these bonds are often sold at a price higher than the face value of the bond. For instance, if an investor is buying a bond of $100 he or she will have to pay $101 or more to buy it, which often depends on the yield of the bond. Yield is the rate of return an investor gets on that particular bond. It could be 3%, 4% or 5%. The higher the yield of a bond, the more the buyer is willing to pay for it.

If the demand for a particular bond decreases the seller lowers the price of the bond. On the other hand, if the demand for a particular bond increases the seller increases the price of the bond. In this way we can say that price of a bond is directly proportional to demand. Because the income is constant the variation is in the price to buy and sell the bond. Of course, investors want to understand it in term of what their dollars buy and so, looking at it from that perspective, when yields go down and bond values go up. In the reverse situation, as yields go up, the bonds become cheaper.

Higher Yield Means Cheaper Bonds

The MBS bonds reflect the demand for mortgages in the economy. If demand is for mortgages is increasing then the Fed will respond by increasing interest rates. This increases the income from new lending, which lowers the sale value of existing bonds (to give them a higher yield) as investors pull out of mortgage backed securities to finance other higher income investments.

Inflation also plays an important role in affecting the demand for bonds, which also impacts the mortgage rates. In the event of high inflation, investors often demand bonds at lower rates to cover their margins. In other words, since bonds produce a fixed rate of income it is quite natural for the investors to buy bonds at cheaper rates so that they can buy more bonds with the same investment. Moreover, booming economy forces investors to divert their funds in businesses where they could earn more profit. Thus, sellers often lower the price to attract investors resulting in rising in mortgage rates.