What Is Bundling a Mortgage?

Sometimes you hear people with mortgages say sardonic things like "Well, it's the bank's house, really." But in many cases, they're wrong, in addition to being mildly unpleasant. Banks commonly don't hold onto the mortgages they write. They sell them off and use the money they get to write more mortgages. The buyers are mortgage bundlers.

Say you get a 30-year mortgage from your bank for $200,000 at 6 percent annual interest. Assuming you stay in the house the full 30 years and make all the payments, you'll pay back the original $200,000 plus about $230,000 more in interest, which is the bank's profit. The problem for the bank is that it would rather not have to wait 30 years to get its profit. That's an awful long time — and, hey, there's the chance that sometime down the road you'll default on the loan, which adds risk. The bank solves this problem by selling your mortgage to someone else for more than $200,000 but less than $430,000.

When your bank sells your mortgage, it's selling the right to collect your future payments. The bank might not be interested in collecting $430,000 over 30 years, but there are others who think this idea is just peachy — namely, investors looking for a steady source of long-term income. But just like the bank, they understand that as good a person as you are, there's always a risk that you'll default. Investors deal with risk by diversifying. That's where bundling comes in.

Mortgage bundlers are financial institutions that buy up a lot of mortgages — thousands or millions of them. They gather up all these mortgages together into a "bundle" and then issue bonds called mortgage-backed securities, or MBS. If you buy an MBS, you're buying the right to a slice of the payments on all of the mortgages in the bundle. With a thousand or so mortgages in the bundle, one default isn't going to affect the return too much.

The MBS, in theory at least, reduces the risk through diversification. Of course, if a significant percentage of the mortgages go into default, then there's a problem. And guess what happened starting around 2006 or so.

During the first decade of the 21st century, demand soared for bundled mortgages. Mortgage-backed securities were seen as safe investments since people will do just about anything to keep their homes. But to get mortgages to bundle into bonds, you've got to find money to lend people. That led to loose lending standards — in some cases, ridiculously loose standards.

Some lenders gave mortgages to people who were all but guaranteed to default, then sold them off to bundlers, locking in their profit and passing the disaster off to someone else. There was so much risk that it couldn't be diversified away. In the end, hundreds of billions of dollars in MBS investments went bad and, boom, the worst economic downturn since the Great Depression. In the aftermath, bundling didn't go away, and it never will — but lending standards tightened considerably.