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How does a bundle of individual loans turn into one big bond issue?

It’s fairly easy to understand corporate, municipal, and Treasury bonds: You lend money to the issuer, who pays you interest and repays your principal at maturity. Asset-backed bonds securities are a different story. Instead of representing the debt of a single large issuer, an asset-backed security is created by bundling a pool of many loans taken by smaller borrowers to back up the obligation.

The most common type, a mortgage-backed security (MBS), represents a pool of mortgages that have been securitized, which means they have been packaged into bonds that are sold to investors. Many kinds of payment streams can be securitized — credit card debt, student loans, and car loans, to name a few. As debtors pay off the underlying loans, the money is passed through to bondholders — which is why these bonds are also called pass-throughs.

Asset-backed bonds have been attractive to borrowers because they tend to pay a somewhat higher interest rate than conventional bonds with similar terms. But the composite nature of these securities means they behave differently than regular bonds do. Just how risky many of these debt securities were became clear during 2008 as home prices fell, credit dried up, borrowers defaulted, and MBSs either traded for a fraction of their original value or were illiquid.

Because of the way asset-backed bonds are put together, their cash flows differ substantially from the coupons paid by other bonds. Because mortgages are paid monthly, mortgage-backed securities generally pay bondholders monthly, too. Each bond payment contains some interest and some principal, just like the underlying mortgage payments. So there’s no big return of principal at the end — it is paid back bit by bit over time.

Since each MBS represents a pool of specific, individual loans, no two behave exactly alike. Some people pay mortgages on schedule over the 15 to 30 years of the original term. But many homeowners end their mortgages early by making extra payments, selling their homes, or refinancing. These prepayments initially bulk up the cash flow, but ultimately they shrink the bond’s yield and lifetime. So an MBS based on 30-year mortgages actually behaves more like an intermediate-term bond.

Because of prepayments, it’s impossible to know exactly how long any particular asset-backed bond will pay out, or how much. This unique risk factor is called prepayment risk.

Credit risk, in the case of debt securities, is the potential that the borrowers whose loan repayments create the income streams that the securities promise to deliver to bondholders will default.

MBSs guaranteed by a federal agency, such as Ginnie Mae, have no credit risk. Those issued by government sponsored enterprises (GSEs), including Fannie Mae and Freddie Mac, had credit risk despite the assumption that the government would not let the GSEs fail — as it, in fact, did not. MBSs from private-sector securities firms, which had increasingly dominated the MBS market, carried varying degrees of credit risk.

The process of buying mortgages, creating MBSs, and packaging them into CDOs was designed to spread credit risk. But the opportunity to sell their loans made some lenders less careful about evaluating borrowers. And the elevated returns they could realize from these products made some investment firms incautious about the creditworthiness of the loans they bought.

At the same time, economists point out, regulators and others were slow to respond to the developing crisis. It appears that rather than reduce risk through diversification as some had assumed, in many cases securitizations backed directly or indirectly by subprime loans were more correlated than expected.

Securities firms, seeking an additional way to profit from the expanding housing market, created another class of security: collateralized debt obligations (CDOs).

CDOs of MBSs take a pool of MBSs and slice the payments into different streams known as tranches. (Tranche is French for slice.) The tranches are designed to offer more defined cash flows.

For example, the basic sequential structure uses tranches that mature at specific intervals. In the first interval, all tranches get interest payments, but prepayments are funneled only to the first tranche. After the first interval ends, the first tranche matures, and the next tranche receives prepayments over the next interval.

However, defaults in the riskiest slices of these CDOs and other complex structured vehicles, caused in part by the subprime mortgage meltdown that began in 2007 and in part by the failure to accurately asses the risks posed by these products, had a profound negative effect on the global economy. These defaults spurred a push for more stringent regulation and greater oversight of these products, both in the United States and internationally.

Because of prepayments, asset-backed securities fare worse than other bonds when interest rates change.

Normally, when rates drop, bond prices rise. But people tend to refinance their debt when rates drop, causing a spike in prepayments. Prepayments decrease an asset-backed issue’s potential yield, making it less attractive to investors. On the other hand, when rates rise, bond prices fall — and the prices of asset-backed bonds fall even more. That’s because prepayments slow down when rates are high, lengthening the lifespans of asset-backed bonds.