Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Jumbo Pool

What it is:

A jumbo pool is a security backed by mortgages from several issuers.

How it works (Example):

To understand how jumbo pools work, it's important to understand how they're created. Let's assume you want to buy a house, so you get a mortgage from XYZ Bank. XYZ Bank transfers money into your account, and you agree to repay the money according to a set schedule. XYZ Bank (which could also be a thrift, credit union, or other originator) may then choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over the next several years) or sell it.

If XYZ Bank sells the mortgage, it gets cash to make other loans. So let's assume XYZ Bank sells your mortgage to ABC Company, which could be a governmental, quasi-governmental, or private entity. ABC Company groups your mortgage with similar mortgages it has already purchased (referred to as "pooling" the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates, maturities, etc.). Normally, it might only pool mortgages issued by XYZ Bank, but in a jumbo pool, ABC Company pools similar mortgages from several different lenders. The interest rates on these mortgages can vary by one percentage point or less.

ABC Company then sells securities that represent an interest in the pool of mortgages, of which your mortgage is a small part (called securitizing the pool). It sells these morgage-backed securities (MBS) to investors in the open market. With the funds from the sale, ABC Company can purchase more mortgages and create more of these securities.

For investors, an MBS is much like a bond. Most offer semi-annual or monthly income, and this payment frequency enhances the compounding effects of reinvestment. However, it is important to note that payments that are part interest and part principal could be unfavorable to some investors, because with each decrease in outstanding principal, there is a corresponding decrease in the amount of interest that accrues. For example, if a $50,000 Ginnie Mae with a 5% coupon would pay $208.35 ($50,000 x .05/12) in interest every month, but it might also pay $100 in principal. This means that only $49,900 is earning interest next month, and by the end of the year there may only be $48,800 earning interest. The return of principal could also vary depending on how quickly the underlying mortgages are repaid.

Why it Matters:

A jumbo pool contains a more diverse set of mortgages because it comes from different lenders. This means the underlying mortgages are geographically diverse and come from a variety of lenders with slightly better (or possibly worse) lending standards. In investing, diversification like this is usually a good thing because it reduces risk. Accordingly, mortgage-backed securities from jumbo pools are often regarded as safer than traditional mortgage-backed securities.

Although the diversification offered by investing in a jumbo pool of mortgages considerably mitigates the risk that an MBS issuer will default, some of these securities have several additional layers of default protection. For example, consider a GNMA MBS. Its first protection against default is the creditworthiness of the original borrower (that is, the borrower's ability to repay XYZ Bank). Second is the mortgage insurance or guarantee provided by a government-sponsored enterprise (for example, if the borrower has qualified for a VA loan, whereby the Veterans Administration promises to repay XYZ Bank if the borrower cannot). Third is the creditworthiness of the MBS issuer (in our example, ABC Company's ability to pass on interest and principal payments to the MBS investors). Fourth is GNMA's financial strength (that is, GNMA's ability to pay the MBS investors if ABC Company does not). Fifth is the full faith and credit of the U.S. government (that is, the government's ability to print currency to make interest and principal payments on GNMA-guaranteed mortgage-backed securities if GNMA cannot fulfill its obligations).

Prepayment risk is a large concern for all MBS investors. When people move, for example, they sell their houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. Like bonds, changes in interest rates affect MBS prices, but the change is exacerbated by the fact that MBS investors are more likely to get their principal back early. They might have to reinvest that principal at rates below what their MBS were yielding.

Ultimately, the MBS industry provides lenders with more cash to make more mortgage loans. This steady supply of mortgage funds keeps mortgage rates competitive and mortgages readily available. Also, banks that are averse to mortgage lending or are worried about losing money if borrowers prepay their mortgages can mitigate these risks by selling their mortgages, and thus transferring these risks, to MBS issuers. Fannie Mae, Freddie Mac, and Ginnie Mae purchase mortgages and issue and/or guarantee MBS as part of their efforts to support the MBS industry and make homeownership possible for more people.