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Booyah Breakdown: MBS 101

In most cases, our Local Bank will still service those loans, though. It will still collect payments, answer any questions and send out tax documents at the end of the year. It'll just keep a service fee, or percentage of the interest payment, for its work. So if the interest payment on the mortgage is, say, 5-3/4%, the bank will keep, say, 1/8% for its servicing. It will send the remaining interest payment on to Fannie or Freddie.

So now Fannie and Freddie are holding all this debt. But after a while, they too realize they need to free up some cash so they can continue to relieve the debt of Local Banks.

Fannie and Freddie also know that there's a whole market of bond investors out there looking to invest.

But bond investors don't want to hold a single mortgage in their portfolio. That does nothing for their portfolio's fixed-income diversification.

So a security is created. This security is basically a bunch of mortgages all under one umbrella, called a mortgage-backed security.

The mortgages can be pooled in a number of different ways -- by different maturity, risk and return characteristics. They can also be pooled by mortgages for single-family home only, multifamily home, 30-year fixed, 15-year fixed, adjustable-rate mortgages, geographic location and, of course, subprime loans. But the permutations are endless.

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