Mortgaged Backed SecuritesPosted by: admin / Category: Business & Finance, Finance, Real Estate
Mortgaged backed securities have been in the news quite a bit these past couple of years, and while they say that, ‘Any publicity is good publicity,’ for mortgage backed paper, this probably isn’t true. These securities have been making headlines because of the role that they played in the housing crisis that many fault for precipitating the entire financial crisis that ravaged the economy starting in late 2007. Before touching on why and how mortgage backed securities may or may not have played a part in our financial calamity, it is important to understand what these financial securities are, how they function, and if they are suitable for your investment portfolio.
Investments Backed By Houses
Well, mortgage back securities aren’t exactly investments backed by houses – you can’t repossess someone else’s home if these investments go sour on you. However they are indeed connected to the housing market in that they are debt obligations, meaning that you pay someone money for these instruments and they in turn are obligated to you, that are tied to the flow of funds generated by mortgage payments made by homeowners to the banks. It gets a little complicated but stated as simply as possible, when a bank issues a mortgage to a homeowner, the bank doesn’t have to keep, or retain ownership of the loan, and in fact most don’t at least not for the entire tenure of your loan. When banks sell and pool all of the various mortgages they are holding it is know as securitization, a process that turns these loans into a financial instrument that can be bought and sold on the open market by almost anyone, including the individual investor. These investment products carry certain ratings and guarantees depending on whether they are backed by Ginnie Mae (Government National Mortgage Association) or Freddie Mac or Fannie Mae, which are other U.S agencies that are involved in the housing market.
Risk of MBS Investing
While mortgage backed securities are said to be backed by the above mentioned U.S. government agencies, this does not mean that there aren’t inherent risks associated with investing in these instruments or that your principal investment is particularly safe because of the role of these agencies in the administration of both the loans and the securitization of the product. These are simply agencies that have the ability to borrow money from the federal government and to provide support and liquidity to the market if necessary. Interest rates and your rate of return on a mortgage backed security will rise and fall based on the prevailing interest rates at the time that you purchase this type of investment. The price you pay for this investment will be a function of prevailing interest rates, as mentioned, as well as the quality or rating of the loans within a particular group of mortgages underlying the security, as well as the coupon or interest rate that is being paid by those paying the mortgages. The most basic risk in purchasing a mortgage backed security is the same as that of any interest bearing investment. If interest rates go up after you buy into an MBS fund you will lose money. If interest rates go down after you buy into these investments you’ll earn a profit.
The other risk associated with mortgage backed securities, other than market risk, is credit risk. Credit risk is best described by how this investment is viewed by the market. If U.S. Treasury securities have the highest credit rating in the world, and that rating rarely changes, there is little or no credit risk associated with investing in them. All other instruments have associated credit risk to a greater or lesser degree and this risk changes as often as the market perceives that the risk with ”what lies beneath” your investment changes. For instance, if you own a bond issued by the government of Greece that pays an interest rate of 8%, and the next day you hear that the government of Greece may default on its debt obligations, interest rates and the credit risk associated with Greek bonds will soar and your bonds will be worth much less than when you first bought them. With mortgage backed securities the same holds true meaning that if you buy into a MBS fund one day, and the housing market collapses the next, the much greater credit risk attached to these investments will undermine your return.
MBS Getting a Bad Rep
MBS have indeed gotten a bad reputation because when the housing market collapsed, so did the value of these investments. And more to the point, many industry experts and outside observers will tell you that in creating these MBS products, too many very risky home loans were included in the mix and when the market went bad it caused the entire pool of securities to go bad, or toxic, too. The real crime was probably in the fact that most of the people involved in the process were well aware that these loans should never have been used for an investment product in the first place.
My take: Be careful….be very careful because the recent experience with MBS and the housing market should teach everyone that even when a rating agency or some other such group of sharpies tell you that it safe to go into the water, you should think twice, especially when it comes to your hard earned money. The reason I say this is because there is nothing inherently risky about mortgage backed securities as long as everyone involved is following the rules. They are grouped and rated based on their risk and then buyer beware. However, market risk is one thing, a scam of biblical proportions created by the bankers and investment bankers is quite another and this is exactly what happened in the MBS market.