Evaluating Popular Investments Lesson 7 Investing in Mortgage Backed Securities

Mortgage Backed Securities Aim:  How can investors participate in the multi-trillion dollar mortgage market? Do Now:  Identify some of the reasons why people don’t normally lend money to others to buy a home. After all, the loan would be an investment which earned them interest.

 Do Now answer:  Homes are expensive, so the amount of money a homebuyer would need could easily exceed $100,000. Many investors don’t have this much to lend!  Even if they did have the money, it’s a lot of money to lend to one borrower. If the borrower defaults, there could be big losses.  Most mortgages are 30 years. The lender might want a shorter term. Mortgage Backed Securities

 So, we see that investing mortgages directly has big drawbacks.  But Wall Street has come up with solution to these problems with the creation of the Mortgage Backed Security, better known as MBS, a type of bond representing an investment in a pool (ie: many loans bunched together) of real estate loans. Mortgage Backed Securities

 When mortgages are pooled and sold off to investors, banks get the cash back that they can then use to give out new mortgages!  The pooling together of illiquid assets, such as mortgage loans, and selling off shares in the pool as bonds is known as securitization.  Basically, the interest the investors buys is designed to be a security that held or sold like a share of stock or ordinary bond.

Mortgage Backed Securities Mortgage 1Mortgage 3Mortgage 5Mortgage 7 Mortgage 2Mortgage 4Mortgage 6Mortgage 8 Pool of Mortgages MBS

Mortgage Backed Securities Prepayment Risk - The largest risk when investing in an MBS. Prepayment occurs when the principal is repaid earlier than the scheduled maturity of the loan.  Often, a borrower will prepay after interest rates have dropped. He or she will get a new mortgage at a lower rate and use the money to pay off the mortgage that is part of the pool.  The borrower sells the home and pays off the mortgage in the process of the sale.  This isn’t a horrible risk. It just means that the investment ends early, leaving with the investor with the need to find a new investment.

Mortgage Backed Securities Example:  H. Owner wants to buy a house with a purchase price of $500,000. He approaches his bank to secure a mortgage.  He funds the purchase of the house with a 30- year mortgage at a 4% interest rate. For the next 30 years, the bank will receive principal and interest payments from H. Owner.  The bank wants to sell the stream of interest (4%) and principal payments from his loan to other investors.

Mortgage Backed Securities Example (continued):  The bank pools / bundles H. Owner’s loan together with 500 other mortgages.  The bundle is sold to investment banks which then create and sell bonds that represent a fraction of ownership of the pool.  Pass-through MBS’s are those that simply take the monthly payments received from the various mortgages and send the appropriate fractions to the various MBS bondholders.

Lesson Summary 1.Why is it difficult for the average investor to participate in the mortgage market? 2.What do we call the process of bundling mortgages together and then selling bonds backed by the payments of the mortgages in the pool? 3.What are these investment called? 4.Why is this process so critical for banks? 5.How can investors participate in the multi- trillion dollar mortgage market?

Web Challenge #1 Q: Can MBS securities experience failure and lose investors’ money?  A: Yes, if they are based on mortgages whose amounts were computed from inflated and unrealistic home values. Or, they could be based on mortgages given to people who can’t afford to make the payments.  Challenge: Research the role of MBSs in the Great Recession. What role did they play? How much in losses did they experience? Did they cause the failure of any investment firms?

Web Challenge #2 Challenge: Visit the web sites of:  Freddie Mac for its offerings of MBSs (freddiemac.com/mbs).  Ginnie Mae, also for its offering of MBSs (ginniemae.gov, then look for Programs & Products).  Research at least five different types of MBS securities they offer. Document the differences and be prepared to explain them to the class.

Web Challenge #3 Challenge: At the two sites mentioned in Web Challenge #1, try to look up MBSs. It appears that a person needs to already know its unique identifier (CUSIP or Pool number). Your challenge is to find (anywhere on the Internet) an MBS screener, a tool that lets you view lists of available MBSs based on various criteria that you specify! Document what you were able to find as well as what you were able to learn from the MBSs listed.