Mortgage Funds Appear to Have Solid Foundation
Investment experts tend to remember the awful years. And while 2006 was a decent year for stocks, it produced some really awful mortgages.
If you own a house, John Waggoner of USA Today writes that you’ve probably already received a written notice that your lender has sold your mortgage to another institution.
In fact, you’ve probably heard this several times over. Home mortgages, like many other kinds of consumer debt, can be bought and sold on the secondary market.
Of course, mutual funds and other institutional investors have little interest in owning individual mortgages. Instead, they buy securities backed by huge pools of mortgages. Some of the best-known mortgage securities are those put together by Freddie Mac and Fannie Mae.
Of the $13 trillion in U.S. mortgage debt today, about $6.5 trillion is comprised of mortgage-backed securities.
The interest and principal from the mortgages in the pools - the money you pay every month - pass on to the owners of the mortgage-backed securities. In an ideal mortgage pool, every homeowner repays his mortgage on time and holds the mortgage for the full term of the loan - say, 30 years.
But even in that ideal world, it’s messy for an individual inestor to own a single mortgage-backed security, because homeowners pay both the principal and interest each month. You’d have to keep careful track of how much of each your investment had generated.
And in real life, home mortgage loan pools can be far messier. Few people live in the same house for 30 years, for example. When U.S. homeowners sell or refinance, the mortgage is repaid early, and the owner of the mortgage gets a big gob of principal back, which he or she must reinvest.
In addition, some people pay their mortgages late.
Others default or go into foreclosure.
And so on.
Mortgages held by less-than-prime borrowers are called subprime mortgages, and this is where the 2006 crop went sour. As median home prices soared, bad credit home loan providers began making loans that, in retrospect, were a bit unwise. About 19 percent of mortgages originated in the first half of 2006 were subprime, and now lenders are paying the price.
Just what portion of those loans will default is hard to say. But losses in the subprime market led New Century Financial, a major bad credit mortgage lender, to restate its earnings last week. Its shares tumbled 43 percent in the three trading days after its announcement.
So who owns these terrible mortgages?
The riskiest loans are typically split up according to their degree of credit risk and are held by speculators, such as hedge funds. They earn higher returns on the worst loans, but they take higher risks, too.
Those low-quality slices are scattered worldwide. Mutual funds typically don’t hold the worst mortgage pools, according to one Morningstar analyst, Eric Jacobson. Many of them stick to high-quality Fannie Mae and Freddie Mac mortgage pools. So should you invest in a mortgage fund now?
Possibly. The best time to invest in a mortgage fund is when rates are stable, says Michael Garrett, co-portfolio manager of the Vanguard GNMA fund. If rates fall suddenly, greater mortgage refinance activity will present itself, giving a manager huge chunks of principal to reinvest.
On the other hand, if rates rise suddenly, few people will refinance, and the fund manager will have less money to reinvest at higher mortgage rates.
Happily, most forecasters see stable mortgage rates for much of 2007. Some analysts even expect the Federal Reserve to cut short-term interest rates late this year.
SOURCE: Montgomery Advertiser