Mortgage-Backed Securities: Catastrophe or Opportunity?

Many of us remember September 2008 far too well.

Children were back in school after a great summer, the lovely hints of fall weather were upon us and the financial system as we knew it was on the brink of collapse.

Banks throughout the world were flooded with toxic assets that were secured by, among other things, mortgages originated in the United States.

All of a sudden theses toxic assets contributed to the fall of the famed investment bank, Lehman Brothers.  Mortgage-backed securities became associated with the financial crisis the country is still recovering from. Many investors across the world have become petrified of these allegedly high risk securities. However, if we have learned anything from the madness of crowds, with fear comes opportunity.

As with any investment, it is critical to understand what you are a buying.

A mortgage-backed security is a structured fixed income instrument that makes periodic principal and interest payments. The payments come from a pool of underlying mortgages, which are generally secured by real estate. As the owners of the real estate in the pool make their mortgage payment, those funds flow to the holders of the given mortgage-backed security.

A mortgage-backed security will have various tranches, sometimes referred to as buckets. Depending on the way the mortgage-backed security is structured, principal and interest payments will flow to certain tranches, while some other tranches may only pay interest.

Once the principal is completely paid down on one tranche, the principal payments will flow to the subsequent tranche and continue until the security is fully redeemed.

After the financial crisis, many investors perceived that all mortgage-backed securities were toxic. If owners of real estate in a given underlying pool are delinquent on their mortgage payments, there may be insufficient funds available to pay holders of the mortgage-backed securities. However, in reality, many Americans continue to pay their mortgages.

Likewise, some mortgage-backed securities have an implicit federal government guarantee from agencies such as Fannie Mae or Freddie Mac. The key is understanding the fundamentals behind a given mortgage-backed security, to see if it aligns with a given investor’s risk tolerances.

Information Alamo Capital provides to investors include, but is not limited to, the tranche type, the collateral type, the number of loans in a portfolio, the state(s) of origination, the average FICO score of the real estate holders, the weighted average loan to value, delinquency rates and foreclosure rates.

Once an investor determines if the fundamentals of the credit align with their risk tolerances, an investor should consider the principal outstanding in the tranche, referred to as the factor, and the average prepayment speed, to understand the projected weighted average life of the bond. 

When a mortgage-backed security is understood, an investor can determine if it is the right investment for them.  With 10-year treasuries yielding below 2 percent  and 30-year treasuries yielding just over 3 percent, many investors are yearning for an investment that will exceed inflation.

Mortgage-backed securities feed that desire and the high yield securities have the capability of producing equity like characteristics from a risk perspective.

While they can be complicated investments, Alamo Capital strives to break down mortgage-backed securities to enhance investor education.  If you are searching for yield, and are tired of the low rates out there, talk to your Alamo Capital bond professional today, and see how mortgage-backed securities could play a role in your portfolio. 

This report is prepared for general circulation and is for informational purposes only.  Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy.

Please consult a Financial Professional for all details including, but not limited to: various tranches, value of the bond, prepayment rates, average life, tax consequences, transactions costs, assumed risks, call provisions, availability, yields, ratings, prices and liquidity.

Alamo Capital is a market maker of mortgage-backed securities.  Alamo Capital is a Broker Dealer Member: FINRA & SIPC.  Mortgage backed securities are for sophisticated investors only.