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Mortgage Backed Securities

SkyRider

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Mar 31, 2009
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Is there such a thing as government guaranteed mortgage securities available to the public? If yes, how do they work? Where can they be purchased?
 

39ajaxmale

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Jan 13, 2012
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The simple answer is no. Governments do no guarantee against default on mortgage backed securities. Some of the mortgages that are within the pool of a mortgage backed security MIGHT be insured through CDIC or Genworth, but there's no way to tell what percentage.

A mortgage backed security is essentially this:

Lender loans out an amount in mortgage loans, let's say $100M. They then bundle these mortgages up, figure out the average interest rate (let's say 4.5%). They then sell shares in this bundle to the general populace and "suggest" a rate of return of 3.5%. Essentially they take 1% for their "work", finders fee, underwriting costs, etc. You can be guaranteed within that 'etc' there is profit.

Essentially the Lender is 'selling' the mortgages to the investors. They manage it still, but they do NOT have any risk any longer, it is entirely assumed by the buyers of the MBS.

The downside? You are locked in. MBS securities cannot be cashed out, you are buying in for a term (since the borrowers are locked into a term, so are you). Are you guaranteed 3.5%? No, if a borrower cashes out early, you aren't earning interest on their pre-payment. You are in effect, the lender in this situation, and subject to all potential losses if the mortgage does default as well. You probably only have a small share of the $100m the entire security fund is worth, so if someone with a $200k mortgage defaults, your hit is minor, maybe $100 on the total payout at the end of the MBS term.

If you go back to 2008, this is how a lot of US banks that DIDN'T underwrite mortgages went bankrupt. They bought into MBS's that were just bad bad investments, and they had no information on the properties that were being loan against.
 

SkyRider

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Mar 31, 2009
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The downside? You are locked in. MBS securities cannot be cashed out, you are buying in for a term (since the borrowers are locked into a term, so are you). Are you guaranteed 3.5%? No, if a borrower cashes out early, you aren't earning interest on their pre-payment. You are in effect, the lender in this situation, and subject to all potential losses if the mortgage does default as well. You probably only have a small share of the $100m the entire security fund is worth, so if someone with a $200k mortgage defaults, your hit is minor, maybe $100 on the total payout at the end of the MBS term.
I was hoping that if the mortgages are NHA insured, there would be no loss of principal even if the mortgagor defaults. With GIC rates so low, I was hoping that MBS would be a good way to safely get enhanced yield.

Do you know if any bank or brokerage currently offer such a product? I called my discount broker and they do not. They offer bond mutual funds and ETF's but the value of the units fluctuates same as stock and there is no prncipal guarantee.
 

39ajaxmale

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Jan 13, 2012
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The only product that offers a principle guarantee is segregated funds, from an Insurance company, but again, usually on a locked in term, 10 years or more. They have higher MER's than standard mutual funds.. but are also creditor protected, a great benefit if you're a business owner or could ever potentially face a lawsuit or bankruptcy.


As I said with MBS's, you're buying a small share of a bulk fund. They group together 500-1000 mortgages and sell them off based on maturity dates. The risk is VERY low compared to most investments, as I said, 1 default in a pool of 100m is a relatively small loss, hence why the returns are also fairly low. You might want to look at something like a Claymore laddered GIC ETF where the returns increase year after year.. They won't yield you 4 or 5% compounded over a 5 year term, but.. the risk level is absolutely nil.
 

SkyRider

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I did some quick research on mutual fund bond funds. They have done ok in the past 5 years. Some of them actually got returns of around 5% or more for the past 3-5 years but that is not surprising given the historical low interest rates currently.
 

39ajaxmale

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Did you mean that IS surprising given the historic low interest rates?

Since the primary investments of a bond fund are.. well.. bonds, they are especially susceptable to interest rate risk.

Most bond funds own Corporate paper. They don't often buy the low yield short term government bonds, opting instead for the longer term bonds to get higher yield and try to live off the semi-annual coupon payments.

I'm a really big fan of the TD fixed income funds and bond funds. They have some very well respected managers, Satish Rai and Geoff Wilson that frequently outperform their benchmarks. I've spoken about them before in a different thread. I don't work for TD, I actually work for a competitor, and I don't soley tout their work because they hold an amazing annual golf tournament at one of the best courses in Ontario (but it doesn't hurt that they do).

If you see their website you can compare their TD mortgage fund vs say their Canadian Bond or Real Return bond fund which is hedged against inflation using Canadian Gov't Real Return bonds.

Just remember these funds are stronger in bear markets when people are buying into safety, and weaker in bull markets where people are investing in equities.
 

JohnLarue

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Jan 19, 2005
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There are other factors when considering a bond fund
1. Current interest rates are pretty close to rock bottom.
While the general consensus is that they will not be raised significantly in the near future (2 years ?)
If inflation starts to rear its ugly head, rates will go up and Bond Funds (excellent managers included ) will get hammered on the NAV, especially if it is a long bond fund
2. Bond funds turn over their holdings in order to maintain their maturity / duration mandate, so they do not always hold the individual bonds till maturity
If you are buying now you get the NAV for the Bonds as struck last night.
If they turn over several bonds in the next few years you may not realize the same return that a buy & hold strategy of the individual bonds might return, especially in a rising rate environment.
The Bond Manager will be making the decision based upon the price paid for the bond when the fund purchased it, the return since then and their expectation for future performance.
In some cases if the maturity drops below the funds maturity mandate, out the door it goes
What you paid for your small claim on that particular bond through the NAV is sometimes just plain bad luck.

Some will argue that that is a minor bump in the road as they are able to reinvest that $ into a higher yielding bond & that anomaly is more than offset by the diversification of credit risk a fund offers vs. a set of individual bonds and by the money mangers expertise.

Buying smaller quantities every 3 or 4 months over several years would average in the costs and smooth over some of the maturity issue.
 
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