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This is generally a pretty interesting article, but I wish he'd expand into the other risks inherent to pools of mortgages: 1) Default risk - Obviously if I in

This is generally a pretty interesting article, but I wish he'd expand into the other risks inherent to pools of mortgages: 1) Default risk - Obviously if I invest in pools of mortgages, and a lot of people stop paying their loans, I am exposed to risk. In many cases I'm insulated, because if someone defaults, I now own the home and can sell it to recoup my losses. But there's costs associated with foreclosing and in some cases, the value of the house goes down by enough that I can't recoup my money anyways (see 2008). We slice and dice mortgage pools to reflect this, so that the junk bonds are at the bottom and pay more and the AAA are at the top and don't lose anything until the lower tranches lose everything. 2) Interest rates rising - he discusses this in the article. If interest rates go up from 5 to 10% then any notes I held on a 5% loan are worth less. 3) Interest rates falling - this is called "pre-payment" risk and is what makes mortgages so interesting (and much harder to value than corporate bonds and most other loans). See point 2 for why rates rising hurts the owners of mortgage notes. You might think that rates falling would therefore help them, but it doesn't directly correlate. If rates fall enough, many people will refinance their loans. You have the right to pay off your mortgage at any time and another bank will be happy to step in and give you a new loan. So if rates fall from 4% to 2%, you can bet that most people will refinance. If I'm an investor holding a pool of 4% loans, then most of those loans will get paid off and now I'm stuck being in a market where I can only buy pools of 2% loans. Corporate bonds generally don't work this way. Auto loans technically do, but given the size and durations of the loans, it's usually not worth the hassle to refinance in the way it is for a house. This pre-payment risk makes the modeling of mortgage investment much more complicated, but also more interesting than many other financial securities.

AussieWog93 5y ago
I'm slightly confused by 2 and 3, as I own cap notes and have friends with mortgages (in Australia). Are mortgage rates and cap note returns in the US not tied to the federal interest rate? Here, pretty much every note traded publicly will yield x% above RBA (reserve bank) interest rates, and most mortgages will be "variable rate" - ie they'll automatically adjust to be some function dependent on the RBA rate.
- chadash 5y ago
  In the US, the standard mortgage is 30 year fixed. i.e. you pay the same rate for 30 years. Adjustable rate mortgages exist, but are less typical.
  - jbay808 5y ago
    That's pretty unique to the US, I think. Canada has no comparable product and the difference between "fixed" and "variable rate" mortgages here is that fixed mortgages are fixed for five years.
    - beebmam 5y ago
      Those used to be much more common in the US. The 2008 housing crisis changed everything, and variable rate mortgages are extraordinarily rare now.
      - inglor_cz 5y ago
        Interestingly, I never saw a fixed rate mortgage for 30 years in my country. The top fixation period is usually 10 years, anything higher than that is unusual. A typical value is 5 years.
      - jjav 5y ago
        Main factor is that interest rates are so low (and have been for years now). With very low interest rates, it would be foolish to get an adjustable rate mortgage since it only has room to go up. Much better to lock in the very low rate for life. Thus, approximate nobody takes variable rate loans anymore. When I first bought my house interest rates were over 7%, so getting discount on the interest in exchange of the risk of an adjustable rate mortgage made some sense.
      - dragonwriter 5y ago
        > Those used to be much more common in the US Only briefly; the 30 year fixed has been a norm for a very long time, and the expansion of ARMs and more exotic creative financing instruments in the bubble leading up to the 2008 finance crises was itself a short-term aberration; there was also a brief run up in popularity when interest rates spiked in the 1980s (to avoid locking in sky-high rates.)
betterunix2 5y ago
Is the prepayment risk really much different from a callable commercial bond? Call protection is not universal in commercial or even agency bonds.
- dtnewman 5y ago
  No, not very different. But as I understand it, most commercial bonds are not callable, whereas most mortgages are pre-payable with no penalty.
- deleted 5y ago
  [deleted]
- lotsofpulp 5y ago
  Does the prepayment risk even matter for most mortgages in the US since they are sold to the government sponsored enterprises? https://en.wikipedia.org/wiki/Government-sponsored_enterprise https://en.wikipedia.org/wiki/Government-sponsored_enterpris... As I understand, the goal of those entities is to simply lower the costs and increase access to loans to the US public.
  - chadash 5y ago
    Yes. Fannie and Freddie sell those loans to investors, they don't hold them. They just insure them against defaults. But prepayments are still investors' problems as far as I'm aware.
  - patrickthebold 5y ago
    The Gses bundle up the mortgages and sell mortgage backed securities to investors. The prepayment risk flows through to those investors. As an extreme example, some securities they separately sell the principle payments and the interest payments. So if you bought the interest payments on a bunch of mortgages you stop getting paid as people prepay. The folks who bought the principle payments are very happy to get paid early.
vishnugupta 5y ago
> because if someone defaults, I now own the home and can sell it to recoup my losses. From what I know that's a rare scenario. Stressed asset (i.e., mortgage contract) holder typically sells off that asset to someone else at a discount. The buyers are those someone who specialise in holding semi-toxic assets and know how to make money out of it. Lenders typically don't want to deal with the underlying assets. It's time consuming and not their speciality. Lenders just want to recoup whatever money they can fast and be done with it.
- deleted 5y ago
  [deleted]
poulsbohemian 5y ago
>2) Interest rates rising - he discusses this in the article. If interest rates go up from 5 to 10% then any notes I held on a 5% loan are worth less. Maybe you meant this and just wrote it differently, but I'd argue it isn't that it is worth less so much as its liquidity has declined. You felt good enough about that 5% at the time you bought out the mortgage, but now it isn't as good a return as you would get if rates were at 10%, thus it may be difficult for you to sell that mortgage off to someone else given their opportunity cost. On the other hand, rates (at least in the US) are unlikely to jump even a full 1%,let alone 5%, in such a timeline that you couldn't retrench if you believed you were better off to liquidate and move on to higher yielding assets.
- SilasX 5y ago
  That’s not what lower liquidity looks like. The bonds sell just fine, you just have to lower the price to sell it, such that the effective yield matches the market rate. Lower liquidity would show up as wider bid/ask spreads, which doesn’t happen in that case.
nostrademons 5y ago
I also wish there was more about inflation risk. After being debt-averse my whole life, I finally got a mortgage in 2020 when the prevailing interest rate dropped below the expected inflation rate. Because that meant real rates were negative, and sure, I'd love to get paid for taking out debt. At least so far, it's been a great trade, with me paying 2.75% on my mortgage and my home's value up about 35%. Out of morbid curiosity, I'd like to know who I'm screwing over. Somebody out there is getting a 2.75% cash flow in a 7% inflation environment. Is it my mom's pension fund? The Saudi sovereign wealth fund? Wells Fargo? The Federal Reserve, and hence everybody who pays for goods with dollars?
- WJW 5y ago
  Probably just future generations of taxpayers and/or the people you will eventually sell your house to?
- throw0101a 5y ago
  > After being debt-averse my whole life, I finally got a mortgage in 2020 when the prevailing interest rate dropped below the expected inflation rate. Now imagine actually having a mortgage with an interest rate that was negative: * https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage https://www.theguardian.com/money/2019/aug/13/danish-bank-la...
  - smsm42 5y ago
    > In reality, the Jyske mortgage borrower in Denmark is likely to end up paying back a little more than they borrowed, as there are still fees and charges to pay to compensate the bank for arranging the deal, even when the nominal rate is negative. Ahhh, there it is. So they probably just make Central Bank finance their fees, using borrowers as a conduit. Clever.
- ctchocula 5y ago
  Vanguard's trademark total bond ETF BND, which is a part of the classic 3-fund portfolio [1], a cornerstone of passive investing, has 2.2% commercial and 20% government-backed mortgage backed securities [2]. So a lot of everyday folks across America, especially those retired looking for a stable cashflow for retirement, are helping fund your mortgage. It's a bit of win-win situation (albeit a loss for them during high inflation as you point out): you need money now, and they need a mostly guaranteed return on their money in 10-20 years time that pays out better than Treasuries, and gives them diversification compared to bonds (either Treasury or commercial). [1] https://www.bogleheads.org/wiki/Three-fund_portfolio https://www.bogleheads.org/wiki/Three-fund_portfolio [2] https://investor.vanguard.com/mutual-funds/profile/portfolio/bnd https://investor.vanguard.com/mutual-funds/profile/portfolio...
yrral 5y ago
For 3) it's a bit more complex than what you described. Mortgages are generally securitized. High level, a pool of unrelated mortgages (think different parts of the US, different types of borrowers, different credit ratings) are packaged up together and then split into different tranches. Say you have tranches AAA-B. These different tranches are sold to different parties with different risk appetites. Each tranche has a set interest rate, and AAA will have the lowest, and B the highest. Say like 2.5% for AAA and 7.2% for B. AAA is the most "senior" and B the most "junior". When borrowers pay back their monthly payments, first the interest gets distributed to AAA->B, then all the excess goes back paying the principal of AAA. Once AAA is fully paid back (say 5 years later for a 30 year loan), the AAA bondholders no longer care about the mortgage, and the excess gets paid towards AA principal (then A, BBB etc). This keeps going on until every tranche gets fully paid back. By structuring it this way it's "almost impossible" for the more senior bondholders to realize a loss. Obviously there is more risk for B bondholders (given they are being paid 7.2% interest). So in this case, losses in mortgages are borne by B principal holders until they get exhausted. Zooming back into the pre-payment risk, it's entirely possible that prepayments/refinances will allow the more junior tranchess to avoid as much principal loss as expected while picking up that juicy yield. (note when the yield for more junior bonds are 7.2%, anyone buying these already planned for some amount of realized losses) This pic from wikipedia illustrates some of the concepts https://en.wikipedia.org/wiki/Tranche#/media/File:Risk&ReturnForInvestors.svg https://en.wikipedia.org/wiki/Tranche#/media/File:Risk&Retur...
patio11 5y ago
On your #1, the biggest change is "private label MBS" (which did not get the GSEs' guarantee) largely vanished from the market (the high since the crisis was a twentieth of 2007's number). The supermajority of investors in pools of mortgages are buying GSE-issued securities, which are insulated from default risk, including the case where the lender seizes the collateral and can't liquidate it for the entire outstanding principal net of costs.
benjaminclark 5y ago
Th article does cover these. For #1, see the section headed "The risk of non-payment". Prior to the mortgages going into the pool, insurance against default is purchased from a GSE. In exchange for this insurance payment, in the event of default, the GSE buys back the mortgage for the remaining principle balance. So as an investor in the typical MBS, you don't face this risk. For #2 and #3, while it could go into it in more detail, this is discussed in the section titled "Every other risk you could imagine, of which there are many". It notes that the value does change as a result of interest rate changes (in the context of noting this as a key reason why most mortgages are not held by banks, but other institutional investors which can better tolerate this interest rate risk).
tata71 5y ago
> We slice and dice mortgage pools to reflect this There's no way to properly do this. It's why 2008 occurred, and why it'll occur again.

AussieWog93 5y ago

I'm slightly confused by 2 and 3, as I own cap notes and have friends with mortgages (in Australia). Are mortgage rates and cap note returns in the US not tied to the federal interest rate? Here, pretty much every note traded publicly will yield x% above RBA (reserve bank) interest rates, and most mortgages will be "variable rate" - ie they'll automatically adjust to be some function dependent on the RBA rate.

chadash 5y ago
In the US, the standard mortgage is 30 year fixed. i.e. you pay the same rate for 30 years. Adjustable rate mortgages exist, but are less typical.
- jbay808 5y ago
  That's pretty unique to the US, I think. Canada has no comparable product and the difference between "fixed" and "variable rate" mortgages here is that fixed mortgages are fixed for five years.
  - beebmam 5y ago
    Those used to be much more common in the US. The 2008 housing crisis changed everything, and variable rate mortgages are extraordinarily rare now.
    - inglor_cz 5y ago
      Interestingly, I never saw a fixed rate mortgage for 30 years in my country. The top fixation period is usually 10 years, anything higher than that is unusual. A typical value is 5 years.
    - jjav 5y ago
      Main factor is that interest rates are so low (and have been for years now). With very low interest rates, it would be foolish to get an adjustable rate mortgage since it only has room to go up. Much better to lock in the very low rate for life. Thus, approximate nobody takes variable rate loans anymore. When I first bought my house interest rates were over 7%, so getting discount on the interest in exchange of the risk of an adjustable rate mortgage made some sense.
    - dragonwriter 5y ago
      > Those used to be much more common in the US Only briefly; the 30 year fixed has been a norm for a very long time, and the expansion of ARMs and more exotic creative financing instruments in the bubble leading up to the 2008 finance crises was itself a short-term aberration; there was also a brief run up in popularity when interest rates spiked in the 1980s (to avoid locking in sky-high rates.)

betterunix2 5y ago

Is the prepayment risk really much different from a callable commercial bond? Call protection is not universal in commercial or even agency bonds.

dtnewman 5y ago
No, not very different. But as I understand it, most commercial bonds are not callable, whereas most mortgages are pre-payable with no penalty.
deleted 5y ago
[deleted]
lotsofpulp 5y ago
Does the prepayment risk even matter for most mortgages in the US since they are sold to the government sponsored enterprises? https://en.wikipedia.org/wiki/Government-sponsored_enterprise https://en.wikipedia.org/wiki/Government-sponsored_enterpris... As I understand, the goal of those entities is to simply lower the costs and increase access to loans to the US public.
- chadash 5y ago
  Yes. Fannie and Freddie sell those loans to investors, they don't hold them. They just insure them against defaults. But prepayments are still investors' problems as far as I'm aware.
- patrickthebold 5y ago
  The Gses bundle up the mortgages and sell mortgage backed securities to investors. The prepayment risk flows through to those investors. As an extreme example, some securities they separately sell the principle payments and the interest payments. So if you bought the interest payments on a bunch of mortgages you stop getting paid as people prepay. The folks who bought the principle payments are very happy to get paid early.

vishnugupta 5y ago

> because if someone defaults, I now own the home and can sell it to recoup my losses. From what I know that's a rare scenario. Stressed asset (i.e., mortgage contract) holder typically sells off that asset to someone else at a discount. The buyers are those someone who specialise in holding semi-toxic assets and know how to make money out of it. Lenders typically don't want to deal with the underlying assets. It's time consuming and not their speciality. Lenders just want to recoup whatever money they can fast and be done with it.

deleted 5y ago
[deleted]

poulsbohemian 5y ago

>2) Interest rates rising - he discusses this in the article. If interest rates go up from 5 to 10% then any notes I held on a 5% loan are worth less. Maybe you meant this and just wrote it differently, but I'd argue it isn't that it is worth less so much as its liquidity has declined. You felt good enough about that 5% at the time you bought out the mortgage, but now it isn't as good a return as you would get if rates were at 10%, thus it may be difficult for you to sell that mortgage off to someone else given their opportunity cost. On the other hand, rates (at least in the US) are unlikely to jump even a full 1%,let alone 5%, in such a timeline that you couldn't retrench if you believed you were better off to liquidate and move on to higher yielding assets.

SilasX 5y ago
That’s not what lower liquidity looks like. The bonds sell just fine, you just have to lower the price to sell it, such that the effective yield matches the market rate. Lower liquidity would show up as wider bid/ask spreads, which doesn’t happen in that case.

nostrademons 5y ago

I also wish there was more about inflation risk. After being debt-averse my whole life, I finally got a mortgage in 2020 when the prevailing interest rate dropped below the expected inflation rate. Because that meant real rates were negative, and sure, I'd love to get paid for taking out debt. At least so far, it's been a great trade, with me paying 2.75% on my mortgage and my home's value up about 35%. Out of morbid curiosity, I'd like to know who I'm screwing over. Somebody out there is getting a 2.75% cash flow in a 7% inflation environment. Is it my mom's pension fund? The Saudi sovereign wealth fund? Wells Fargo? The Federal Reserve, and hence everybody who pays for goods with dollars?

WJW 5y ago
Probably just future generations of taxpayers and/or the people you will eventually sell your house to?
throw0101a 5y ago
> After being debt-averse my whole life, I finally got a mortgage in 2020 when the prevailing interest rate dropped below the expected inflation rate. Now imagine actually having a mortgage with an interest rate that was negative: * https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage https://www.theguardian.com/money/2019/aug/13/danish-bank-la...
- smsm42 5y ago
  > In reality, the Jyske mortgage borrower in Denmark is likely to end up paying back a little more than they borrowed, as there are still fees and charges to pay to compensate the bank for arranging the deal, even when the nominal rate is negative. Ahhh, there it is. So they probably just make Central Bank finance their fees, using borrowers as a conduit. Clever.
ctchocula 5y ago
Vanguard's trademark total bond ETF BND, which is a part of the classic 3-fund portfolio [1], a cornerstone of passive investing, has 2.2% commercial and 20% government-backed mortgage backed securities [2]. So a lot of everyday folks across America, especially those retired looking for a stable cashflow for retirement, are helping fund your mortgage. It's a bit of win-win situation (albeit a loss for them during high inflation as you point out): you need money now, and they need a mostly guaranteed return on their money in 10-20 years time that pays out better than Treasuries, and gives them diversification compared to bonds (either Treasury or commercial). [1] https://www.bogleheads.org/wiki/Three-fund_portfolio https://www.bogleheads.org/wiki/Three-fund_portfolio [2] https://investor.vanguard.com/mutual-funds/profile/portfolio/bnd https://investor.vanguard.com/mutual-funds/profile/portfolio...

yrral 5y ago

For 3) it's a bit more complex than what you described. Mortgages are generally securitized. High level, a pool of unrelated mortgages (think different parts of the US, different types of borrowers, different credit ratings) are packaged up together and then split into different tranches. Say you have tranches AAA-B. These different tranches are sold to different parties with different risk appetites. Each tranche has a set interest rate, and AAA will have the lowest, and B the highest. Say like 2.5% for AAA and 7.2% for B. AAA is the most "senior" and B the most "junior". When borrowers pay back their monthly payments, first the interest gets distributed to AAA->B, then all the excess goes back paying the principal of AAA. Once AAA is fully paid back (say 5 years later for a 30 year loan), the AAA bondholders no longer care about the mortgage, and the excess gets paid towards AA principal (then A, BBB etc). This keeps going on until every tranche gets fully paid back. By structuring it this way it's "almost impossible" for the more senior bondholders to realize a loss. Obviously there is more risk for B bondholders (given they are being paid 7.2% interest). So in this case, losses in mortgages are borne by B principal holders until they get exhausted. Zooming back into the pre-payment risk, it's entirely possible that prepayments/refinances will allow the more junior tranchess to avoid as much principal loss as expected while picking up that juicy yield. (note when the yield for more junior bonds are 7.2%, anyone buying these already planned for some amount of realized losses) This pic from wikipedia illustrates some of the concepts https://en.wikipedia.org/wiki/Tranche#/media/File:Risk&ReturnForInvestors.svg https://en.wikipedia.org/wiki/Tranche#/media/File:Risk&Retur...

patio11 5y ago

On your #1, the biggest change is "private label MBS" (which did not get the GSEs' guarantee) largely vanished from the market (the high since the crisis was a twentieth of 2007's number). The supermajority of investors in pools of mortgages are buying GSE-issued securities, which are insulated from default risk, including the case where the lender seizes the collateral and can't liquidate it for the entire outstanding principal net of costs.

benjaminclark 5y ago

Th article does cover these. For #1, see the section headed "The risk of non-payment". Prior to the mortgages going into the pool, insurance against default is purchased from a GSE. In exchange for this insurance payment, in the event of default, the GSE buys back the mortgage for the remaining principle balance. So as an investor in the typical MBS, you don't face this risk. For #2 and #3, while it could go into it in more detail, this is discussed in the section titled "Every other risk you could imagine, of which there are many". It notes that the value does change as a result of interest rate changes (in the context of noting this as a key reason why most mortgages are not held by banks, but other institutional investors which can better tolerate this interest rate risk).

tata71 5y ago

> We slice and dice mortgage pools to reflect this There's no way to properly do this. It's why 2008 occurred, and why it'll occur again.