Richmond Times-Dispatch Weekend

Investing in multiple mortgages; Understand­ing mortgage-backed securities

- BY ERIK J. MARTIN | CTW FEATURES

When you obtain a mortgage loan to purchase a home, you trust that this is a smart investment that will pay you back handsomely when it’s time to sell. But this isn’t the only way to invest in real estate.

You can also explore a mortgageba­cked security, a type of asset-backed instrument secured by a collection of mortgage loans – often dozens or hundreds of mortgage loans bundled together into a single financial vehicle available to investors.

With an MBS, the lender serves as a middleman between investors and homebuyers: The lender provides mortgage loans to its borrower clients and then sells them at a reduced rate to be included in an MBS.

“An MBS is a group of mortgages packaged together and securitize­d so that investors can buy them,” says Ralph DiBugnara, founder of Home Qualified in New York City. “An MBS essentiall­y makes a mortgage bank a conduit between the customer and the investor. Here, the investor is actually who is lending the money to the customer at the end of the process, as the investor is buying it with a specific rate of return on their investment to them. And the lender is selling those mortgages to the investor for an upfront profit rather than a longterm profit.”

MBSs are available to investors typically in the form of mutual funds and exchange-traded funds (ETFs).

“Many large mutual fund organizati­ons sponsor funds that specialize in mortgage-backed securities. They invest shareholde­r funds in a diversifie­d portfolio of such securities,” explains Robert R. Johnson, professor of finance at the Heider College of Business, Creighton University, Omaha, Nebraska. There are two types of MBSs: passthroug­hs and collateral­ized mortgage obligation­s.

“A pass-through is the simplest form of an MBS. Cash flow proceeds are passed through to investors, who receive principal and interest payments on that pool of mortgage loans after servicing fees are subtracted,” says Katsiaryna Bardos, associate professor of finance at Fairfield University in Fairfield, Connecticu­t.

Collateral­ized mortgage obligation­s (CMOs) are more complicate­d.

“CMOs are synthetic instrument­s consisting of multiple mortgageba­cked security bundles whose value and rate of return depends on the underlying quality of the component loans,” Brian Martucci, a Minneapoli­sbased finance expert with Money Crashers, says.

Put another way, a CMO is a group of MBS securities pooled together and given a rating; investors are paid based on the rate of return determined by that rating, per DiBugnara.

The good news? The average person can invest in an MBS.

“Mutual funds and ETFs are particular­ly attractive to small investors who may not be able to invest directly in mortgage-backed securities due to the large minimum investment required and most securities. These funds and ETFs often also offer automatic monthly reinvestme­nt of interest, principal or both for investors who do not need additional income,” Johnson says.

Martucci says there’s another quick path for average investors with relatively modest resources to easily invest in the MBS market.

“You can choose a government bond fund that invests in MBS products backed by government-sponsored enterprise­s, such as Ginnie Mae. Government bond funds are among the lowest-risk investment­s available to ordinary investors,” notes Martucci. It pays to keep an eye on the MBS market, particular­ly if you invest in government bonds.

“There’s a good chance your retirement plan invests in government bonds, unless it’s entirely composed of stocks,” Martucci says. “For homeowners, it’s not as important to monitor the MBS market. But it is important to understand that securities can affect housing prices and liquidity.”

Before the financial crisis occurred, MBSs were extremely popular investment­s. That insatiable demand led mortgage bankers to loosen their lending standards.

“Lower lending requiremen­ts led to lenders aggressive­ly competing for customers, resulting in mortgages that relied on little to no documentat­ion required,” Johnson explains. “That resulted in a spiraling of housing prices, as many unqualifie­d buyers were able to obtain mortgages and bid up the prices of homes. Mortgage brokers were more than happy to provide questionab­le borrowers with loans. That’s because these brokers didn’t hold the mortgages – instead, they packaged and sold them to investment banks that created mortgage-backed securities based upon these loans.”

At the same time, rating agencies, paid by investment banks, “failed to properly estimate the riskiness of mortgage pools they rated. Buyers of mortgage-backed securities blindly relied on the ratings and assumed they were buying low-risk assets,” says Bardos.

Fortunatel­y, MBSs are safer investment vehicles today than years ago.

“The Dodd-Frank legislatio­n passed as a result of the financial crisis addresses previous flaws in mortgage-backed securities and collateral­ized debt obligation­s. This legislatio­n provides for increased scrutiny of credit-rating agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings. It also mandates that a firm that puts these securities together retain at least 5% of the credit risk of those assets,” says Johnson.

In other words, investment banks and firms today are obligated to have some “skin in the game”; if the value of an MBS goes down, that firm will suffer consequenc­es, just like investors will.

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