The majority of the bad news reported is about "sub-prime" or poor credit quality loans and "teaser rate" mortgages that are now re-pricing at prevailing interest rates that people cannot afford. Having said that, there is a list of caveats and "what-if’s" an investor should be aware of even on normal mortgage-backed-securities before participating in this portion of the fixed-income market.
How Mortgage-Backed Securities Work
A mortgage-backed security is actually a pool of everyday loans that are securitized through a government agency such as "Fannie Mae," "Ginny Mae" or "Freddie Mac." These agencies guarantee the timely payment of principal and interest and the originating lender keeps ¼% to ½% as a servicing fee. These securities are then sold through dealers to the end investors.
Every month the security pays the investor principal and interest. The upshot of that is if the investor spends the principal, that money will never be available for reinvestment. The principal portion is "par" dollars, so if the investor paid 102 for an MBS, every dollar of principal that is paid back is an automatic 2% loss. The opposite is true of an MBS at a discount.
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