Mortgage Investment Information

Mortgage investments provide entry into the real estate market--without the red tape and expense associated with actually buying homes, maintaining property, and servicing tenants. As a mortgage investor, you will be looking to earn a competitive return that outpaces the rate of inflation. For success with mortgages, it is critical for you to understand how the prevailing interest rate and economic environment affect the housing market.

Identification

• You can invest in mortgages through mortgage-backed securities (MBS). Also referred to as collateralized mortgage obligations (CMOs), mortgage-backed securities carry claims over a large pool of mortgages. After buying into mortgage-backed securities, you collect income when homeowners make principal and interest payments on their mortgages. In America, Fannie Mae and Freddie Mac are the dominant players within the mortgage-backed securities market. These two government-sponsored enterprises buy individual mortgages from banks and then engineer mortgage-backed securities for investors. You canl buy into mortgage-backed securities through your broker, or directly from mutual fund companies.

Features

• Individual mortgage-backed securities are further classified into tranches. Tranches are prioritized according to mortgage payments, and carry distinct risk versus reward profiles to match your objectives as an investor.

  For example, Tranche A could be the first MBS tranche to receive principal and interest payments. In exchange for these terms, investors are willing to pay a high price for Tranche A. The high prices paid for Tranche A lower its potential returns. Conversely, Tranche Z would be the last tranche to collect mortgage payments, and therefore trades for a low price. People that buy into Tranche Z stand to make big profits -- if all homeowners continue making principal and interest payments.

Considerations

• Mortgage-backed securities perform best amid a strong economy and stable interest rate environment. When the economy performs well, homeowners should be able to meet their mortgage obligations. In recession, however, the risks of mortgage default and foreclosure increase due to job layoffs and investment losses.

  Mortgage-backed securities are susceptible to interest rate risks. When prevailing interest rates fall, homeowners are likely to refinance debt, and take out new mortgages to pay off their old mortgages. As an MBS investor, you would then lose out on the future interest payments applicable to the old mortgage. Rising interest rates also adversely affect MBS performance. At that point, new fixed income investments offer higher interest payments than existing mortgage-backed securities. Old MBS must then be sold at a discount.

Benefits

• Because of mortgage-backed securities, banks can tap into large pools of investment capital, from which to make mortgage loans. Rather than financial risk being concentrated within one financial institution, one MBS can spread mortgage default risk between hundreds of different investors. These conditions improve liquidity for the overall housing market, which translates into lower interest rates for homeowners.

Warning

• Mortgage-backed securities and easy access to credit may also lead to real estate speculation, as people place abnormally high bids on homes. Over time, speculation creates a housing bubble--where middle-income people are shut out of the market. Inevitably, home values would crash on weak demand.