Sunday, January 23, 2005

Mortgages, Bonds, and the end of the world.

First, for those of us not familiar with how mortgages work (which there is no real reason to know how they work):

(From my understanding): Let's say that you have 10 people that buy houses. They each put 10% down, they all have similiar credit scores, they all have loan amounts of 100k, and they all take a mortgage out at 6% for 30 years.

Since the above are all very similiar mortgages, they are collatoralized into one bucket. One product. More specifically they are packaged together as bonds (if you need a name you heard before, think Freddie Mac or Fannie Mae). The bonds are then sold to bond buyers, like your Grandpa. The banks are not lending the money, bond buyers are.

2004 was a record year in housing sales. Everyone knows that everyone and their mom and blind cousin have refinanced their mortgages.

Alright so what does this have to do with the end of the world? Probably nothing. But here's what I'm wondering:

If I own one of these bonds that pays 6%, and the interest rates go up, then I will be able to get a bond that pays 8%. So I will sell my low yielding bond and buy a higher yielding one. I would imagine that EVERYONE who owns these bonds will react the same way. Why would I want to get 6% when I can get 9%? As people sell, the bonds will decrease in value (see supply and demand). If they plummit in value, then who is going to hold the bonds that backs the mortgages? In other words, these bonds are considered "mortgage backed securities", well who is going to back the morgage backed securities!?

Nevermind, my stream of consciousness just clued me into why the world won't collapse. Sure people will sell thier bonds. That will make the bonds drop in price, thus being at a discount. These type of bonds are redeemed at par. So the people that buy the bonds that other people are bailing out on, will simply make their money by redeeming the discounted bonds at par. Plus if there is a buyer than there has to be a seller.

Which would lead me to believe that it might be a good idea to short mortgage backed securities right now. Shorting stock/bonds/anything is when you sell it before you buy it. So in essence you are betting that the price of that security will go down. Thus you would have sold it for more than you later buy it for. (Disclaimer: I am not putting my money where my mouth is here, but I will watch!...I'm not a speculator, I'm an investor.)


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