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How can an investor tell what proportion of a mortgage bond consists of lower-quality "creative" mortgages? Are the subprime mortgages (e.g. no-documentation, option-ARM, etc.) packaged and sold as AAA?

I have read that the weakest mortgages may be broken out, into tranches, but is this always the case? As you pointed out, historically, mortgages were very safe. Are the new mortgages being slipped into bundles, and being sold as equally safe (supposedly because the risk is spread)?

Sorry, Wendy. Way over my pay grade. (One of the reasons I would have preferred Jack or someone like him write this FAQ.) I think warning people that they might want to inform themselves before assuming mortgage securities are as risk free as in the past is about all we can do. As best I can understand from what I've read, the option-ARMs and such are not going to be in the packaged mortgage securities (GNMA, Fannie, Freddy), at least nothing with 30 year or 15 year maturities. I'm not sure whether there are enough government backed long term mortgages (15, 30 year) we might consider sub-prime (i.e., the home owners have little room to spare in keeping up with payments) to constitute a problem. The mainstream analysts don't seem to think so, though of course the doom and gloom crowd does.

You might also want to mention that the "bits and pieces" calls of mortgage bonds are most likely to happen when mortgage rates are falling...and that this is most likely to happen when other interest rates are also falling. Therefore, the investor takes on the principal fluctuation risk of a long-term bond, without the protection of having the initial, higher interest rate apply to the entire principal, for the lifetime of the bond. If interest rates rise, the value of a mortgage bond will fall. However, if interest rates fall, the principal of the mortgage bond will be called away, just when reinvestment will yield lower rates.

I do mention the "reinvestment risk" with heavy refinancing during declining interest rates in passing. I can easily make that a separate point and add the point about rising interest rates, then take the opportunity to mention that as a particular problem for funds, especially since the reason this is a problem for funds would probably be clearer when talking about mortgage bonds than when talking about funds.
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