No. of Recommendations: 1
Loki, thank you for your excellent FAQ on mortgage bonds.

I have a question.

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)?

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.

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