Investors can diversify their portfolios by purchasing residential mortgage backed securities, which are investment products whose payoffs depend on the cash flow from a pool of residential mortgages. These securities facilitate the secondary market for residential mortgages because they allow investors to become involved in the market conveniently. With residential mortgage backed securities, an investor can put money into residential mortgages without putting in the effort to find homeowners who want to take out mortgages. They also eliminate some of the risk of traditional mortgage investment because the payments are guaranteed by the entity that issues the security. There are, however, risks associated with investing in the securities.
Residential mortgage backed securities are essentially bonds. The issuing entity gets the purchase price of the security in exchange for the promise of a stream of future payments: the purchase of the securities creates debt for the issuing entity. Unlike traditional bonds, residential mortgage backed securities do not specify coupon payments or a face value. Instead, they guarantee payments of some portion of the payments made by the borrowers who are involved in a pool of residential owners. These people make their mortgage payments to the entity that issued the securities, which owns the mortgages, and in turn that entity makes payments to the security holders.
There are three main agencies that issue residential mortgage backed securities. They are Fannie Mae, Freddie Mac and the Government National Mortgage Association, also known as Ginnie Mae. Each entity guarantees the payments on its securities. Fannie Mae’s and Freddie Mac’s guarantees are corporate guarantees, while Ginnie Mae’s guarantee is backed up by the United States government.
Despite the guarantees of the issuing entities, investors in residential mortgage backed securities do face risks as a result of their investments. Some of these risks are faced by the holders of almost every type of investment. One is default risk, which is the probability that the entity which guarantees the security will not be able to meet its obligations. Another is interest rate risk. If the prevailing interest rates in the market increase, then the returns on mortgage backed securities relative to the opportunity cost are reduced if the interest rates for the pool of mortgages are fixed.
A risk that is specific to the holders of securities that are based on loans, and in particular residential mortgage backed securities, is prepayment risk. The payments of residential mortgage backed securities depend on mortgage payments. Part of those payments is interest on the principal of the loans. The borrowers have the option of prepaying their mortgages, however, which deprives the investor of the stream of interest payments that he would have received had that loan continued.