Mortgage Bondholders May Be Exposed to Subprime Problems
It's not just the housing market that's being affected by the subprime problems; it's also affecting the investment market. According to an article on BusinessWeek.com, mortgage funds are not as exposed to credit risk because of defaulting loans as might be expected. However, the impact to the mortgage bond as an investment will depend on a number of factors, including how invested the fund is in subprime loans. Don't know what a subprime loan is? It's a loan that's given to an individual who has a credit score under 620.
Interested in mortgage bond funds? Your best bet seems to be "Ginnie Mae" bonds; Ginnie Mae is the Government National Mortgage Association (also known as GNMA) and these bonds are guaranteed by the federal government and bear no credit risk.
The risk to mortgage bonds and mortgage bond funds as an investment has arisen over the past five years as lenders got more aggressive in the types of mortgage loans they were willing to underwrite. A booming housing market and rapidly escalating home vales led many to loosen loan writing standards in order to get more of the business. Now, the market is paying the price in higher than expected delinquencies and foreclosures.
Mortgages in default were about 5% in the fourth quarter of 2006, which was the highest rate since 2003. Foreclosures were up 1.2%, which is minimal. However, in subprime mortgages, delinquency rates were up over 13%. The foreclosure rate in subprime loans rose to 4.5%, which is markedly higher than the overall rate. As data for the new year rolls in, it looks as if defaults and foreclosures will be even higher in 2007.
This is the problem with bond funds that are heavily invested in subprime loans. High foreclosure rates could impact the value of individual units of a fund. It's not just the loss of income from the borrower repaying, it's also the loss of value of the original asset.
Given the challenge in housing market, if you want to stay in mortgage bonds or funds, I'd pick commercial mortgage funds.