Mortgages are a manufactured product
This is generally a pretty interesting article, but I wish he'd expand into the other risks inherent to pools of mortgages:<p>1) Default risk - Obviously if I invest in pools of mortgages, and a lot of people stop paying their loans, I am exposed to risk. In many cases I'm insulated, because if someone defaults, I now own the home and can sell it to recoup my losses. But there's costs associated with foreclosing and in some cases, the value of the house goes down by enough that I can't recoup my money anyways (see 2008). We slice and dice mortgage pools to reflect this, so that the junk bonds are at the bottom and pay more and the AAA are at the top and don't lose anything until the lower tranches lose everything.<p>2) Interest rates rising - he discusses this in the article. If interest rates go up from 5 to 10% then any notes I held on a 5% loan are worth less.<p>3) Interest rates falling - this is called "pre-payment" risk and is what makes mortgages so interesting (and much harder to value than corporate bonds and most other loans). See point 2 for why rates rising hurts the owners of mortgage notes. You might think that rates falling would therefore help them, but it doesn't directly correlate. If rates fall enough, many people will refinance their loans. You have the right to pay off your mortgage at any time and another bank will be happy to step in and give you a new loan. So if rates fall from 4% to 2%, you can bet that most people will refinance. If I'm an investor holding a pool of 4% loans, then most of those loans will get paid off and now I'm stuck being in a market where I can only buy pools of 2% loans. Corporate bonds generally don't work this way. Auto loans technically do, but given the size and durations of the loans, it's usually not worth the hassle to refinance in the way it is for a house. This pre-payment risk makes the modeling of mortgage investment much more complicated, but also more interesting than many other financial securities.