agree with everything @Ikioi has said. an middle/upper class person with 3% interest mortgage debt tied to an appreciating asset is going to benefit a lot more from inflation than a poor person carrying a credit card balance with 20%+ interest.
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May I interest you in mortgage backed securities? Perhaps, junk mortgages rubber stamped with a AAA rating?
My pony was a day or two slow
Cut it up into many pieces and sell it as a horse.
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I came back to post this joke!
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Isn’t the financial press pulling a major scam in their inflation reporting? 6.9% in inflation for October (compared to last October)…. okay, not great Bob…. but then they are like zomg 6.8% inflation in November too (compared to last November), it’s just spiraling out of control!
The two data sets have an 11 month overlap… should expect them to be very similar.
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Right. And bear in mind that default risk isn’t the only risk that matters.
A big issue with holding mortgages (as an asset) is the risk of prepayment. That might sound like a good thing, like it’s the opposite of a default. “Oh noez, the borrower paid me back too fast.”
But it’s actually a huge problem because it’s kind of a negative freeroll for the asset holder, due to reinvestment risk. Consider a fund manager who buys a basic pool of mortgages that yield 4% in a world where the risk-free rate is 3%. If nothing changes, that fund manager can just log in to Bloomberg once a day, then go golfing as the 4% return continues on as expected.
But obviously, rates change, and it’s the asymmetric effect of those changes that presents a problem:
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If rates go down, the borrowers (homeowners) are more likely to refinance their mortgages to take advantage of the lower rates. Those prepayments mean that the fund manager who owned the mortgages no longer has a large investment yielding 4%. Instead, they’ve got a big pile of cash that they’ve got to invest in a world where available rates are all less than 4%.
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If rates go up, the borrowers are going to happily sit on their low-interest mortgages and not refinance/prepay them. That means that the fund manager is sitting on a long-lived asset that will continue to yield 4% in a world where all other investments are yielding more than 4%.
In short, interest rate risk means that prepayments happen exactly when the fund manager doesn’t want them to.
So how do you fix this with financial alchemy? Simple - you create tranches where the principal-protected tranche does not carry any prepayment risk, because all prepayments are first taken against the non-protected tranche. The investor in the protected tranche can be relatively comfortable that the duration of the tranche is semi-fixed, and can be effectively matched against liabilities of similar duration. Meanwhile, the investor in the non-protected tranche is subject to significant prepayment and extension risk, but presumably is compensated for that risk via a lower purchase price.
All of this shit is super interesting to me, and periodically makes me wish I had done this for a living.
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Yes. They also don’t reference back to the pre pandemic to account for the stagnant prices during the pandemic. If you look at Canada’s CPI in Nov 2019 it was 136.4, so allowing for two years of perfectly expected target price inflation of 2% per year you would expect about 141.9 in November 2021. Actual CPI in Nov 2021 is 144.2, i.e. 1.6% above target. So our completely out of control disastrous price inflation that is going to destroy the economy is … two years of experience at an average of 0.8% inflation above target. Oh no.
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Just to make it explicit, the way this alchemy works is that the junior tranches don’t just have prepayment risk, they have actual default risk. The interest payments to the senior tranche have to be made first, and if mortgages start prepaying, the only source for those interest payments is the repaid principal. I’m a little hazy on the mechanics, but I’m pretty sure that tax rules don’t allow the securitization vehicle to buy new assets, at least not new mortgages. So the coupon on the senior interests eats away at the principal that was supposed to pay back the junior interests.
Yes, I think you’re correct. The securitizations of loans operate kind of like private placements where you put your capital in and you wait to get your capital back out (hopefully with gains). It’s not like a mutual fund or ETF that is constantly accepting new money and making redemptions and adding and subtracting investments in accordance with an investment policy.
Interestingly, I think that one can buy units in a fund where the fund buys securitized loans. That would be a way to diversify away the right of holding just the tail end of one basket of loans. One lesson learned in 2008 (and largely forgotten, lol) is that the diversification doesn’t work in a financial crisis. You can hold as many different loans or as many different baskets of loans, it doesn’t matter if the correlations between loan defaults is high.
So making extra principal payments on my mortgage doesn’t just help me, it also screws over the lender? Oh hell yeah. I’m tripling it next month.
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Don’t get too excited. It may actually not help you. If you can make a higher return on the money elsewhere, then prepayment hurts you.
Also in environments with high inflation, your real debt will go down with time, so you’re better of not prepaying.
Of course, there are factors that can offset these consideration, so maybe it could help you. It’s just not a slam dunk.
The mortgage is small and payments are low. The peace of mind I’ll get from paying it off early outweighs whatever middling gains I might find elsewhere.
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I agree its not a slam dunk, but usually the risk adjusted and tax adjusted “return” on your mortgage is not a bad deal. Now, in years where the market goes up 20% sure you would have been better off on stocks.
I also think the US tax deduction on mortgage interest really mucks up the economics too. In Canada we don’t have that impact, but in the US a compelling argument can be made for YOLOing with an interest only mortgage and shovel all your cash at stocks. Its theoretically risky but its also a way of making your financial exposure basically look like a rich person’s exposure (albeit on a smaller scale). So you can at least trust that policy makers will be trying to act in your favor.
Something like 20% of VG’s total bond fund is actually MBS.
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This is always been my mindset, however theoretically wrong, and I’ve never regretted doing it.
Peace of mind is priceless.
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that, plus a bunch of corp assets are also held in low risk instruments, like bonds and MM (which also defied expectations in ‘08). so a large bond crisis can start tanking “unrelated” stonks, which will start tanking employment, which will make people start to miss mortgage payments further.
- Looks like domestic futures are down sharply, could be a bad day.
- Well let me check on EU and APAC market and see how they are doing so far today, maybe this is the day they actually act as a volatility buffer as imagined and intended in my allocation.
- Well then…
I’ll never learn.
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The entire globe getting Covid at the same time seems like GOOD NEWS for stonks.
Costco stock is going to end the year up 50%
Also