Mortgage-Backeds Offer Returns for the Vigilant

Yet despite the national average home price declines, most borrowers within the agency universe probably still have strong equity. The FHFA's Home Price Index (formerly OFHEO) has declined by only 4% year over year. In terms of general economics, the Case-Shiller index probably better represents the housing picture. But remember that the FHFA index is calculated by looking at homes with GSE mortgages, so it's exactly the relevant index for agency MBS investors.

All this leads to a very divergent degree of refinancability among agency MBS pools. If you have a pool that originated in 2007 with 90% loan-to-value (i.e., 10% equity), those borrowers will struggle to refinance in today's tight credit environment. A pool where the original loan-to-value was 75% and which was originated in 2005 might be highly refinancable should rates continue to fall.

Geographics will also be crucial. Only 21 states have actually experienced price declines, according to FHFA, with some very large states suffering outsized declines. A pool with mostly Midwest or Southeastern exposure would not have many underwater mortgages, whereas a pool concentrated in the Southwest would. The former will repay much quicker than the later.

Mortgage prepayment speeds are especially dangerous for investors in collateralized mortgage obligations. A CMO structure is dependent on prepayment speeds occurring within some range. But we are likely to see some pools pay extremely fast while others pay extremely slowly. This kind of bifurcation could easily burst CMO structures and leave investors with cash flows wildly different from what was expected.

The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would cause a massive refinancing wave that would make 2003 look like a splash in the kiddie pool.

Are mortgages worth owning? Sure, but beware of the risks. Investors who need more certain cash flow should look elsewhere. Investors focused on income and who are willing to dig into the specifics of a mortgage pool can find great rewards.

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Know what you own: Leaders among mortgage investments include Annaly Capital Management (NLY - commentary - Cramer's Take), MFA Mortgage Investments (MFA - commentary - Cramer's Take), Hatteras Financial (HTS - commentary - Cramer's Take), Capstead Mortgage (CMO - commentary - Cramer's Take) and Anworth Mortgage (ANH - commentary - Cramer's Take).

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Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.