If I buy a mortgage backed security, what will happen to my investment if:

  1. The person that took out the mortgage defaults
  2. The person makes a prepayment
  3. The person refinances
  4. The bank that gave out the mortgage defaults
  • Curious - is there a difference in how Canadian mortgages are securitized? I am aware that you do not have 30 year fixed rates, correct? A 5 year cycle? Dec 20 '13 at 15:20
  • @JoeTaxpayer 5 years is generally right. While amortization periods in Canada are typically 25 years, the contract & rate term with a bank is typically 5 years, rarely longer. The other distinct difference is that Canadian mortgages are typically closed, i.e. you can't just up and refinance with another lender when rates drop, not without steep prepayment penalties. Here's more than you'd care to know about the differences :-) Dec 20 '13 at 18:07

This can help in understanding some basic details of Mortgage Based Securities. Almost all of the investment banks and financial institutions deal in them. They are risky products so people with knowledge about them, deal with them.

They aren't securitized and sold as a single product. They are divided into tranches(3 level of products) with different rate of returns and the riskiness of it and likewise rated to reflect their riskiness. Plainly speaking the senior tranches are given higher preference in terms of their principal being returned and their buy price will be higher than the other tranches. The lower tranches are serviced only after all the higher tranches are serviced and are priced lower than the upper tranches.

The person that took out the mortgage defaults

The property is foreclosed and the bank, probably sells the house to recover the mortgage. The people are reimbursed depending on the tranches they had bought i.e. the higher tranches will be paid up first and then the lower ones.

The person makes a prepayment

Same as above like being paid up.

The person refinances

Same as before like being paid up.

The bank that gave out the mortgage defaults

The MBS will still be serviced by the collateral(mortgaged houses) against which it was created. Guarantees provided by the issuer will come into play. People might have taken insurance i.e. CDS google AIG's debacle, against the bought products.

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