Mortgage Investments Offer Both Opportunity and Risk: Making Sense of Conflicting Reports

Recently, I finished reading an engaging book that explained in detail how John Paulson generated more than $20 billion betting on a crash in the housing markets. Many wise investors could see the writing on the wall months ahead of the panic period, but since you can't exactly short an individual house, it was difficult to figure out the best way to profit from the coming crash.

After months of studying and more than one false start, Paulson eventually determined that the best strategy was to buy protection on mortgage securities. I'll spare you the tedious details, but the concept of mortgage securities is very interesting (and potentially very lucrative). Essentially, many of the loan originators – the companies actually lending money for home purchases – didn't want to keep these loans on their books. Instead, they bundled the loans together in a pool and sold these "securitized" loans to investors.

Over time, the process got very complicated, with the pools being sliced up into different categories – some with more risk and potentially greater returns, and some with much lower risk and consequently lower profits. Leading up to 2007, there was so much investor demand for these securities that the loan originators couldn't keep up with all the buyers. Eventually, new derivative markets emerged, allowing more investors to bet on these pools of mortgages.

When housing prices started to decline, trouble hit these mortgage-backed securities (MBS) and the risky sections started taking on losses. Like a vicious disease, the losses quickly spread up the line, ultimately causing losses in even the most conservative securities. Major banks and brokerage firms who owned billions of dollars' worth of these toxic assets were in deep trouble because they had borrowed huge sums to buy mortgage investments that were now worth pennies on the dollar.

The devastation in mortgage investments has had a huge impact on investment psychology. Investors from Park Avenue to Main Street are still shell-shocked by the devastation and many are blind to see opportunities developing in some specific mortgage investments.

A Tale of Two Risk Levels

Unemployment, falling property values and weak consumer sentiment have pushed residential mortgage securities down to historically low prices. In many cases, residential mortgage securities are being held at 20 or 30 cents on the dollar, even for performing loans that continue to make payments. This means that an institutional fund can pay $20 million for a package of loans that could eventually generate a 400% return. Even if half of the mortgages default, that would still represent a return of 150%.

Ironically, it now appears that the risks in residential mortgages (which everyone is afraid of) are dwarfed by the risks in commercial mortgages (which have yet to be recognized by the major institutional investors). The commercial side could be a catastrophe in the making, with the potential losses mirroring – or even surpassing – the risk levels formerly seen in the residential mortgage meltdown.

But the residential side actually offers some excellent opportunities that could show up as opportunities in the coming months. In fact, my options trading service – Taipan's Velocity Trader – has already opened a turbo-charged opportunity I call "foreclosure slips," which should benefit from improvement in the residential mortgage market.

Closed-End Funds Offer New Profit Opportunities

One of the areas that I am carefully watching is a series of "closed-end funds," which invest money in residential mortgage securities. Unless you have a professional license or an investment account worth more than $10 million, it's very difficult to invest directly in mortgage-backed securities. And quite honestly, you probably wouldn't want to. The actual trading of these vehicles can be tricky, with brokers and dealers taking advantage of unwary clients.

But closed-end funds are professionally managed pools of money that are invested with a particular purpose. Some funds invest in natural gas pipelines, some invest in commercial loans, and the ones I am interested in are fully invested in mortgage-backed securities.

There are two different types of funds worth looking at:

• Funds that have been around for a number of years. You can recognize these funds because they usually have a very low price per share. That's because they likely took a bath during the mortgage crash of the past 18 months.
• And new pools of capital that are being arranged to take advantage of the very opportunities I'm talking to you about right now.

Essentially, with these closed-end funds, there are two ways that investors can make money

The first way is for the value of the mortgages held to increase. If the weakest homeowners have already been foreclosed on, and a good percentage of the remaining borrowers are able to make their mortgage payments, then the value of these mortgage securities should increase sharply in 2010.

The second opportunity is the prices paid for these closed-end funds. Many investors are so scared of residential mortgage losses that they are paying less than the value of the depressed mortgages held by the fund. For instance, a fund might be holding $7 per share in mortgage investments, and the fund might actually trade for $4. So even though the price of the mortgage investments is extremely low, investors in the funds are paying an even lower price for the assets.

Buying these funds in today's market is not without risk. But it's a strategy that also offers a unique upside opportunity. If the value of mortgage assets rises, we should make a relatively attractive return. On the other hand, if mortgages remain stable, but the investor fear begins to wane, we will also see our investment climb.

But the best scenario is for both mortgage prices and investor psychology to improve. If both of these measures tick higher – even marginally – you could have a huge winner on your hands.

[Editor's Note:   Retired hedge fund manager Zach Scheidt is the editor of Taipan Publishing Group's Velocity Trader and Taipan's New Growth Investor. Scheidt spent the last 10 years managing investments for three private hedge funds, rubbing shoulders with some of the brightest investment minds in the business, and uncovering some of the most sophisticated profit opportunities in the marketplace.

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News and Related Story Links:

• Money Morning Special Report:
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• Money Morning Special Report:
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• Wikipedia:
  Mortgage-Backed Securities
• Site-by-Site:
  Closed-End Funds and ETF Data and Research