A lot of the MBS paper is of pretty good quality. I know, there are a lot of risky mortgages around, with “foreclosure” written all over, but that’s the exception, not the rule. Let’s put things in perspective: if 5 out of 100 outstanding mortgages default, that would be the equivalent of “blood in the streets”. Complete crash and panic. Imagine 1 out of 20 houses in foreclosure. Really bad. But for the MBS holders, it may be not pretty, but not a disaster. They still get paid interest on 95% of their holdings, and the 5% that default won’t be a total loss (they unload the REOs, and still get something for them). If the interest rate they are paid is high enough, they might turn a profit even with 5% of hodings in default. Also, keep in mind that when these things are packaged into MBSs, they spred the risk not only over many borrowers, but over many markets, too.
Now for the bond ratings, yes, a lot of them can be AAA. Why not? Move-up buyers usually have both good credit and substantial equity from the sale of their home. Even in the worst of crashes, the rate of default in many segments of the market will be very low.
Now, there’s also subprime paper, where there is a large concentration of risky loand made to first-time buyers. That is likely to get hit much harder. Obviously, that is not rated anywhere near AAA.
As a final disclaimer, I don’t own any MBS paper (neither high-rated nor sub-prime), and I don’t recommend it either. Chances are, the returns on both will be lousy going forward, although I don’t think anybody will be losing their shirts on high-rated MBSs.
