Nimble Mortgage Bond Investors Needed As Housing Slows
Dow Jones Business News - September, 2006
By Danielle Reed
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--The slowdown in the housing market is making life tricky for mortgage bond investors - even those who are careful to buy only securities that are guaranteed by the nation's two largest housing agencies.
That's because those guarantees only protect investors against losses from outright homeowner defaults - but there are other ways to lose money when investing in this complicated asset class.
So far, the effects of the softening housing market have been gradual and haven't caused mortgage bond investors much pain. But if the slowdown gets more pronounced and the rate at which homes are bought and sold fall more steeply, there's a greater risk that mortgage bond prices will become volatile and lead to investor losses.
The advantage of investing in the roughly $4 trillion market for
mortgage bonds that are guaranteed by housing giants Fannie Mae (FNM) or Freddie Mac (FRE) - known as "agency" mortgage bonds - is that it's Fannie and Freddie, not the bondholders, who ultimately have to cover any losses incurred from loan defaults.
But despite these guarantees, agency mortgage bonds are still
vulnerable to a slowdown in housing. That's because the housing market affects the rate at which mortgage loans are paid off early due to refinancings or sales of homes. This so-called prepayment rate is a key metric for figuring out how to value mortgage bonds.
In a weaker housing market, this prepayment rate tends to slow. For the roughly 64% of agency mortgage bonds that can now be bought at a discount - a price below 100 - a slower prepayment rate diminishes their value.
Here's why: when investors buy discount mortgage coupons, they are repaid at 100 (100% of face value) when the mortgages underlying the bonds are paid off early due to refinancings or home sales.
For example, if an investor were to buy a $10 million mortgage bond at 99 - a price of $9.9 million - and if all the loans underlying the bond refinanced, the investor would get $10 million back. For that reason, high rates of prepayment are desirable for investors in discount mortgage bonds.
During the past couple of years, when the housing boom reached its peak, mortgage bond investors were seeing fairly high levels of prepayments on discount mortgage bonds. Taking Fannie Mae 30-year 5% coupons as an example, the percentage of loans in those securities that prepay in a year has been in the 10% to 12% range recently, whereas historically the norm has been closer to 6% to 7%, according to Amin Majidi, director of mortgage-backed securities research
for Deutsche Bank.
As a rule of thumb, each 1 percentage point drop in the annual rate of prepayment would probably bring discount coupons a point lower in price, said John Sim, a mortgage-backed securities analyst with J.P. Morgan. So with Fannie Mae 30-year 5% coupons now priced at 95 24/32, a 1 percentage point drop in the prepayment rate would bring the price down to 94 24/32. With discount mortgage bonds "you're relying on prepayments heavily to support the price of the bond," Sim said, "so those are the ones that feel it most" when housing slows down.
From Hot To Cold
Investors who pay a slightly higher price in order to buy bonds that are backed by specific kinds of mortgage loans - for example, an investor might want only loans from California, and only loans on single-family homes where the borrowers had a down payment of at least 20% - also have to be careful in terms of predicting how a slower housing market will affect the value of their bonds.
According to Michael Bykhovsky, president and chief executive of mortgage-backed securities analytics company Applied Financial
Technology, investors in these kinds of "specified pools" of mortgage loans (and bonds backed by them) can all too easily make wrong assumptions about the rate at which mortgages will be refinanced and/or the rate at which houses will trade in states like California. And not predicting the rate of prepayments correctly can cost investors a lot of money, he said.
"There is very much a misunderstanding prevailing in the marketplace about geographic differences," he said. California is seen as a state in which houses change hands and mortgages are refinanced fairly quickly, for example. But in the past five years, California has experienced fairly dramatic house price appreciation. That has lead some homeowners to refinance their mortgages and/or to sell their homes and trade up to bigger homes when in a more normal housing
market they might not have.
As soon as home price appreciation reverts to a more normal pace in California, Bykhovsky said, "we think California will be one of the slower states" in terms of the rate at which mortgage loans are paid off early, assuming similar types of loans are being compared.
Investors in some mortgage derivatives - for example, bonds that carve up standard home loans by separating the mortgage interest payments from principal payments into "interest-only" and "principal-only" bonds - are also highly vulnerable to a slowdown in housing. For investors in interest-only (IO) bonds, a slowdown in the rate of mortgage refinancings and home sales is good, since it means the interest on mortgages backing the bonds will continue to be paid (and the investors will see returns) for a longer period.
But if the rate of prepayments doesn't slow as much as investors are anticipating, they could be paying too high a price for the bonds, Bykhovsky said. And the reverse is true for principal-only bonds (POs) - if prepayments slow more than anticipated, investors will have to wait longer to be paid.
Finally, investors who have bought certain classes of bonds in
collateralized mortgage obligations (CMOs) - structured bonds backed by pools of mortgage bonds - may see the effects of a slowing housing market amplified. The bond classes in some CMOs known as "companion" or "support" bonds, for example, are set up to receive the cash from the majority of mortgage prepayments ahead of other bond classes. Those support classes would therefore feel any change in prepayment rates more intensely.
In general, for all types of mortgage-backed securities investors the problem of predicting how fast the collateral underlying bonds will be paid off becomes trickier and the effects more magnified in a changing housing market. "The whole reason" for investing in mortgage bonds "is your belief you can manage prepayment risk better than the next guy," Bykhovsky said. But when the market starts to change, predictions of how that slowdown will affect mortgage refinancings and sales can be off, and mispricings of securities can happen "throughout the mortgage market," he said.
-By Danielle Reed, Dow Jones Newswires; 201-938-2039;
danielle.reed@dowjones.com
Copyright (c) 2006 Dow Jones & Company, Inc.
