During the past couple of years, investors have treated residential MBS paper democratically.
During a hungry period, markets have been hardly differentiating among issuers, regardless of quality, capital and liquidity of the companies. This seller's market reflected an insatiable demand, as buyers scrambled to load up on product from any issuers, major or minor.
It was not always so. In the late 1990s, wider spreads reflected the shaky status of companies such as Conti Financial and First Plus Financial Mortgage Corp. Historically, the subprime market had divided itself into three tiers, which were highly correlated with the perceived financial strength of the issuing entities and their frequencies of issuance. More frequent issuers tended to have more issues outstanding, with larger groups of participants willing to hold their securities in the secondary markets.
The next question is whether tiering may be ready for a comeback. A highly articulated market could move toward more rational pricing, especially as synthetic CDO structures appear poised to reduce the gargantuan appetite for all paper.
New focus on collateral
"We have been seeing a new focus on characteristics of underlying collateral, as well as on the particular forms of credit enhancement," said Michael Youngblood, managing director of asset-backed securities research at Friedman Billings Ramsay.
As for the latter, he noted that wrapped securities trade higher than those with senior subordination, whereas pure seniors command better prices than those supported by mortgage insurance. Mortgage insurance may even represent adverse selection, and reduce the overall level of subordination.
"We have also seen a slight preference for regular issuers," Youngblood said. "It runs about two basis points on triple-A floaters and five basis points on triple-B floaters."
Youngblood reported that investors are also starting to scrutinize the risk characteristics of the pools more closely. They juggle many factors, ranging from weighted average LTVs, credit scores and debt-to-income ratios, to percentages of second mortgage loans, percentages of interest only and other innovative products, and even what portion of the pool may be located in California. Various participants weight the elements differently.
"For the past two years, we've seen no tiering of any kind," said Glenn Costello, managing director and co-head of Fitch Ratings' RMBS Group. "But if companies begin to show some distress, or if the collateral itself were to do very poorly, then we might begin to see it emerge."
Costello said the growing synthetic market could be associated with an increase in tiering.
"Sellers of credit default swap protection may be able to command larger premiums as that market evolves," he said. "And the new CDS market, which has recently redefined its pay-as-you-go contractual language, is an important development."
Costello, however, does not expect to see spread differentiation correlated to collateral quality.
"It would still be determined by issuer names," he said. "The strength and quality of the companies that service the loans is key."
Another changing factor has been the issuance of multiple shelves. Issuers have been delving into the same fungible loan pools of collateral for different deals.
"In some cases, very large and active issuers have broken their transactions into multiple shelves, and the resulting confusion could also lead to some wider spreads," Youngblood said.
Traders, he suggested, might distinguish between one particular shelf of originated loans and a second shelf of purchased loans.
"We have also seen some fresh signs of tiering," said Brian Vonderhorst, director of the RMBS Group at Standard & Poor's. "It's more market chatter than hard evidence, but some concern over the affordability products, like IO loans and option ARMs, may be prompting closer inspection of the underlying collateral."
Savvy traders
If investors are going to examine collateral pools carefully, they need to know what to look for. Various tools, such as S&P's Levels program, and those provided by LoanPerformance, can help to slice and dice the information.
"The mortgage market, which is dominated by highly specialized investment professionals, does not reward amateurs," Youngblood said.
The volume of residential loans has inhibited deep analysis compared to the CMBS field, which is driven by a more intimate knowledge of properties and a thorough understanding of cash flow characteristics.
"The proliferation of CDO issuers may end up sharpening the focus on residential mortgage collateral, leading toward the depth of disclosure and expertise we see in CMBS," Youngblood said.
The Levels program serves as a loan level collateral evaluation model. An originator, who licenses the model from S&P's, records its pool data on preformatted tapes. The information covers about 70 variables, including property type, FICO, LTVs, documentation, purpose, term, maximum ARMs as well as borrower and loan characteristics.
"The model produces foreclosure frequencies and loss severity at each rating level," Vonderhorst said.
Measuring tiering
If tiering does resurface as investors become choosier, how are we to quantify the new development?
"It is not easy to isolate exactly what aspect of spreads differentiation is due to tiering," Vonderhorst said.
As markets fluctuate from day to day, a large element of price movements is inevitably capturing broader macroeconomic perceptions.
The only scientific method to assess such observations would be to compare pricing for similar originators for deals trading on the same day. If it turns out that spreads are diverging, we might soon be returning to a more finely tiered market.
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