By Dale Westhoff, senior managing director at Bear, Stearns & Co.
At current valuation levels, we believe the Alternative-A non-agency sector represents one of the most attractive opportunities in the mortgage market for the following reasons:
Pricing assumptions are consistent with the current interest rate environment. Rate backups have a much more limited prepayment impact for Alt-A collateral than for jumbos, so the Alt-A sector is less susceptible to systematic mis-pricing of new deals in a bear market.
In contrast, the market pricing assumption for pure jumbo deals has been slow to change during the current rate backup, even though new deals are backed by collateral that is now at a substantial discount to market rates.
Alternative-A issues have an accelerated seasoning curve that counters extension. Prepayment lock-in is less of a factor in Alt-A paper because there is no single mortgage rate that applies to all Alt-A borrowers. In many cases, Alt-A borrowers can "situation cure" in order to refinance into a more attractive Alt-A product, or into a conventional loan. In addition, the generally high percentage of investor properties in Alt-A deals supports higher turnover levels in a flat or rising rate environment.
Nominal spread compensation is the same to 5 basis points wider than jumbo mortgages. The systematically wider spreads reflect the impact of a liquidity premium, as well as less investor familiarity with the sector.
By pricing the Alt-A sector against a benchmark with much more negative convexity, market convention makes Alt-A paper intrinsically cheap. This is a clear opportunity, particularly for buy and hold investors, to take advantage of the sector's superior prepayment performance.
Better convexity. The prepayment story has been outstanding in every market since the sector emerged in 1996. During the 1998 and 1999 refinancing waves, peak speeds in the Alt-A sector were between 22% and 48% slower than speeds for jumbo collateral with equivalent refinancing incentives.
Between April 1996 and June 1997, when the 30-year conventional rate ranged between 7.82% and 8.70% (the mean rate for the period was 8.28%), speeds for new 30-year Alt-A collateral averaged 10.67 CPR, versus 7.45 CPR for new 30-year jumbos.
Since the 1998 credit crisis, the sector has recovered in step with jumbos, despite narrower sponsorship by investors. The Alt-A sector has not suffered from permanently wider spreads after 1998, as have some of the credit-sensitive whole-loan sectors.
The Alt-A liquidity premium may or may not disappear with time, but the intrinsic performance benefits of the sector have a long and proven track record in all types of markets.