NEW YORK - As the world's economies head toward globalization and the fixed-income markets become more volatile, it is becoming impossible to remain competitive by doing what one is expected. To provide a clue as to how to effectively manage these volatile times, Credit Suisse First Boston offered ways for investors to see beyond the obvious in a roadshow conference last week.
"We're living through very interesting times, for better or for worse," said David Montano, head of mortgage-backed securities strategy.
David Goldman, global credit strategist, said that the difference in the market as it existed two years ago and the one that exists today is "like night and day." The Russian default crisis in 1998 is seen as the major shift in the market. He said that if you try to do the obvious, you would not be competitive in a global market.
Members of CSFB's securitized assets research team provided an array of ideas to manage risk and made some predictions for the market going forward.
Ginnie Mae Prepayment Risk
With housing starts at 20% to 25% above their historic 10-year average, the "benign prepayment problem" that greatly varied according to geographic region has become "boring," according to John Vibert, MBS prepayment strategist.
He noted that seasoned Ginnie Mae prepayment speeds are generally faster than conventionals, with 1996 and 1998 production seasoning very quickly. Ginnie Mae 1999 and 2000 production "should manifest a more traditional profile associated with first-time homebuyers and high LTVs," Vibert said.
Because there is no sign of a housing recession, he predicts that Ginnie Mae prepayment speeds are likely to remain "conventional-like" long-term as mortgage insurance fund payments elevate relocation or refinance incentives.
Also, Vibert added that because the only way to alter a Federal Housing Administration mortgage - loans that are securitized by Ginnie Mae - is to buy it out of the pool; until the FHA reworks its buy-out policy, buy-out activity will persist.
ABS Tail Risk
Combating tail risk on asset-backed securities has become another prominent issue facing fixed-income markets. Tail risk is the losses that occur late in the life of an ABS collateral pool, usually ranging from four to five years on home equity pools, seven to eight years on manufactured housing, and 2.5 years on automobile.
Eugene Xu, strategist in subordinate ABS/MBS, says that there are two ways of looking at tail risk, and those opposing views will shape the future of tail risk.
The first method of looking at tail risk is "adverse selection," in which loans with high-borrower credit will prepay earlier as the pool seasons, leaving lower quality loans in the pool. Therefore, higher losses will be assumed in a seasoned pool.
However, in the "diminishing prospect of losses" theory, loan-to-value ratios will become lower by the time of seasoning, as home prices appreciate over time and mortgage balances are paid down. Seasoning will weed out the troubled loans, as Xu stated that 70% of loan problems are caused by origination, and 30% by servicing. "Because of the release of high-profile loans, ill-originated loans will be weeded out," he said.
Because many deals are structured to satisfy rating agency criteria, Xu said, those rating agency models may overestimate or underestimate tail risk. Therefore, he suggests "investors to be more cautious when examining a triple-B home equity or manufactured housing bonds."
Also, he said there is more value in mezzanine pieces of those assets. "Single-A is relatively attractive," said Xu.
Mortgages and Relative Value
With a decline in government bonds and "unprecedented yield-curve volatility," Montano has suggested the need to find a new benchmark for mortgage products. While CSFB has suggested the London Interbank Office Rate (Libor) or swap curve be used as the benchmark, agencies seem to be the more feasible debt benchmark for mortgages.
The key to a benchmark is its liquidity, and Montano says that swaps are fairly liquid as long as spreads are stable. But mortgages and agencies are stable, and agency debt must find a way to separate itself from swaps. "Agencies have to differentiate themselves from swaps," he said. They "must break Libor minus-30 consistently."
He noted that a mortgage yield curve cannot invert, and next to Treasurys, mortgages are the most liquid.
Montano also stated that the inverted yield curve has helped mortgage rates remain stable. "Mortgages depend on the entire yield curve for value," he said. "Because rates have been stable for a couple of months, that's a big positive for mortgages."
With an agency futures market taking shape, Montano said that liquidity should increase for agency debt. And as supply dwindles, technicals will play a more important role, while mortgage rate volatility should remain low. He recommends up-in-coupon trades.
TBA Hybrid Market Emergence
Two proposals are currently on the table to help create a more standardized hybrid to-be-announced (TBA) adjustable-rate mortgage (ARM) market. One is being presented by the Bond Market Association, and the other is a part of President Clinton's budget that will allow the FHA to guarantee hybrid ARMs up to 10/1.
Glenn Boyd, mortgage strategist, said that TBA Ginnie Mae ARM originations increased from $100 million in October 1998 to $1.2 billion in October 1999. He is predicting $2.1 billion for each of the months of April and May.
"Hybrids are priced inefficiently," he said, noting that these proposals, if passed, will bring standardization to a fragmented market, letting TBA pool issuance take off once standards are put in place. "MBS issuance is declining; hybrid issuance is not following originations."
Hybrids have jumped to 13% of ARM originations, from 4%, leaving balloon loans to fly away. Boyd said that 5/1 hybrids "are clearly the winner."
Boyd also predicts that investors should buy 5/1 hybrids and the Ginnie Mae 6.5 March/April roll, and that spreads are likely to tighten based on the long-term TBA market.
CMBS in the High-Tech Economy
Upstart e-commerce companies have begun filling up vacant office space and constructing industrial warehouses. This has left the commercial mortgage-backed securities market as a born-again pioneer.
Gail Lee, CMBS strategist, said that 90% of all venture capital funding over the last year has gone into high-tech, with some of that spilling over into the CMBS market. She pointed out that the states with the most venture capital funding also had the largest CMBS issuance.
However, she said, "the shopping center is not museum-bound. It's not going away. Developers have always found ways to innovate." She said that commodity-type items such as books and compact discs will be more affected by the Internet economy than "try-on" items such as clothing.
Also, with office and retail sharing the same amount of the CMBS market - about 28% each - there is room for both to grow. Companies are often signing leases with "obsolete" buildings, often with a two- or three-year security deposit and a 15-year term.
However, the industrial sector, with only about 8% of the market, has held its own and remained fairly stable over the years, with more construction to be seen. New construction, though, will be more highly specialized space, located next to airports.
On a final note, Lee noted that if there is going to be a recession, it will be more demand driven, rather than supply driven.