The MBS market has been buoyed up by low volatility and demand from banks in 2006. Coming into the new year, whether these positive factors would continue to drive performance is a big question mark. And, like everything else, there is the specter of deteriorating credit that is hovering over the prime market.

One issue that is going to be prominent in 2007, according to MBS analysts, is credit. "I think there's a potential that there might be more issues with originations from some small mortgage lending firms," an MBS analyst said. Even though prime investors are still expected to worry more about prepayment risk rather than credit risk, there is the fact that "although there used to be dividing lines that clearly demarcated the Jumbo, the Alt-A and subprime sectors, you can't just do that anymore. Credit has become a continuum." He said that sometimes what shows up as Alt-A, may look solid based on FICO scores, but there are other factors that might affect the credit of the borrower such as CLTV and the level of documentation. "There is a more layered risk in the mortgage market now, most notably with the non-traditional' loans," he said. Although he downplayed the risks, he pointed out that since the market for credit product has become so widespread with the strong CDO bid in place, there are fears that issues in the subprime market could cascade into the prime side as well, particularly in the Alt-A arena.

In terms of demand, the analyst said that the securitization market is being driven by an overwhelming demand for Libor floaters, specifically European investors who are more likely to be investors in credit. In contrast, Asian investors are much more diverse and have different investments styles, including some large investors that manage to the major bond indices. Traditional fixed-rate managers are not concerned by the fact that the spread over their cost of funds does not give them enough return, as long as they outperform their benchmark. But for other investors that manage a spread over funding cost, the thinking is, why take on duration and price risk when you're upside down in your funding. This makes participation in the mortgage market spotty, with banks less involved in fixed-rate products and more inclined to buy floaters, the analyst said.

Although low volatility was a big positive for mortgage-backeds in 2006, this run might not hold for the next year, analysts said.

Art Frank, a director in the MBS strategy group at Barclays Capital, said that declining volatility as a source of returns "probably won't be there in 2007." He added that the a steeper curve, which is generally good for MBS probably won't happen over the first half of the year, with the Barclays' economics department predicting that the Federal Reserve cuts expected by many for the first half of 2007 are not likely to happen. Aside from the possibility of increasing volatility in the mortgage market, Frank said that home prices declining should also play a factor in pushing down mortgage performance in the coming year. He noted the Office of Federal Housing Enterprise Oversight report that HPA is getting slower, indicating a weaker housing market. This is expected to result in slower discount speeds - a clear negative for MBS. These speeds are driven in a high HPA environment by cash out refinancings, which usually slow down in a less robust housing environment.

Aside from these two negative factors, there is also the drawback of diminishing demand not only from the GSEs, which, according to Frank, are still a presence in the MBS market but are only "buying to replace paydowns but are not growing their respective portfolios." Some banks have also reduced their security portfolios as well, with deposit growth slowing a bit, although other banks are still buying mortgage-backeds.

However, despite these negative factors, Barclays Capital has stayed neutral on mortgages, pointing out two factors that might buoy up the sector's performance. The duration bid from long-duration investors such as pension funds is expected to continue. Also, Asian buying is expected to be robust from countries like China and Japan.

Aside from this, there is more certainty in terms of the passing of the GSE regulatory reform bill. According to a Barclays report, with Democrats taking over control of both houses of Congress in January 2007, the prospect of GSE regulatory reform passing next year seems "fairly bright." Aside from this, the Treasury Department, which, according to the report, has long insisted on a highly restrictive portfolio cap has "recently withdrawn from the position in the fact of the 2006 midterm election results and strong Democratic opposition to such a provision." Thus the report said that it is unlikely that the President would veto the bill. The report concluded, "There are always things that can go wrong in Congressional negotiations, but we think there is about a 60% chance of a GSE regulatory reform bill being enacted into law in 2007." Also, it should also be noted that Fannie Mae's financial restatement for the January 1 2002 to June 30, 2004 was at least neutral, or even arguably, according to Barclays, positive news for the credit quality of the agency's debt and MBS holdings. "In a sense the board of directors' decision to restore 54% of the dividend cut made in Q1 05 tells us as much about the financial health of the company as the 358 pages of the new 10-K, " the Barclays report said.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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