The Federal Reserve cutting discount rates last Friday helped mortgages record an impressive recovery. For example, prior to the Fed action, the Lehman Brothers MBS Index was down 69 basis points month-to-date through Aug. 16. By Friday's close, mortgages had recovered 32 basis points to close down 37 basis points so far for August. Given the turnaround and Fed action, Lehman considers whether investors should add mortgage exposure, particularly non-agency triple-As. While risks still remain, analysts suggested adding non-agency triple-As, but staying below a full overweight.
Non-agency triple-As are trading wider than the wides of 1998, Lehman analysts noted. In addition, compared to every other asset, triple-A non-agencies look very attractive from a spreads standpoint: 30 to 40 basis points pick in spread versus triple-B corporates and nearly 100 basis points versus agency TBAs.
Analysts acknowledge that spreads can widen from current levels, but they remind that it is difficult to time the market perfectly. Investors instead should consider the answers to these two questions. The first is whether triple-As are fundamentally sound credit assets while the second is whether triple-A supply over a six-month horizon is likely to be contained.
To provide an answer to the first question, analysts conducted a severe stress test scenario where home prices dropped by about 12% annually for two-years and credit conditions remaining tight. This scenario would suggest subprime loss estimates could be as high as 19%, equivalent to 40% of borrowers defaulting, which Lehman said seemed onerous. Still, in such an extreme scenario, triple-A assets had loss coverage multiples above two.
Lehman also considered the risk that losses exceeded expectations enough to impact triple-As. In this case, the effect on the return is not "digital" and is rather gradual, they said. "If losses on alt-collateral were 20% (which is about five times our stress expectation), triple-As would still be positive-yield assets unlike double-A/single-A subordinates."
Analysts also calculated what losses would need to be for triple-As to yield Libor-flat returns. On Alt-A pools, collateral losses need to be nearly 10% to 11% for triple-As to yield Libor, they determined, which translates to 22% to 25% of the pool defaulting over life. They believe this would be unlikely, particularly as it would seriously effect the macro-economy with prime borrowers going into default, and would elicit some response from the Federal Reserve and the government.
Turning to the second question, Lehman says that in the short-term there are reasons to be cautious about technicals, but they are optimistic about net supply over a six-month horizon. Near term, there is potential risk of sales from conduit vehicles such as REITS. There are also the issues in ABCP and other short-dated financing that add to the technical risks. But Lehman believes that this could be overblown. Analysts estimate that only about $250 billion of ABCP assets are mortgage related. In addition, there is almost no mortgage exposure in multi-seller conduits that account for $750 to $1200 billion in ABCP outstanding, Lehman analysts said. Delving further into the numbers, Lehman estimated that of the "mortgage-heavy" ABCP without a liquidity put provider is around $30 to $35 billion. While still large, analysts say this amount is manageable.
Other factors favorable for the technical outlook is that total supply of new triple-A mortgage paper has dropped off tremendously, and with the Fed's action of Friday, the tone is a bit more positive for short-term credit.
Based on the answers to their two queries, Lehman recommended adding exposure to truple-As in the current environment.