At least half-smiles must be creeping across the faces of home equity ABS investors, as even the most notoriously bearish participants collectively shift their outlook on rising long-term interest rates. While Treasurys are expected to rally on anticipation of lower-than-expected long-term interest rates, adjustable-rate assets should also enjoy fewer defaults and delinquencies in that scenario, analysts say.
If the Federal Reserve is truly in the "eighth inning of a tightening cycle," with a ninth inning approaching in June, as Richard Fisher, head of the Dallas Federal Reserve Bank and FOMC voting member said the preceding week, the risk of mortgage loan default is substantially diminished, according to research released yesterday by Merrill Lynch.
At least in the short term, that bodes well for CDOs full of home equity ABS assets, more and more of which are hybrid and adjustable-rate, qualities which make borrowers vulnerable to "payment shock" when the honeymoon period of low rates ends and higher payments begin. Future low rates would keep excess spread in the assets intact, consequently maintaining the structure's available funds cap, according to Merrill.
"In our worst case scenario, even moderately higher rates and near-flat home prices growth, on their own, are unlikely to cause losses in the typical mezzanine [home equity] ABS tranche," the report states.
According to Merrill, a rise in Libor of more than 50 basis points is unlikely, and most deals start with about 4% excess spread - creating a substantial cushion protecting the available funds cap. Fitch Ratings estimates that it would take a 3% increase in Libor to trigger the AFC in a triple-B home equity ABS; Merrill pegs that number at 500 basis points.
Merrill's interest rate committee on May 25 said it expected the Federal Reserve to actually cut rates early next year, effectively lowering the federal funds borrowing rate to 3%. The bank's economists are predicting no more than a 50 basis point rate hike this year.
U.S. Treasurys fell last week, however, as investors speculated that Federal Reserve Chairman Alan Greenspan's Congressional testimony Thursday meant continued measured increases in the federal funds rate, indicating an earlier inning than the eighth. Movements Thursday on fed funds futures on the Chicago Board of Trade suggested a majority of traders anticipate a federal funds rate of 3.75% in November, according to Bloomberg.
But one managing director said his firm's future rate outlook for 10-year nominal Treasurys did not change following Greenspan's testimony Thursday and that a rate of even 3.5% isn't expected anytime soon.
Although, a future low-rate environment is bittersweet.
Some view all the liquidity sloshing around due to low rates as a threat to the current financial market, which has grown increasingly levered. A sputtering economic environment could negatively affect such structures as CDOs and real estate if investors become disenchanted with lower yields, PIMCO points out.
As PIMCO's Bill Gross recently stated in research, "if institutional and retail investors in levered products become increasingly disenchanted with quarterly/annual returns, an unwind of levered structures could take place even in the face of continued economic growth."
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