NEW YORK - With the ARM sector and Asian investor interest increasing significantly, the MBS landscape is changing compared to how it was just a few years back. MBS market participants at the Bond Market Association's annual meeting held here last week discussed how they are dealing with these changes and highlighted their views on current mortgage valuations and housing sector trends.
Bear Stearns Senior Managing Director Dale Westhoff said that the mortgage market is currently transitioning into a purchase environment after being dominated by refinancings in recent years, noting that there is increased market uncertainty in a rising interest rate environment as prepayment models have been calibrated for a lower-rate scenario, or to reflect the 2000 experience. He also noted that the housing market, which he believes has peaked, is now facing a "perfect storm" scenario, adding that he expects a prepayment speed compression on a relative coupon basis going forward.
Westhoff's remarks echoed a lot of what participants in the Investor Outlook and Opportunity panel focused on, specifically his views on the housing market. Panelists expressed concerns about how further Federal Open Market Committee moves to tighten could bankrupt the marginal or subprime borrower. They added that subprime market data in the last five years is "meaningless" as it does not reflect the recent growth in affordability products. Panelists expressed concerns about slowing home price appreciation and its negative impact on subordinated debt, specifically in light of decreasing credit support levels. Some said that they would rather have more triple-A exposure than get paid for taking on additional risk.
Stephen Gallant, senior vice president at ING Investment Management, said that the housing market poses a big risk, noting that rating agency models have not properly accounted for the delinquency component. However this is a "slow moving issue," Gallant said, that would take about two to three years before the real impact would be felt. Gallant also voiced his concerns about the rise in application fraud and low documentation stated-income loans.
Michael Buttner, senior vice president and asset manager at Wachovia Corp., said that he is concerned about specific geographic pockets and this plays a part in their security selection. The future state of the housing market would play out depending on future FOMC moves. However, Buttner believes that the Federal Reserve would not want to cut out marginal or speculative borrowers as it would be detrimental to the housing market. Buttner also raised doubts about the housing sector's sustainability and from a cyclical standpoint, he speculated on when the market's performance could take a turn for the worse.
Panelists also discussed two major changes in the mortgage market - the influx of Asian investors and the significant increase in ARM production that is "cannibalizing" the fixed-rate sector, with a few of the participants pointing out that with the movement into ARMs, there is now less mortgage convexity to manage.
In his opening remarks, Tom Marano, senior managing director at Bear Stearns and chair of the BMA's MBS and Securitized Products Division, said that the growing ARM share - which implies increased credit risk - has created challenges for investors and dealers in terms of modeling and servicing technology. Traditional fixed-rate investors are now compelled to consider the ARM market while many hedge funds are moving into ARM IOs.
Panelists also noted that the increasing presence of Asian buyers would pose a challenge for traditional MBS investors, especially with the GSEs currently playing a lesser role. In his remarks, Marano noted that aside from Asian investors, more European and Middle East buyers are emerging as cash purchasers, which is uncharacteristically unrelated to CDO activity. In the past, these investors were more on the credit side of the equation.
W. Scott Simon, managing director a PIMCO, said that many participants are pointing to the influx of Asian investors for making MBS pricing rich. He said that although this could be a factor, the fundamental reason for the rich market valuations is the dearth of risk premiums across the board. He also noted the growth in hybrid ARMs contributes to the rich levels, as it has decreased mortgage market convexity.
The emergence of new marginal MBS buyers is making investors wary. Daniel Choquette, senior vice president at Putnam Investments, said not knowing what these marginal buyers are going do - when they are going to buy or sell - is making them extremely defensive. Another concern raised by panelists is the possibility of significant and accelerated liquidation by Fannie Mae and Freddie Mac in light of their increased capital requirements.
Although panel participants expressed concern over the future of GSE MBS participation, they said that bank demand is more certain. Despite the recent uptick in C&I loans, banks still have a considerable deposit base for them to continue to hold securities, panelists said.
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