The spreads on the subordinate tranches of RMBS might have narrowed from the wider levels achieved in the final months of 2005, but the outlook for the performance of the residential housing market is not necessarily better - or worse - than before.
According to Bear Stearns analyst Gyan Sinha, it would be "hard to point out" any prior year in which exuberant investors, unleashed from year-end balance sheet restrictions, tightened spreads by piling into structured finance bonds, a phenomenon often seen in the equities market. "The idea that investors park money on the sidelines waiting to deploy it at the turn of the year is not new, but the effect has been relatively muted in most years," Sinha wrote last week, "A confluence of events appears to have changed history in this regard."
For example, spreads on Baa1 cash RMBS bonds were at 190 basis points, 250 basis points and 350 basis points, respectively, as of December 5. By January 8, spreads had moved out to 150 basis points, 190 basis points and 290 basis points. As well, the basis between cash and synthetic spreads on the same bonds had moved from -50, -35 and -25 to -30, -15 and -20 for triple-B plus, triple B, and triple-B minus RMBS bonds, respectively.
Those events would include the recent rash of buying home equity ABS credit default swap protection from hedge funds and others looking for a new way to short the housing market. The activity caused a degree of volatility within the sector that hadn't been seen in some time. And, as Sinha pointed out, the widening caused the return-on-equity for some ABS CDOs to reach beyond 20%, and CDO deals with tight liability structures also viewed the asset markets as fundamentally cheap, he wrote.
But aside from recent tightening, Sinha and others are anticipating that uncertainty in regard to the housing market's outlook, among other factors, will lead to spread volatility within the sector - at least in the near term.
HEL performance mixed
Performance indicators so far have been relatively unclear, and most forward-looking estimates rely on future interest rate and gas price estimates. The American Bankers Association last week echoed this sentiment. While the organization reported a 42 basis point drop - or 2.33% - in home equity loan delinquencies in the third quarter of 2005, the organization warned that short-term interest rates could pinch consumers' budgets too far. Meanwhile, the ABA said that positive factors such as economic growth and lower gas prices could help push consumers along with timely mortgage payments. Home equity line of credit delinquencies were up by three basis points, or 0.46%, according to the ABA, while property improvement loan delinquencies also saw an uptick in the third quarter, to 1.55% from 1.52%.
"The persistent interest rate increases by the Federal Reserve and record high gas prices in the third quarter provided a one-two punch that continued to inflict pain on personal budgets," said James Chessen, the ABA's chief economist, in a statement last week. Chessen added that the full impact of Hurricane Katrina has yet to be felt.
Agency MBS: headed
On the agency side, Margaret Kerins, a U.S. agency strategist with RBS Greenwich Capital, is anticipating spreads to trade "directionally with the level of rates and shape of the curve in 2006," she wrote last week, "The historical relationship between spreads and rates suggests that in a flat yield curve, relatively low rate environment, front-end spreads are fair. Longer-end spreads are rich, but we think that is justified by the lack of supply."
Kerins added that a worst case scenario for agency spreads would include heavy agency supply coupled with low Treasury supply, high headline risk and an inverted yield curve - causing spreads to widen to resist inversion. For 2006, those types of risks do not pose a threat to agency spreads. The big risks, instead, stem from competing products; foreign demand; and cheapening of agency arbitration, which would result in portfolio growth, Kerins wrote.
Meanwhile, Citigroup wrote last week that even though seasonal patterns may be providing a "short-term boost for the mortgage basis, increased supply is likely to quickly overwhelm this positive. We recommend caution on the mortgage basis."
Citi is anticipating more agency fixed rate net supply in the first part of this year due to a combination of a flatter yield curve and greater regulatory oversight on the so-called nontraditional mortgage products. The push toward fixed-rate origination, which began in the latter end of 2005, should be amplified by a purchase-driven atmosphere. As well, ARM prepayments should show more of a slowdown than their fixed-rate counterparts. These, among other factors, will increase agency supply - causing Citi to recommend conservative strategies for agency MBS going forward.
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