In the latest Amherst Mortgage Insight, Amherst Securities Group's Senior Managing Director in charge of research Laurie Goodman said that forecasting cash flows from month to month has become increasingly difficult.
But, despite this uncertainty, Goodman said that there is one trade that seems "obvious" given this framework, which is to sell subprime passthroughs and to buy super-senior pay option ARMs.
Goodman said that the cash flow uncertainty is much higher in subprime. Additionally, the yields are much lower in this sector. "Rarely does the market afford investors this obvious an opportunity, so do take advantage of it," Goodman wrote in the report.
She explained that not only is the yield higher on pay option ARMs, but there are other factors that also support this trade. She mentioned that cash flow uncertainty is much higher on subprime seniors compared with super-senior pay option ARMs.
Aside from this, the liquidation lags are also much more of an issue for the subprime sectpr since the coupon that is being advanced is much higher.
Goodman also said that future modification activity, which is not accounted for in most models, will impact subprime much more compared to option ARMs given that the gross weighted average coupon reduction is bigger. This results in the overestimation of subprime cash flows.
Predicting Cash Flows
Intially, the report discussed the difficulties involved in matching actual to expected cash flows. In other words, it is hard to match "the cash flows that have been received to those that would have been expected," Goodman said.
Goodman also talked about the the difficulties in forecasting future cash flows because of the uncertainty with the liquidation lags, modification activity, as well as the uncertainty regarding the severity to use in terms of both a cutback in servicer advances as well as the increasing time between the last payment and liquidation. Severity, in short, is itself affected by the liquidation lags and advances.
"With the continued growth of modifications, combined with increased uncertainty about when liquidation proceeds will be received, and the cutbacks in servicer advancing — cash flow forecasting has gotten increasingly difficult," Goodman concluded.
In the first part of this article, we discuss the difficulties in estimating what cash flows will be from
month to month. In the second, we discuss some issues in forecasting future cash flows. Finally, we wrap these thoughts into a trade idea, arguing that investors should be [selling subprime + buying pay option ARMs]. Subprime has a much lower yield in the base case, as well as more cash flow uncertainty.