The U.S. economy and housing market have stabilized, leading to a rally in some sectors of ABS and MBS.
However, the rally masks the fact that the housing market has yet to reach its bottom, and that will have a large impact on investment decision making in 2010.
Market analysts believe that the recent housing stabilization is a result of the shrinking share of foreclosures driven by moratoriums, but as this inventory works through its cycle, it is likely that the market will see an increase in foreclosure sales next year, which will add to total house price decline.
Although the housing cycle is getting closer to the end, Goldman Sachs Asset Management expects another 10% decline in home prices before the recovery truly begins.
There has been some measure of housing activity and house prices have been stabilizing, but it is likely that house prices will continue to fall again before reaching equilibrium by mid-2010.
Government Intervention
Jesse Litvak, a residential mortgage trader at Jefferies & Co., expects that the market in 2010 will see more fallout - or unintended consequences - from government involvement, particularly in the residential market space.
"The big one will clearly be the modification story and how that plays out," Litvak said. "My views on the modification angle are pretty straightforward. That is one big problem they have to tackle. I am hard pressed to see all the servicers actually make their way to these borrowers in a timely fashion. When you think about how many people are really in need of help, I'm sure the number is much larger than what the Fed/Treasury leads on."
The market has already seen up to 800,000 trial loan modifications in the Home Affordable Modification Program, or HAMP.
According to one market source, servicers expect one-third to become full modifications, although it is still uncertain what will happen to the other two-thirds of the equation.
"What happens to those homes very much affects what will happen to home prices, but a major concern is also that loan modifications that don't work straight out of the box may just delay the inevitable," the market source said.
Litvak believes that the modification risk to mortgage assets is one that should be taken seriously by all investors, noting that it will likely lead to certain servicers becoming more aggressive than others.
"This will ultimately lead to a lot more tiering in 2010 as the market gets a better handle on who is being successful in modifying and who is just kicking the can down the road. I think we can come to expect a lot more regulation in 2010," he said.
Addressing the Shadow Inventory
Figuring in the dynamics of a "shadow inventory" makes predicting the effects of loan modification ever more complicated.
In a recent report, First American CoreLogic estimated that a 1.7 million pending supply of homes was ready to hit the market as of September 2009. Also known as the shadow inventory, these homes are either in serious delinquency or in the foreclosure process. This new estimate from First American is up from 1.1 million a year ago.
At the current sales rate, it will take 3.3 months to run through the supply, up from 2.4 months last year. The amount of new and existing homes now in the market reached 3.8 million, a drop from 4.7 million a year ago. It would also take 7.8 months at the current sales rate to move through the existing inventory, dropping from 10.1 months a year earlier.
Combined, the pending and existing supply of homes reached 5.5 million homes in September, down from 5.7 million a year ago, and it would take 11.1 months to move through the inventory. That's down from 12.7 months last year.
According to the report, this indicates that while the existing supply has dropped and is about to approach normal levels, the injection of pending inventory will affect the housing market for the next few years.
What matters is how this pending inventory will hit the market. Unless banks disperse the shadow inventory onto the market at a controlled and measured rate, housing prices could double-dip again in 2010.
"This is one area within housing that is on a lot of folks' minds as a catalyst for a potential double-dip," Litvak said. "I would put this in the same camp as the modification storyline in that we will learn a lot more about how these assets are handled in 2010."
Litvak added that as long as this shadow inventory of foreclosed properties that these banks and the Federal Deposit Insurance Corp. are sitting on are not put back onto the market, housing could start to actually show some real signs of the bottoming process.
Solving an Oversupply of Outstanding Securities
A necessary step to restarting the market will be better constructed infrastructure and the overall demand for securitization to create a new price for market deals.
The Public-Private Investment Program (PPIP) announced last year will likely remain one of the major sources of support for both demand and prices in the non-agency sector in 2010.
"When the program was first announced, it was expected to be one of the bigger sources of demand, since it was the only program that had the benefit of leverage," Barclays Capital analysts said. "With the availability of inexpensive third-party repo leverage, prices in some sectors have rallied beyond the level at which it makes sense for the PPIPs to get involved. However, the program will likely play an important role in supporting prices in 2010."
According to Barclays, sectors such as Alt-A hybrid SSNRs still offer attractive PPIP yields of 18% to 20%. For sectors in which prices are too high to earn the required PPIP yields, PPIPs will remain a good backstop bid should prices go down.
Although the size of the PPIP is also below expectations - PPIPs have raised only about $5 billion in private capital so far out of the maximum possible $10 billion - the administration has promised to make $30 billion available as public equity and debt investment in the Public-Private Investment Funds (PPIF), bringing overall spending power to $40 billion when private capital is included.
"If there is any substantial widening in risk premiums from here, it will turn into an opportunity for the PPIPs to raise more money and support the market," Barclays analysts said. "This, along with the ability of the government to expand the program if required, should keep levels of non-agency prices fairly firm and not substantially below where they trade at the moment."
Re-remic issuance will likely be another source of support for prices in the non-agency sector. While re-remics could become impractical if unleveraged yields drop much further in the jumbo market, there is still some leeway in the alt-A sector.
The dealer community has also recently voted to start trading an ABX-like index for clean jumbo/prime passthrough triple-As in 2010 called the ABX.Prime (or Primex).
According to Litvak, during all of 2009, the market saw very high correlation between pricing in ABS and stocks.
He added that considering how highly correlated all capital markets have become, he feels that we are all part of one big bicycle wheel, with the stock market being the center of the wheel and all the other spokes following. "From all that I have read thus far, there seems to be an overwhelming view that growth is going to come back in a big way (already seeing that) in 2010, and that the unemployment rate will peak in 2010 as well," Litvak said.
But these predictions will work only to the extent that housing can stabilize.
Fed GSE Purchases Coming to an End?
One of the bigger questions that looms for the New Year is what will happen after the Federal Reserve stops purchasing GSE MBS that has thus far generated nearly $1 trillion of newly issued securities?
The Treasury department also stated that it will be ending its MBS purchase program on Dec 31, and that by then it will have bought $220 billion in agency MBS. Earlier, it had estimated purchasing $249 billion in 2009 and $60 billion in 2010.
It is a significant amount of purchasing that once ended could leave a huge gap in the potential supply of securities. The U.S. agency MBS market has so far exhibited strong price performance in 2009, supported largely by Fed buying. The end of the $1.25 trillion Fed purchase program should pressure spreads wider, but Barclays analysts believe there will be strong demand for this paper nonetheless.
"The Fed bought around $1.1 trillion in agency MBS in 2009 but net agency MBS issuance was less than $400 billion," analysts said. "That means someone sold the Fed the other $700 billion."
Most of the selling was from unleveraged accounts such as money managers and mutual funds, which together sold more than $300 billion in the first six months, or an annualized $600 billion, according to Barclays analysts. Many of these investors are benchmarked to the bank's indices.
They believe that these sellers will come back to buy when spreads widen.
"Most top fixed-income money managers are now sharply underweight MBS against their benchmark - after all, spreads are so tight that there was little upside in being long," analysts said. However, as spreads widen with the Fed's departure, demand should come back as index players move closer to market weight.
The GSEs also face a mandate to reduce their retained portfolios by 10% per year. Barclays said it's likely they will find it difficult to sell their non-agency MBS or whole loan holdings, which might put more pressure on the firms' agency MBS portfolios.
"In terms of the 2010 expiration of so many of the government's initiatives, the one thing that I keep coming back to is that I think if things were to ever break down again (post ending of buying agency MBS, for example), they will just turn the switch back on and start buying. Investing as we know it will always have the risk that D.C. chooses/feels the need to step back in the fray," Litvak said.
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