The residential real estate market could be characterized as a buying panic. It seems that anyone and everyone who could afford to buy a house bought one, pushing home prices in many markets to record highs. Trouble is, some analysts fear that millions of these home-buyers stretched themselves too thin, using financial engineering (such as interest-only loans or adjustable-rate mortgages), to purchase their houses.
Now that they have, the investments that everyone thought were safe — residential mortgage-backed securities (RMBS) — may be far riskier than expected.
“A lot of consumers used nontraditional loans because they couldn't even get into a starter home without them, and now there's some concern that we might see some of those houses go back to the bank,” says Marilyn Bergen, co-president of CMC Advisers, a financial-planning firm in Portland, Ore.
Like most fixed-income investments, residential mortgage-backed securities attract their fair share of retail investors, though the bulk of them — about three-fourths — are purchased by institutional investors. Retail investors use them to diversify their fixed-income portfolios, but they also provide tastier yields than muni bonds and corporate paper; and they have the same load as other fixed-income vehicles, too. Mortgage debt is a huge part of the U.S. bond market, representing $5.2 trillion of the $21.3 trillion bond market. In comparison, corporate bonds account for roughly $5 trillion, while municipal bonds account for $2.2 trillion and U.S. Treasury bonds account for $4.1 trillion, according to the Bond Market Association.
A Piece of the Action
You can buy RMBS directly from the agency originators and through securities firms like Lehman Bros., Bear Stearns and Credit Suisse First Boston. Agency RMBS, paper that is issued by Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Association (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), accounted for $3.6 trillion of the bond market in 2005. Non-agency RMBS, often called private label paper, represented $1.1 trillion of the entire bond market in 2005, according to the Bond Market Association.
Alec Crawford, managing director and head of agency RMBS and strategy for RBS Greenwich Capital, recommends that average investors should have at least one-third of their fixed-income investments in mortgages, but warns registered reps to carefully review the individual mortgages that make up each RMBS.
Because residential paper is so readily available — the huge volume of home loans has provided plenty of securitizations — financial advisors and reps are having no trouble putting their clients into RMBS. But, a lot of non-agency RMBS are comprised of interest-only loan and adjustable rate mortgages, exposing investors to a default risk. In fact, Fitch Ratings, one of the nation's leading ratings agencies, predicts that U.S. mortgage delinquencies will increase 10 percent to 15 percent in 2006, damaging the yields on newly originated and seasoned RMBS.
Most investors choose agency-backed RMBS over non-agency RMBS because agency bonds have AAA ratings, notes Roelof Slump, a managing director with Fitch Ratings, which rates the credit quality of RMBS pools. However, plenty of retail investors have been seduced by the yields on private label paper, which can be as much as 250 basis points higher than agency RMBS.
That's not to say that many fixed-income experts think it's a good idea. At the recent Asset-Backed Security West 2006 Conference in Phoenix, a panel of industry players agreed that investors should avoid what they call layered risk — risk created by the types of loans that support the securities. “Those kinds of loans produce too many early defaults,” one expert said. “Trouble likely will not come until 2007, but it might arrive in 2006.”
“As an investor, I certainly wouldn't want to touch anything that's backed by those kinds of loans,” says Nate Cultice, a partner and certified financial planner at Santa Barbara, Calif.-based West Coast Financial. “I stay away from private label, because I feel like I can get a good enough yield for my clients from the agencies, and I don't feel the need to extend out into the private label area. I am concerned about institutions putting together pool that aren't worth anything.”
Recognizing RMBS Risk
Industry experts contend that the growing popularity of nontraditional loans has created a rise in so-called Alt-A RMBS. As a result, far more RMBS are supported by borrowers who are considered riskier than a traditional “prime” credit but not as risky as a subprime borrower.
Within the non-agency RMBS, the biggest growth has been in the Alt-A space. The volume of Alt-A RMBS surged in 2005 to a record of $425 billion, a 96 percent increase over 2004, according to Moody's 2005 Review and 2006 Outlook study.
“There's been huge growth of the Alt-A space and the designations have become somewhat convoluted,” Slump says. “It's very easy to identify a subprime and prime pool, but many originators have taken certain programs and tweaked them to call them an Alt-A program.”
The problem is that there is no true industry standard for Alt-A, says Frank Pallotta, executive director of correspondent conduits for Morgan Stanley. “There's enough gray out there to cause some concern among investors,” he notes.
In fact, Alt-A pools differ depending on programs and originators, according to Slump. “Retail investors really have to drill down to find out what is in the RMBS deal, including the originator, underwriter and borrowers,” he says.
Slump is not the only industry professional to note the differences in Alt-A mortgages. “My opinion is that Alt-A is a product that is not standardized across different originators,” Crawford of RBS Greenwich Capital says. “Each originator has different guidelines.”
Because Alt-A securitizations vary, their performance also varies, according to Moody's recent RMBS report. The agency sees a direct connection between the increased quality variance and poor performance. To that end, Moody's is forecasting delinquencies to increase in 2006.
With a nonperforming loan, the actual loss is passed on to investors, points out Mark Adelson, director of Nomura Securities International. “When a borrower defaults on a loan in the RMBS pool, investors lose a portion of their initial investment, and there's nothing they can do about it,” he says.
Mixing in Mortgage Mutual Funds
Even agency RMBS pose risk from prepayments and refinancings — in other words, how long will a borrower pay his mortgage before paying it off? With few exceptions, borrowers can prepay their mortgage even if it has a 30-year term. Prepayment is by far the biggest risk related to RMBS, Adelson says, which is why “investors who take prepayment risk get a higher yield.”
“Theoretically, an investor could get all his money returned at any time if all the homeowners in the RMBS pool prepay their mortgages,” Crawford says. “That scenario is highly unlikely, but for each loan that is prepaid, the investor must take that money and try to reinvest it.”
When interest rates are dropping, RMBS typically get paid off early, so the investor's return is cut short early. And, adding insult to injury, that investor will likely have to accept an investment that offers lower yields because of the interest rate environment. The flip side isn't much shinier, either. During periods of rising rates, homeowners will stick with their lower-interest mortgages through the full term, forcing investors to be stuck with a low return for years to come.
In general, RMBS offer positive duration like normal bonds, which have an inverse relationship to interest rates. However, there are some classes of RMBS that actually move up and down in concert with interest rates.
Discerning the difference between different types of RMBS can be a challenge and require for more research than other types of investments. That's why so many FAs steer their clients toward mortgage-backed mutual funds. “Mortgage mutual funds offer a really simple way to get involved in the sector without having to do any significant research,” Crawford says.
In particular, investing in mortgage mutual funds solves the tax issues that RMBS present (unlike Treasuries and municipal bonds, RMBS offer no tax benefits; they are fully taxable by state, local and federal governments. In a mutual fund, all returns of principal are immediately reinvested in other RMBS, allowing investors to capture higher-than-Treasury yields. Moreover, mortgage mutual funds offered reasonably attractive total returns with five-year, three-year and one-year total returns of 4.44 percent, 2.26 percent and 0.90 percent, according to Morningstar.
These returns may be enticing, but determining the best bonds to buy is quite complicated. “Reps and investors need to do their homework,” Crawford says.
RMBS 101: A GLOSSARY
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RMBS investors receive checks every month when homeowners make their monthly mortgage payments of principal and interest minus the fee that the mortgage servicer receives.
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Ginnie Mae RMBS are guaranteed by the United States. RMBS issued by Fannie Mae and Freddie Mac are also guaranteed, although not by Uncle Sam.
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All non-agency RMBS pools are rated by agencies such as Fitch Ratings, Moody's Investors Service and Standard & Poor's.
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All securitized mortgages fall into three categories: Jumbo Prime (also called Jumbo A), Alternative-A and subprime. Each category represents a different kind of borrower.
