Smart shoppers for used cars know how to avoid lemons. Now buyers of residential mortgage-backed securities are likewise learning how to distinguish the bad from the good. That bodes well for healing housing finance.
Prices of privately issued mortgage bonds, which fell sharply earlier this year, have rebounded well since early March. According to Amherst Securities Group, a specialized broker-dealer, mortgage bonds backed by 30-year fixed-rate prime loans issued in 2006-07 are trading for a little less than 80¢ on the dollar, up from just 55¢ in March. Adjustable-rate loans rated in between prime and subprime and issued in 2006-07 are trading for about 60¢ on the dollar, up from less than 40¢ in March. That's evidence that buyers are scouting for value instead of treating the whole market as undifferentiated toxic waste.
Meanwhile, early repayments of principal are rapidly shrinking the $3.7 trillion pool of residential mortgage-backed securities that were issued privately during the go-go years, 2004 through 2007. The smaller the pool gets, the less trouble it can cause. When a borrower pays off a mortgage ahead of schedule, the owners of the mortgage-backed securities get their money back early, and the face values of their bonds shrink. The shrinkage is happening on both ends of the spectrum: Creditworthy borrowers are prepaying as they refinance into cheaper mortgages made possible by easy monetary policy. The least creditworthy, meanwhile, are losing their homes to foreclosure. That's cleansing the system as investors receive whatever the foreclosed house resells for (minus fees) and write off the rest of what they were owed as a loss.
Help from the Market
Amazingly, only $1.7 trillion worth of the $3.7 trillion in securities remains, according to Standard & Poor's Market, Credit, & Risk Strategies group (MHP), which, like BusinessWeek, is a unit of the McGraw-Hill Companies. All this even before the launch of the government's Public-Private Investment Program, which is intended to move those assets into stronger hands. "The market has kind of resolved a lot of the problem," argues Michael G. Thompson, the managing director who runs the S&P group, which is separate from the ratings group.
As any used-car dealer knows, you can't fetch a decent price for your good cars if shoppers suspect that all you have on the lot is lemons. In the mortgage market, that problem is slowly being solved through improved disclosure. Credit bureaus and loan servicers are getting better at disclosing the existence of second-lien mortgages upon request. An interindustry group called the American Securitization Forum plans to make second liens and other data available automatically starting in 2010. Spying an opportunity, companies such as LoanInsights of San Francisco are valuing iffy mortgage portfolios by figuring out how much of a hit investors will have to take on each loan that is underwater.
The mortgage market is far from healthy. Home prices are falling, and foreclosures keep rising. Rates on Fannie Mae and Freddie Mac mortgage bonds have spiked upward in recent days. "The fundamentals remain very negative," says Laurie Goodman, a veteran analyst who is senior managing director of Amherst Securities. Nevertheless, it's good news that the market is getting better at figuring out which assets are lemons and which have real value.
Coy is BusinessWeek's Economics editor.