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March 16, 2006

Bond Banter: ARM in ARM

Lauren Young

I've been covering fixed-income for a long time. And while I'm the first to admit it can be a snoozy topic, lately it's a little more interesting to write about. That's because everyone has a different opinion on what's going to happen. For example, rising interest rates and the proliferation of adjustable-rate mortgages make Didi Weinblatt, portfolio manager of USAA GNMA Trust Fund (USGNX), jittery. But Andrew Clark, senior research analyst at Lipper, isn't too nervous.

Weinblatt, who recently came to visit me on a chilly New York day from sunny San Antonio, is especially worried that fixed-income investors could take a significant hit if homeowners default on their mortgage payments. "It seems like a market ripe for something bad to happen," she says.

Weinblatt's nightmare is a jump in interest rates combined with a drop in property values. That would spell disaster for holders of adjustable-rate mortgages, which now account for more than one-quarter of all U.S. mortgage debt. ARMs automatically reset as interest rates move, so if rates rise, they can quickly add hundreds of dollars to monthly mortgage payments. High rates would make it really tough for lots of already-cash-strapped homeowners to cover their mortgage payments. Yikes!

Even worse, if the housing market collapses, more mortgage defaults could occur if homeowners stop making payments on a mortgage that is worth more than the house, Weinblatt says. "Now the house is worth less than the mortgage--you can just send the keys to the bank," Weinblatt says.

As a result, I recently asked Lipper, which has great bond holdings data, to run a screen of bond funds with hefty holdings of adjustable-rate and interest-only mortgages.

But I had no luck because these bonds are lumped together in securitized portfolios and incredibly tough to weed out. "We do have a separate classification for ARM funds but not ones that hold IOs and unfortunately, no easy way of finding funds that have a sizeable exposure to them," Clark says.

Even so, Clark thinks a significant turn-up in mortgage delinquencies or personal bankruptcies where the house will go into foreclosure will have a small impact on mortgage funds. "That payment on the loan is guaranteed first by the bank that issued the mortgage and as most of the ARM funds buy Fannie or Freddie paper, Fannie or Freddie is in second position on the payment, i.e., if the bank cannot make the payment, the agency will," he says.

He points to the late 1980s and early 1990s when housing prices fell quite rapidly while rates were being ratcheted up. "I am not aware of any problems either fixed or floating rate funds had during this period when home values fell about 20% - 33% on average nationally and, in some places, 50% or more," he says. What was affected, to a limited extent, was the mortgage-backed securities market itself, as the credit ratings on certain banks fell and this made it more difficult for them to sell mortgages into the market, be it to the agencies, the investment banks or to anyone else.

Finally, any ARMs or IO mtgs that were sold as a non-conforming pool will carry a greater risk of non-payment. This is because the bank is the one and only guarantor of these mortgages and the bank?? ability to pay is what stands between the investor and her payment.

Clark says these loans do bare some watching, though. How do you know if your fund holds potentially dicey debt? "They can be found easily in the fund?? prospectus as they will have an individual bank or other entities name attached to the security," Clark says. "It will not be listed as a Fannie or Freddie security."

12:29 PM

Mutual Funds

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yes, if interest rates rise monthly mortgage payments will increase automatically.

regards,

http://www.stocksatbottom.com

Posted by: lisa at August 9, 2006 03:23 AM


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