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Defaults in the subprime mortgage arena raise fears that the malaise might spread. But diversification reins in the risk for bondholders
According to the Mortgage Bankers Assn., an industry trade group, delinquencies in mortgages of all types rose to about 5% in the fourth quarter of 2006, the highest level of late payments since the second quarter of 2003. Actual foreclosures edged up to 1.2%. In the subprime segment of the market, the scenario was decidedly worse. Delinquency rates rose to 13.3% in the fourth quarter of 2006, while the foreclosure rate climbed to 4.5%.
Over the past year, a rise in early payment defaults has led dozens of mortgage lenders, including New Century Financial, to either file for bankruptcy or exit the business entirely. Large brokerages and banks, including HSBC (HBC), have warned of huge losses arising from their subprime loan operations.
Left Holding the Bonds
According to Randall Bauer, a fixed-income portfolio manager at Federated Investors, the total U.S. mortgage-market value is estimated at $9.5 trillion to $10.5 trillion, with about 15% of the total represented by subprime assets.
While the problems for subprime borrowers and lenders appear clear, the impact on mortgage bondholders depends on a variety of factors. Some mortgage bonds, such as those issued by the Government National Mortgage Assn. (Ginnie Mae or GNMA), are guaranteed by the federal government and bear no credit risk.
Bauer says the current crisis was facilitated by the housing boom of the past few years, which caused a substantial expansion of mortgage credit, particularly in non-traditional areas like subprime.
"Over the past five years, lenders got more aggressive in the types of mortgage loans they were willing to underwrite, leading them in many cases to loosen standards," he notes. "Investment banks and brokerages expanded their activity in securitization—the process of bundling mortgages into collateralized mortgage obligations (CMOs) and selling them as bonds, backed by loan payments, to investors hungry for higher yield in an environment of low interest rates."
Fuel for Speculation
This allowed more people with poor credit and low income to purchase homes, Bauer says, and also fueled a significant speculative element in the marketplace. Hence the explosion in both the subprime business and the Alt-A market, where mortgages are made to borrowers who have better credit quality than subprime borrowers but do not conform to standard agency underwriting guidelines.
According to the Securities Industry and Financial Markets Assn. about $2.12 trillion of mortgage-backed bonds were sold to investors in 2006. Of that sum, about $540 billion are backed by subprime mortgages, Bear Stearns estimates.
Mortgage-backed securities have been the largest sector of the bond market for many years, exceeding Treasuries and corporate bonds. Essentially they are bonds that represent claims to cash flows from a pool of mortgage loans. The loans backing these bonds are issued by various mortgage lenders, savings and loans, commercial banks, and others.
Safety in Numbers
The MBSs themselves are typically issued by quasi-governmental entities like Ginnie Mae, or federally chartered enterprises like the Federal Home Loan Mortgage Corporation (Freddie Mac) (FRE) and the Federal National Mortgage Assn. (Fannie Mae) (FNM). These mortgage securities are high quality and carry essentially no credit risk. Investors are guaranteed interest and principal payments, but are subject to prepayment risk.
Mortgage-related securities found in mutual bond funds may be structured as collateralized debt obligations (CDOs). These vehicles purchase pools of mortgage bonds (or other CDOs) and like the underlying CMOs they invest in, segregate risk into "tranches"—the upper tranches are generally considered high-quality assets since the lower tranches are the first to absorb losses in the underlying pool.
This configuration helps to diversify risk; however, it's difficult to sell the senior-tier securities before unloading the lower-tier assets. When this process is applied to pools of subprime mortgages (or any mortgage pool, for that matter) and the quality of the underlying mortgages deteriorates, the lower tranches in the structure become much more vulnerable to loss.
Slow Deterioration Forecast
Jeffrey Gundlach, the chief investment officer of TCW Group and manager of the TCW Total Return Bond fund (TGLMX), believes some perspective is necessary. Gundlach, whose fund has no credit exposure to subprime assets, notes that the recent rise in delinquencies among risky mortgage owners has not been dramatic, but likely presages a long, slow-moving period of deterioration. "Subprime delinquencies were at 13.3% in the fourth quarter of last year," he says. "But two years ago, that figure was at 10.6%; that's really not such a big jump. Subprime has been notorious for systematic ongoing delinquencies."
Bondholders exposed to high-quality agency-issued mortgages have nothing to worry about, Gundlach says. "I've told people for years that our Total Return Bond Fund has no credit risk. We have no subprime mess to clean up. I also see no spillover into the high-quality prime mortgage market from these subprime defaults."
Gundlach warns that the subprime delinquency rates are probably headed higher, a process that will unfold over the long term. "There are many issues still at play, including many payment re-sets still to come," he says. "Subprime loans have much shorter reset periods—in general, a few months to a few years—than do prime loans. Subprime loan holders will either have to default or seek to refinance, which many of them won't be able to do."
Long Road to Foreclosure
Adding to the gloom, S&P credit analysts Michael Stock and Scott Mason forecast that cumulative losses on subprime-backed bonds issued last year will amount to between 5.25% and 7.75%. "If the country experiences a recession, or if home prices fall dramatically, losses may exceed the 7.75% threshold," they wrote in a recent report. (S&P Ratings Services operates separately from S&P Equity Research.)
However Milton Ezrati, senior economic and market strategist at Lord Abbett, cautions the subprime market may represent up to 15% of all new mortgages, but in terms of dollar value, they account for only about 1% of all outstanding mortgages. Moreover, it takes a long time for properties to be foreclosed. Ezrati estimates that in the unlikely event all delinquent subprime loans entered foreclosure, the loss would amount to just 0.3% of the dollar value of all outstanding mortgages.
Ezrati believes the high level of securitization of subprime mortgages may actually protect investors by spreading risk. "By taking those inherently risky loans off the books of lenders and generalizing them throughout the investment community, securitization reduces the chance of bankruptcy," he notes. "Instead of a few lenders losing all, many people lose a smaller portion on their assets."
Surviving the Tumult
As for bond fund holders who find they have significant exposure to subprime loans, Gundlach believes they have few options. "There's nothing magical about subprime mortgages that distinguishes them from other kinds of debt," he says. "They are somewhat analogous to junk bonds. You can sell them at a loss, hold them because you're stuck with them, or you can buy more because you think it's overdone on the downside."
Thus far, mortgage bond funds appear to have survived the tumult. The Lehman Brothers Mortgage-Backed Securities index gained 1.6% in the first quarter of 2007. By comparison, the Lehman Brothers U.S. Aggregate Bond index—a proxy for the U.S. fixed-income market—returned 1.5% over that period.
Other mortgage bond funds include Pimco Total Return Mortgage (PTMDX), Huntington Mortgage Securities (HMTGX), Pimco GNMA (PGNDX), and Vanguard GNMA (VFIIX).