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If investors were asked to identify the largest contributors to the housing bubble that led to one of the worst recessions in U.S. history, it is likely that subprime mortgages would be near the top of that list. After all, these loans enabled the dramatic increase in home ownership rates and home prices that ultimately proved to be unsustainable. And as the housing bubble collapsed, so, too, did the prices on residential mortgage-backed securities (RMBS) without the backing of government entities, such as Fannie Mae, Freddie Mac, and Ginnie Mae.1
Although home prices collapsed by about 35% nationally as the bubble burst, not every home with a non-agency mortgage fell into delinquency or foreclosure; many of these homeowners continued to meet their monthly obligations. Those ongoing mortgage payments, combined with the recent improvement in home prices, have enhanced the potential value of the non-agency RMBS market, which includes prime, Alt-A, subprime, and option-ARM securities.2 The greater allure of the asset class, however, may be its relatively attractive yields in today’s yield-starved environment.
As investors' search for income has broadened, the demand for non-agency RMBS led to double-digit annualized returns, on average, in the asset class as of December 2012.3 Of course, such gains have been from very depressed levels and may not be repeated. They might also remind some observers of the heady days leading up to the housing bubble. But these recent returns have been supported by improving fundamentals in the housing market, rather than the deteriorating conditions that precipitated the bubble's collapse.
While observers could point to numerous metrics that reflect the housing market's recovery, these metrics required ample time to take hold. And more than six years after the housing market peaked in July 2006, home prices have started rising, inventories have declined, and strategies have emerged to manage the backlog of distressed mortgages. The combination of these factors may not signal another surge in home prices. But they could support further gains in the prices of carefully selected non-agency RMBS and the rationale for active fixed-income strategies to invest in these securities.
Are We There Yet?
Investors' search for yield has contributed to the recovery in the prices of non-agency RMBS, but the securities still remain sensitive to changes in housing market conditions. Movement in home prices is one of the most widely cited housing metrics that can not only reflect the health of the housing market, but that can also affect the losses experienced by non-agency RMBS.
Considering the volatility in the monthly data, annual price figures provide a better perspective on the sustainability of the recovery in home prices. Although these figures represent a comparison with the period after the conclusion of a first-time homebuyer credit—a program that pulled sales forward, causing a temporary increase in prices and premature declarations of a market bottom—their recent upturn reflects some sustainable momentum behind housing's ongoing stabilization. (See Chart 1.)
Year-over-year % changes in home prices and existing home sales
Source: Bloomberg, National Association of Realtors, and Standard & Poor's.
Data as of September 30, 2012.
This stabilization also extends to securities tied to real estate because higher prices mean lower loan-to-value ratios for homes with outstanding mortgages. When loan amounts are equal to or less than the market value of the properties, this generally translates into fewer losses for real estate-related securities because a property sale could generate proceeds that match or exceed the amount of the loan.
Although there have been concerns about a possible surge in the inventory of homes for sale that could affect the recent price improvements, that surge has failed to materialize on a couple of different levels.
With the inventory of homes listed for sale declining by 1.4% in October 2012, the overall inventory was about 22% lower than it was a year earlier.5 While this has led to a relatively flat trend in existing home sales (see Chart 1), the demand for homes has steadily absorbed the supply and supported home prices as a result.
In addition to the effect that lower prices can have on housing demand, demographics also play a significant role. And time has helped heal this important aspect as well. As one might expect, the pace of household formation fell sharply amid the economic downturn from about 1.5 million a year from 1997–2007 to about 500,000 per year from 2008–10. But in 2011, the pace rebounded strongly to about 1.1 million household formations, according to the Federal Reserve Bank of Cleveland.
While these demand trends can affect the traditional inventory of homes for sale, there are additional factors that have contributed to a smaller "shadow" inventory of homes. Properties in the shadow inventory are generally defined as those that are not yet listed for sale, but might be listed in the near future because their mortgages are delinquent, are in foreclosure, or are already owned by a lender. The eventual listing of these properties for sale can increase the supply of homes priced at relatively low prices and, therefore, can potentially affect price trends in the broader market.
After surging with the collapse of the housing bubble, the shadow inventory has gradually declined over the past few years. (See Chart 2.) This time has been critical in allowing lenders and servicers to handle their distressed mortgages, and a couple of specific strategies involving loan modifications and short sales have contributed to this trend.
Source: Lender Processing Services and Morgan Stanley. Data as of July 26, 2012.
Managing the Backlog
The more frequent use of loan modifications and short sales has been driven by a couple of major factors. One involves federally sponsored programs that provide incentives for loan servicers to modify loans, such as compensating them 63 cents for every $1 in principal write-downs. Another source of funding for modifications has come from the $25 billion legal settlement reached by mortgage servicers with state and federal authorities as part of the investigation into faulty foreclosure practices.
In 2012, the combined factors are expected to generate about 1 million in estimated mortgage modifications, which can involve reductions in the principal amounts and/or the interest rates on a loan. This process could continue in 2013 as well with about half a million estimated modifications.6 And loans can go through multiple modifications, as seen in the subprime segment of the market, where more than half of the loans have been through at least two modifications.7
The use of short sales (when the remaining amount on a property's mortgage is higher than the sale price on the real estate) has recently increased as well. As of July 2012, short sales made up about 45% of all distressed mortgage resolutions, which was the highest percentage since the housing bubble collapsed,8 and have provided another tool for loan servicers to keep reducing their "shadow" inventories.
To some observers, a look at certain housing metrics, such as mortgages that have been delinquent for more than a year, could indicate some fragility in the market's recovery. (See Chart 2.) However, a closer look at the delinquency situation may be more of an indication of just how far the housing market's recovery has progressed.
Considering how the collapse of the housing bubble affected certain states worse than others, one might assume that most of the severely delinquent mortgages would be located in states such as Nevada, for example. However, due to factors besides depressed prices, states that were at the forefront of the housing bubble have actually experienced a relatively rapid decline in delinquency rates as these markets have recovered.
The geographic segmentation that has occurred among delinquent mortgages is a function of how states handle foreclosure proceedings. About half of the states handle the foreclosure process through the court system, which significantly lengthens the time needed to liquidate a loan. The liquidation process in the judicial states of New York and New Jersey, for example, takes an average of 43 and 39 months, respectively.9 These delays have led to a rising percentage of loans in judicial states that have been delinquent for more than a year, while the delinquency rates in nonjudicial states have been declining due to the faster pace of their resolution processes.10
Although there are additional implications about the rising share of delinquencies from judicial states, such as a higher percentage of loan liquidations, the ongoing shift indicates that the housing recovery has progressed past the states at the forefront of the housing bubble. It also indicates that while some housing data appear stagnant, there are often underlying factors that can reveal how far the recovery has progressed.
A Subjective View
The geographic differences in delinquency rates highlight the wide variations that not only exist in the housing market, but that also extend to the non-agency RMBS market. Indeed, one of these subjective aspects of the market that can vary with each participant relates to loss expectations for particular RMBS issues. And this is a particularly important point because these expectations partially determine the quoted yields on non-agency RMBS.
Quoted yields on the securities include loss assumptions because the bonds rarely reach maturity due to losses, prepayments, or other activities that may call mortgages before their stated maturity dates. This is different from the yields that appear in other segments of the taxable bond universe, such as the corporate bond market. When a company issues a bond, for instance, its yield is based on the assumption that the company will make all the interest and principal payments on the bond without any losses to the bondholder.
The subjectivity of the loss-adjusted methodology is yet another reminder that analysis of the market is subject to interpretation regarding the range of factors, which also includes prepayment trends. Therefore, yields quoted in the market can also vary, and this is why quotes are usually provided in dollars. (See Table 1 for an example of recent yields in the various segments of the market.)
Data are as of September 27, 2012
For illustrative purposes only. Past performance is no guarantee of future results.
Another aspect of the asset class that should be considered is that many non-agency RMBS are categorized as defaulted by credit rating agencies following the swoon in the housing market. Yet this classification might only mean that a mortgage bond has experienced some loss, but the security could still be an asset that is generating an attractive level of current income.
As with assumptions about the actual housing market, the nuances in the non-agency RMBS market underscore the subjectivity in any analysis. And given the idiosyncrasies that can occur within the market, such as a suggestion from San Bernardino, California, to seize and restructure mortgages by eminent domain, it is sensible to take a balanced approach when approaching the non-agency RMBS market.11
A Sequential Analysis
One way to form an objective view on the market is to have an in-depth research process, especially considering the recent changes in supply and demand trends.
After the prices of non-agency RMBS collapsed with the housing bubble, primary issuance of the securities ground to a halt and remains very light. Considering the solid demand for the bonds, the lack of new issuance has created a favorable technical aspect in the market as its total size has contracted from about $2.3 trillion in mid-2007 to slightly less than $1 trillion as of the third quarter of 2012.14 The absence of new issuance coupled with the surge in investor demand also means that there has been a significant increase in secondary market trading. This trading has also been facilitated by a regulatory change that may make it easier for banks to hold RMBS.15
Within the secondary market, Lord Abbett tends to look for securities with certain characteristics. For example, we might initially look for issues that are larger in size and that have higher dollar prices in order to ensure adequate liquidity of our selections. Our models then cull through those securities for an additional, customized round of credit analysis, which is a crucial step given the vagaries that can exist within the market.
This subsequent step can model the effects of servicer and borrower behavior on a particular security. Selected securities are then subject to various stressed scenarios as they pertain to prepayments, defaults, loss severities, modifications, servicer advances, and interest-rate changes.
This analysis can help shape price opinions for securities, and, subsequently, we can compare these opinions with the price guidance from the dealer that circulated the list. At that point, we may make the decision of whether or not to purchase particular securities.
In a low-rate environment where yield remains highly sought after, there is a risk that investors might reach for yield without analyzing an asset's underlying fundamentals. On their surface, the loss-adjusted yields on non-agency RMBS may be attractive to investors amid the ongoing stabilization in the housing market. Yet recent developments within the asset class and the housing market remain highly subject to interpretation, which underscores the importance of a customized research process that can identify the securities that may provide attractive risk-adjusted returns for fixed-income portfolios.
—Matthew Shepard, CFA, Lord Abbett Portfolio Manager of Taxable Fixed Income
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.