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By Eric Jacobson | 04-11-2011 05:20 PM

Housing Still in Doldrums, But Mortgages Look Attractive

The non-agency mortgage-backed securities market still has very onerous assumptions embedded in it, says TCW-MetWest's Bryan Whalen.

Eric Jacobson, our director of fixed-income research, recently visited the offices of TCW-Met West, and sat down with Bryan Whalen, a specialist portfolio manager, to discuss the mortgage-backed securities market.

Eric Jacobson: Bryan, thanks so much for being with us today.

Bryan Whalen: Thanks for having me.

Jacobson: So your area of expertise, of course, is with non-agency mortgage-backed securities among other things, and we know that they've played a big part in MetWest and TCW portfolios over the last few years.

I have a lot of questions for you about that, but maybe you can start by just giving us a little recap snapshot of what's happened in that sector between the financial crisis and now?

Whalen: Well, obviously we all know what happened during the financial crisis, and prices in that sector like most other credit sectors bottomed out around March or April of 2009. The latter half of 2009, obviously, there was some recovery. It wasn't necessarily specific to that sector. It was more about just the markets emerging from the credit crisis.

As we entered 2010, I think a lot of participants in the market took a hard look at this sector and realized that the underlying assumptions embedded into the forecasted defaults and the prepayments and the severities were so onerous that the sector represented really what we thought, and I think most people came to the same conclusion, which was the cheapest loss-adjusted yields--not just in fixed income, but probably in the capital markets. And we saw throughout 2010 not just excellent performance, which as a whole the sector returned about 20% during 2010, but we also saw just a change in the mentality of how the market looked at the sector. Right around May of 2010 and from every point there forward, it was probably the most resilient sector. At any point during a pullback or a widening in credit spreads or potentially a downturn in the equity markets, non-agencies became the last thing everyone wanted to sell instead of the first thing. Part of that has to do with the fact that there's just a growing demand for this paper and an ever-dwindling amount of supply.

At one point, this sector was over $2 trillion in current face value, now it's about 1.6 trillion. I think everyone knows they are not making new non-agency mortgage-backed securities anytime soon, and every month about $20 billion to $25 billion worth of this market share, or marketplace, actually just goes away through natural events like pre-payments, amortization, and even defaults.

So that's really led to the point where we are now, which is a large amount of buyers, very strong hands. They are not relying upon ratings, for instance. A dwindling supply. And really a sector that still has very onerous assumptions embedded in it.

Jacobson: I want to go back in a minute to the return situation that you just described for 2010 and going forward. But before we do that, just for our readers and viewers who may not be as familiar with this sector, if you could just take us back to the way that a manager or an analyst in this space thinks about value, and understanding the valuation of security. And what I mean by that is, I think there's probably a popular perception among a lot of people that: Here we are; we're still seeing housing being very weak. We've had some very scary things happen with defaults in certain communities around the country, and a lot of people aren't really seeing the light at the end of the tunnel, and they may look at that situation and then say, well, how can non-agency mortgage-backed securities be attractive if those are the market fundamentals.

For some of the folks, hopefully, this is just a little bit of a refresher. Obviously, there are structural issues. Maybe you can just give us a thumbnail on that before we move back to returns?

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