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Housing Still in Doldrums, But Mortgages Look Attractive

Eric Jacobson

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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Whalen: First of all, most of the return numbers I mentioned and at least the investments that we're making here at TCW and in the MetWest side of the business, is all at the senior part of the capital structure. So you can think of that as the first claim in a default. When a mortgage defaults, you go in, you take that property back, and you sell it through a liquidation or foreclosure sale or maybe a short sale. You have most senior claim on that recovery, and you need to get paid back a hundred cents on the dollar before anybody else gets paid back a dime. So, I think that's one thing to keep in mind.

Secondly, with regards to your point as to, we're still in a difficult point in housing; we have a lot of distressed homes that need to be sold. I think Case-Shiller is still forecasting another 5% depreciation nationally up until where we're going to hit the trough around December of this year or January of 2012.

So, your question, how can the sector look so cheap with such a fairly bleak outlook in housing? Well, it all comes down to what's embedded in the price. So, what's the price you're buying these bonds at, or another way to say it is, what is the market expecting? What's going to happen? As long as you're pricing that appropriately, that's what make something rich or cheap, and we would say right now that consensus--Case-Shiller, for instance, forecast a 5% depreciation in housing. We would say that at today's valuations, you could withstand a 15% to 20%-plus depreciation in housing and still, on a hold-to-maturity basis, still get a positive return on the investment.

Jacobson: To dig into that just a hair deeper, help us understand the analysis that goes into, okay, what are these worst-case scenarios? So, in other words, take us through just for a minute, if you would, the concept of understanding loss severities and what happens in the case of not only depreciation but actual defaults, recoveries, and so forth?

Whalen: Well, when you're looking at a pool of mortgages, we're at the point in time where I think we can break out the analysis into two pieces. You've got the loans that are in what we call the delinquency pipeline. Those are borrowers who have stopped paying their mortgage. Some of them have only stopped for two months; others are as long as 28 to 30 months, and those are the borrowers you hear about how they're living for free and they're not being foreclosed upon.

So, that's one part of the analysis. We're at a point right now where the market basically assumes that any loan in that delinquency pipeline is going to eventually be liquidated, and that there is very little chance for any of those borrowers to eventually start paying again and eventually fully prepay their mortgage.

The market right now looks at those, and it projects a timeline from where they are right now in that delinquency stage to the point at default, and then it projects an actual liquidation. The analysis, or at least the valuation comes back to, what are you going to sell that property at? What's the recovery value going to be? And if you've lent hundred cents on the dollar, are you going to receive back $0.90, $0.50, $0.10 or nothing? That really comes down to the strength of your analytics. Are you able to get down to the loan level and determine based upon where that property is located, the zip code, what's going on around it in terms of housing, what's going on in the metropolitan area in terms of the economy, demographics, things of that sort--if you are able to get down to that level, you can get a fairly high confidence in your projection.

Second part of the equation comes down to looking at the borrowers that are current. So, these are the borrowers that are still paying their mortgage. A lot of them have never missed a payment. Some of them have in the past, but have since cured. So that's buckets that are either always current or current for the last year. So, the analysis there is, at what rate over time will those borrowers leak into a delinquency pipeline and then they eventually default.

A lot of our premise as to why non-agencies are still so cheap is that the rate at which those borrowers become delinquent, the market is still projecting a rate very high, very similar to what we saw during the worst of the credit crisis, but the data is supporting something else. It's supporting that the profile of those borrowers keeps getting better and better. It's a term that markets use called "credit curing."

So, when we look at that, we say, over time eventually as markets settle down and confidence levels rise, the market will recognize that you are seeing a credit-curing effect, and that applying credit crisis like rates at which those borrowers become delinquent isn't appropriate, and you're supposed to use better or lower rates. And when that happens, you then project higher overall cash flows to this mortgage-backed securities trust, and higher cash flows at the same discount rate equals higher prices, and that's what we are expecting to occur over time.

Jacobson: So, if you could, let's go back now to what you said before about performance in 2010. I think for the cohort that you folks invest in, roughly around 20% returns. Break that down a little bit, if you would, into the components that produce that number to help us understand a little bit about how and why your thesis says these kinds of securities can continue to perform pretty well in the future, despite what looks like a lot of upside that they've already had?

Whalen: That's good point. I think when you hear a return number like 20%, I think most investors gravitate toward thinking about equity markets. And while some stocks do pay a dividend, generally speaking, dividend rates are fairly low. So, those return numbers are typically associated with actually rises in the asset's price.

In the non-agency sector, yes, prices have risen, but if you look back over 2010, just over half of that 20% return was actually attributed to price increases, the other 40% to 45% of that return actually gets attributed to, you can think of it as current coupon. Think of it as the coupon that's being paid on those securities divided by your price with some other attribution due to amortization coming back at you from prepayments and amortization and defaults. And you own that sector at a discounted dollar price. So when you own something at $0.70 on the dollar, and every day you're getting paid 100 cents on the dollar back, that also is accretive to returns.

So, when you add that up, your current yield plus this additional returns from amortization, it gets you to about a 9%-type of base-case return expectation on an annualized basis before you even start to analyze whether there is or is not any price appreciation potential embedded there. So, it's a fairly healthy amount of cushion if there is a pullback in prices, but obviously given where everything else is in fixed income, starting with a 9% type of return is fairly attractive.

Jacobson: It sure is. Well, thank you very much. We appreciate your time today.

Whalen: Thanks for having me.