In The Year 2010: Residential Mortgage Edition
Okay, in a series I just thought of, called “In The Year 2010” I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000”). This is a thought experiment, nothing more.
Residential mortgages. What can be said about where they’ve been that hasn’t been said already? I can’t even pepper that sentence with links because I wouldn’t know where to start. I mean to cover this product from the capital markets side, but let me starts by saying that this industry will probably be scared of it’s own shadow when it comes to making loans–probably for quite some time. Gone will be the sub-prime loans we all know and, well, we all just know them… 720 FICO, 25% DTI, 72% LTV? Greenlight. 600 FICO, 50% DTI, 90% LTV? Redlight. It’ll nearly be that simple.
Now, given that the loans will likely be much cleaner, what will the capital markets products look like? Easy! Well… hold on. First, there are some powerful subtleties. First, Fannie and Freddie won’t be nearly the same presence as they were in the residential mortgage markets in general, and probably sub-prime and Alt-A mortgage markets specifically (buying AAA’s). That’s one source of liquidity down. Second, CDO buyers are gone (this product will be a different post, but keep in mind CDO’s are not all mortgage related). CDO’s would buy the lower credit pieces, such as BBB’s (including BBB+, BBB, and BBB- … For Moody’s lovers, Baa1, Baa2, Baa3) and lower rated classes. Oh, and not as many investment banks are around. Guess what they bought? The residuals. Residuals were the 1-5% of the securitization that was unrated by the agencies and took the first losses of every pool. Banks “took these down” assuming they would pay off and that was how they would make their money. Most of those banks are also either not around or hurting.
So, we have fewer AAA buyers, fewer buyers of the lowest rated pieces, and fewer buyers of the lowest unrated pieces. Hmmmm…. I’m guessing there will be less securitization volume. However, I do think there will be securitizations going on. The financial technology is sound–slice up risk to those who can best take said risk. However, securitizations will be much simpler beasts. Gone will be the reliance on the rating agencies to evaluate risk. I doubt anyone will see a AA+ and a AA tranche on deals, risk will be cut into much broader swathes.
With these facts in mind, will AAA’s (or, more generally, high quality low-leverage securities) have a home? Well, at 10+% returns with banks paying 5% to the government for billions in new equity capital (just an example), which they can still lever over 10x (from what I can tell banks generally run 11-15x leverage), AAA’s seem like a good buy. Now, granted, those estimates for returns aren’t adjusted for losses, although AAA’s taking a loss hasn’t happened yet to my knowledge. This would seem to indicate that banks (there are no more investment banks) have a compelling value proposition when it come to holding market-rate AAA securities that are higher quality than found in ABX, but still not prime. Even if these AAA’s only returned 7%, and with current prime mortgage rates at around 6.5% that seems ridiculously unlikely, with 5% cost of capital they could be making over 20% ROE (way over, I’m being conservative and fudging downward). A lot of the these numbers aren’t apples to apple, but we’re also guessing at the future, so we use what we have.
If AAA’s have a home, the next question is what becomes of the lower-rated pieces. Well, my belief is that these will go wholesale to hedge funds and specialized funds focused on these products. The returns will be something in the 20-30% realm, near current levels. Credit analysis will drive value in this market, but if loan pools are kept clean enough then there can be sufficient liquidity to ensure a given securitiation can be sold (i.e. there will be enough funds bidding to ensure that, at a price, bonds will be sold). This is probably the easier problem than the AAA’s to be honest. The hedge funds that will do a lot of work to get a good return already exist, AAA buyers will need to convince themselves that they should be doing those transactions before anything starts happening.
Lastly, I think a market that will grow is the whole loan market. There will be a lot more trading volume in raw loan positions–transactions that aren’t driven by securitizations and don’t need to have tranches of risk in order to sell. Without going too much into the details, this market will be driven by dynamics of servicing arrangements, accounting rules, and detailed credit analysis. Currently this market is thriving, but in the form of “scratch and dent” trades of non-performing and re-performing (people that stopped paying and restarted paying later) pools of mortgage loans.
So, to sum up, what I believe the residential mortgage market will see is a return to simpler times. Selling off loans either a pool of actual loans or in two tranche securitizations seems reasonable. Indeed, this theme will most likely hold for other products as well, but the reasons fit here, so I’ll call it now and risk sounding redundant later.
Now, just to mess with everyone, I’ll use a newly added WordPress feature: polls! Tell me your thoughts on this…