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Guest columnist Roy Hingston is a Senior Vice President, Portfolio Strategies Group, at Shay Financial Services Inc. Roy has been involved in Strategic Planning, Investment Analysis and Asset/Liability consulting with financial institutions at Shay since 1985. Roy brings his passion for community banking and balance sheet expertise to bankers with a no-nonsense approach to improving the bottom line. He is the author of “Creating The Perfect Portfolio For Your Financial Institution,” published by FMS, and is a frequent speaker at financial industry functions.

Take Advantage of What You Know
By Roy Hingston, Shay Financial Services

You know mortgages. You originate and retain (or sell) mortgages as part of your core product line. You know how to tell a good credit from a poor one. You can use this knowledge to make money in today’s securities market.

The recent market upheaval has changed the perceived value of mortgage-related securities. Many international investors and hedge fund managers have decided to exit the business of buying mortgage-related securities, since the securities they bought have not performed well. They simply did not understand what they were buying. They were under the (false) impression that if a security was given an investment grade rating by Moody’s or S&P, they did not need to do any further due diligence. They could not tell the difference between a security backed by quality collateral and one backed by sub-prime, poorly underwritten collateral.

When those buyers were in this market they had reduced the spread on mortgage-related securities to as little as 10 basis points over agency backed MBS. In the past, these same “AAA” private label mortgage-related securities would have offered 25 to 40 basis points over agency MBS. Today, the spreads are 50 to 80 basis points!

Fallen Angels
Pendulums always swing too far. Many investors are now totally avoiding the entire private label mortgage-backed security market. As a result, high-quality securities that were well underwritten and have more than adequate credit support are trading at much higher than normal spreads to similar agency securities.

We call these bonds “Fallen Angels” because they are good bonds that have become associated with lower quality bonds in the minds of some investors.

If you are willing to do your due diligence on these assets, we believe that you will find many high-quality performing assets with virtually NO credit risk that offer substantial rewards for your time and effort. Here is just one example:

HVMLT 2004-1 4A offers a coupon of 4.788% at a discount price of 96 7/8 to yield 6.05%. This calculation assumes an effective duration of 2.40 and a lifetime effective CPR of 25. The collateral underlying this security is 10 by 1-year hybrid ARM mortgages, where the borrowers are paying an average rate of 5.063%. This bond has four years of seasoning so it is now more like an 6/1 Hybrid ARM.

Compare this to a similar 10/1 Hybrid Agency bond, such as  FNMA Pool #952835 which has a gross WAC of 6.307%, a coupon of 5.877%, a price of 101 1/4 and a yield of 5.50% at 15 CPB. While this bond is newer (only 5 months of seasoning), they were both 10/1 hybrids at the start.

Risk/Reward
Why are we being offered 55 basis points more “reward” for this private label security than we are offered for the agency MBS?

First, agency MBS are now relatively “scarce.” The agencies have recently been restricted in the amount of bonds they could buy. During the period when FNMA/FHLMC were restricted in their mortgage purchases, many more private labels were created, thus increasing the supply relative to the agency pools. When you look at the demand side, many market buyers have gone from buying both types of securities to buying only agency paper. Therefore, agency paper is scarce with more buyers (leading to higher prices/lower yields), and private label paper is more common with fewer buyers (leading to lower prices/higher yields).

Second is the whole question of collateral structure and underwriting. Call this the credit decision if you will. In this case we are being offered a much larger reward because the bond is a private label mortgage-backed security. It is not guaranteed by the U.S. Government or any agency of the U.S. Government.

Given these two facts, we will need to examine the credit very carefully. First, what is happening with the loans? Are they current? How many 30 day delinquencies? 60 days? 90+ days? How many are in the process of foreclosure? How many have become Real Estate Owned (REO)? What are the trends in these delinquencies? Getting worse?

The reality is that the loans within the collateral have no problems whatsoever! There are no 30 or 60 day delinquencies at all. In fact, the 30 day, 60 day and 90 day delinquency ratios are all ZERO! How much credit support exists to cover any future problem? In fact, the deal has 10.2780% subordination to this AAA tranche.

The deal has 69% exposure to the California real estate market, 52% in Northern California and 17% in Southern California. The weighted average Loan-to-Value ratio is less than 54%. The loans are serviced by Wells Fargo.

The fact that there are no delinquencies in the pipeline, along with the fact that any borrowers who have mortgages locked in at 5.06% are unlikely to prepay, make this an attractive security to fund. Funding can be structured to virtually match the cash flows and yet provide a 1.35% net spread.

This is just one example of the kind of additional return available to any institution willing to do some thorough due diligence in today’s market to find these “Fallen Angels.” I think it would be well worth your time to explore this market sector.

Shay Financial Disclosures: The analysts who prepared the research report contained herein certify that the views expressed in the research report accurately reflect their personal views about the subject securities or issuers referred to herein, and no part of such analyst’s compensation was or will be directly or indirectly related to the specific recommendations of views expressed herein.

The data underlying the information contained herein has been obtained from sources that we believe are reliable, but we do not guarantee the accuracy or computations based thereon. This analysis was intended to be used as an illustrative report and not intended to predict actual performance results. Performance analysis results are based on certain inputs to mathematical models. Model results may vary significantly based on the inputs to calculate results.

This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may receive this report. Clients are advised to make an independent review and reach their own conclusions regarding the economic benefits and risks of this transaction and the legal, regulatory, credit, tax and accounting aspects of this transaction relating to their particular circumstances. Shay Financial Services, Inc. makes no representations or guarantees regarding the accuracy, reliability or completeness of the pricing information. All price indications are subject to change without notice. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive less back than originally invested. Past performance is not necessarily a guide to future performance.

This report has been prepared from original sources and data we believe to be reliable but we make no representation as to its accuracy or completeness. This report is published solely for information purposes and is not to be construed either as an offer to sell or the solicitation of an offer to buy any security or the provision of an offer to provide investment services in any state where such an offer, solicitation or provision would be illegal. Shay Financial Services Co., Inc. (Shay), its affiliates and subsidiaries and/or their officers and employees may from time to time acquire, hold or sell a position in the securities mentioned herein. Upon request, Shay will be pleased to disclose specific information on such positions or transactions. Shay or an affiliate may act as principal for its own account or an Agent for both buyer and seller in connection with the purchase or sale of any security discussed in this report. Opinions expressed herein may differ from the opinions expressed by other divisions of Shay.

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The information presented in the article  is not investment or business advice, nor is it an offer to extend credit or buy any security or financial product. Readers must not rely on any of this information when making any investment, business or credit decision.