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December 2007

All AAAs Are Not Created Equal

By: Margaret Isberg

Troubles in U.S. subprime are scaring investors away from prime mortgage-backed securities. Rising delinquencies and defaults of U.S. subprime mortgages and the resulting tidal wave of rating downgrades have discredited the major credit rating agencies. Whether it is Canadian ABCP, CDOs, or straight subprime ABS, the surprise downgrades are causing a paradigm shift that is rocking the structured finance business to its foundations as investors lose confidence in the black boxes of the rating agencies, Wall Street, and Bay Street. As often happens during financial dislocations, pendulums can swing too far. In today’s markets, all assets associated with the eye of the storm – U.S. housing – are suffering. This has presented fundamental investors with compelling opportunities – particularly in U.S. agency mortgage pass-throughs.

The Wonders Of Securitization

Prior to the 1970s, when a financial institution issued a mortgage to a homeowner, it typically kept the loan on its balance sheet until it was repaid. However, clever investment bankers began bundling individual mortgage loans into pools and selling them as securities that ‘passed through’ the principal and interest payments from the loans in the pool. This securitization process converts individual mortgage loans into mortgagebacked securities that can be easily traded, thereby turning illiquid and undiversified assets into liquid and diversified ones.

In Canada, a smaller proportion of residential mortgages have been securitized since regulation and limited competition have permitted the large banks to underwrite mostly well collateralized mortgages with terms of five years or less, which fit well on their balance sheets.

In the more fragmented and competitive U.S. mortgage market, terms are typically 15 or 30 years, so financial institutions are eager to take them ‘off-balance sheet.’ Only 21 per cent of outstanding Canadian mortgages are securitized, while the figure in the U.S. is 57 per cent. That makes the U.S. residential mortgage-backed securities (MBS) market, at $7 trillion, the largest single sector in the global bond market.

Looking Under The Hood Of MBS

MBS investors are potentially assuming three types of risk:

All fixed-rate bonds have interest rate risk. When rates go up, the price of your bond drops, and vice-versa. All bonds also have default risk, the risk that you won’t get your principal back. Not all bonds have the third type of risk, prepayment risk, but it is this characteristic that boosts the yield on MBS and makes them a good diversifier.

The majority of outstanding MBS are assumed to be of AAA or higher quality because they are issued with an explicit or implicit government guarantee for the timely payment of interest and principal. In the case of Canada Mortgage Bonds and MBS issued by the U.S. Government National Mortgage Association (GNMA or Ginnie Mae), the guarantee is backed by the full faith and credit of those governments. In the case of the U.S. government sponsored entities – the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), market participants assume they have the implicit support of the U.S. government.

Fannie Mae and Freddie Mac were created by an Act of Congress, reflecting just how high home ownership is as a social priority in the U.S. Fannie and Freddie help to keep reasonably priced capital flowing to the housing market and the failure of either is assumed to be an outcome that policy makers would avoid at all cost. While both organizations have recently posted losses, these are largely associated with their portfolio investments, and not with the loans that back the MBS they have issued and guaranteed. FHLMC, for example, reports that defaults are running at three basis points of their average total MBS outstanding.

As, or more, important than a government guarantee in assessing the credit or default risk of MBS is the collateral that backs them. They are collateralized by homes. In the U.S., homes have been a reliable store of wealth over time. While average U.S. home prices are poised to end 2007 roughly five per cent lower than where they began the year, that will mark the first down year since the Great Depression. Since the average loan-to-value (LTV) ratio on the stock of U.S. agency mortgages (GNMA, FNMA, FHLMC) is about 60 per cent, prices would have to decline a further 40 per cent before the average MBS is less than fully collateralized. The combination of the government guarantee plus collateral protection means that the default risk of U.S. agency MBS is next to nil, as evidenced by recent experience.

Non-agency MBS are a different story. They are issued by private sector institutions and can be backed by either high quality or low quality loans. Non-agency MBS will sometimes be issued with private sector credit enhancements and are categorized as prime, Alt A, and subprime. Prime mortgages are issued to high quality borrowers with strong credit scores, subprime to borrowers with low or no credit scores, and Alt A loans lie somewhere in between. It is the subprime sector and, to a lesser extent, Alt A that have experienced mark-to-market losses this year.

The origins of the problem can be found in reckless lending to low quality borrowers in recent years, using new and untested structures. Those loans are now underperforming the expectations of rating agencies and investors. Subprime delinquencies are averaging as high as 13 per cent (depending on the year of origination) and are headed higher as house prices continue to fall and mortgage rates reset higher. So most subprime ABS are not for the faint-of-heart.

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