Investors are backing off worst-case housing scenarios for the first time in this cycle -- a milestone shift that is keeping a mortgage bond rally alive and setting the stage for a recovery in securitization.
Prices in the market for private label MBS -- those not backed by Fannie Mae, Freddie Mac -- have gained 60 percent to 90 percent in the past 12 months as investors bought bonds at distressed levels, with a thick cushion for loss.
Today, the rally is on track as investors and dealers tweak housing and bond performance models they use to decide on yields they require to ensure profit. This trend is important for the private residential mortgage-backed securities market, where Redwood Trust Inc. on Wednesday finally broke the silence, selling the first bond backed by new loans since 2008.
People are starting to think otherwise about the double dip (recession) happening, said Jesse Litvak, a managing director at Jefferies & Co. in Stamford, Connecticut.
There is stability in mortgage defaults, home sales are rising and JPMorgan Chase & Co., the No. 2 U.S. bank, last week delivered an assessment of improved credit trends. Home prices as measured by the S&P Case-Shiller indexes rose in January for the eighth straight month.
Laurie Goodman, head of Amherst Securities Group's strategy team, said that bonds are stressed less severely by investors as they pare expectations for further home price drops.
It's definitely not as bad as you would have guessed six months ago, said Steve Kuhn, partner and portfolio manager at Pine River Capital Management in New York. There is real data to back up the view that people are changing assumptions.
Expectations on loss severity, or total losses as a percentage of the principal, had remained stubbornly high even after house price and other data began to suggest stability. Rising foreclosures and unemployment have underscored that U.S. housing was still shaky, and some investors are warning that federal foreclosure prevention plans are setting the market up for a new downturn.
For months, investors would buy RMBS only if prices compensated for loss severities that far exceeded trends. They have projected severities of around 55 percent on some prime jumbo deals would jump to 65 percent over a 12- to 18-month period, in anticipation of falling house prices, Litvak said.
Recently, these buyers have inched away from draconian assumptions and took expected severity back down to 55 percent for the bond's later years, he said. This could have the effect of raising loss-adjusted yields from 8 percent to 9-10 percent, and adding to the rally in RMBS, he said.
Investors are still evaluating bonds using rather harsh scenarios, but they now look at these scenarios as being more 'worst case' than 'base case,' said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.
Potential returns are grabbing attention in bond markets where bond funds flooded with cash are thirsting for yield. Prime RMBS prices hit 88 cents on the dollar in March, the highest since August 2008, Amherst data shows.
As prices rise it will essentially lock buyers out of the market unless they believe improvements in housing will last, or they accept a smaller cushion for loss.
Cutting loss assumptions is tempting because if you don't, it makes it tough for you to buy bonds, Kuhn said.
Acceptance of the trend will help improve chances issuers can restart RMBS issues whose absence has made it tough to get funding for many types of mortgages. Because of high loan costs and limits to investor demand, issuers trying to structure RMBS until Redwood's issue have had little luck, analysts said.
The No. 1 challenge is pricing, said Tom Deutsch, executive director of the American Securitization Forum. There is such a significant amount of outstanding RMBS securities that are trading at depressed levels, that any new issuance is effectively competing in terms of price.
Some stability can be tied to loan modification programs launched by the government, said Guggenheim's Buchta. While the majority of loans are far from fixed, the programs keep borrowers in homes and properties off the market, he said.
If the lion's share of troubled borrowers can't be helped under federal programs, investors fear homes will eventually flood the market and depress prices. Added supply could create a slight double-dip in home prices in 2011, Buchta said.
There's a real risk of renewal of a vicious cycle if modifications don't reach enough borrowers, said Whitney Tilson, founder of hedge fund T2 Partners. Falling home prices will put more homeowners underwater, or owing more than their house is worth and prompt defaults, he said.
It's hard to say whether that will be true, said Pine River's Kuhn, who saw federal programs as a balancing act.
If you had asked six months ago -- given the state of the economy and the state of modifications -- and you told me house prices were going to be up for six months, I would have said 'no way' and I would have been wrong, he said.
(Additional reporting by Archana Shankar in Bangalore; Editing by Kenneth Barry).