Investors in the world's largest credit market — the one for U.S. mortgage-backed securities — appear to be taking little damage so far from the foreclosure problems that have sapped leading underwriters and servicers of home loans.
Market observers and some bondholders say that investors may be comforted by the fact that shoddy foreclosure paperwork may actually give them a leg up on banks that have issued the securities. The thinking is that investors would have an easier time forcing banks to buy back bad loans pooled within the bonds.
Also, holders of some of the more junior classes of mortgage securities may receive more interest payments as a result of the foreclosure fiasco. That's because servicers are expected to keep making monthly payments for properties that would have been foreclosed on otherwise.
The single factor that may determine if a fund manager will have sleepless nights is whether any bonds in the portfolio include loans that lack a government-sponsored enterprise's guarantee.
The crisis has effectively no impact on the $5.2 trillion market for agency mortgage securities, since Fannie Mae and Freddie Mac buy loans out of pools once they are 120 days delinquent — long before foreclosure. But investors in the $4.7 trillion private-label market may have to take a second look at their holdings.
"When the nonagency market was fully functional, like many markets, the majority of investors bought parts of the structure — triple-A-rated tranches — explicitly because they never wanted to go through a loan-by-loan analysis of the underlying credit," said Steven Abrahams, head of mortgage-backed securities research at Deutsche Bank Securities. Now, "it's hard to see how people will escape" that kind of analysis.
With $8.9 trillion outstanding, the U.S. residential mortgage-backed securities market eclipses even the $8.5 trillion market for Treasury debt. Even after the credit crisis, mortgage bonds reside in all kinds of portfolios from banks and pension funds to foreign governments and central banks.
The market is so massive that hedging in response to interest rate moves can affect the country's overall interest rates. (Many investors like to balance the duration of their mortgage bond portfolios with 10-year Treasuries.) Investors in mortgage debt count on regular and timely payment of interest and principal. But major lenders, responding to federal and state investigations, have suspended foreclosures in a number of states, delaying recovery of any principal on delinquent loans.
Also, some market participants are questioning whether mortgages were assigned properly to securitization trusts, and whether servicers have the right to repossess a property if the loan was assigned improperly.
These legal challenges threaten to undermine a recovery in the housing market by making it harder for banks to clear their inventory of repossessed homes.
The foreclosure mess temporarily made it harder to trade bonds in the nonconforming market. Bill Bemis, who oversees $7 billion of residential and commercial mortgage and other asset-backed securities at Aviva Investors, said there was "definitely a lot less liquidity in the first week or 10 days" after foreclosure problems started making headlines. The bid-offer spread on nonagency bonds widened by a half or quarter of a point. The spread has since narrowed for higher-rated nonagency bonds.
Bemis is not making any adjustments to Aviva's holdings, but he does say foreclosure delays affect his firm's prepayment expectations "at the margin."
Meanwhile, market participants say whole-loan prices have held up surprisingly well. Banks typically unload bad loans they buy back from securitization trusts on the secondary market, so stepped-up buybacks could translate into additional supply.
Jason Kopcak, head of whole-loan trading at Cantor Fitzgerald, said the prospect of an influx of bad loans was a concern when problems with the foreclosure process surfaced a few weeks ago. He said that since then two large lenders have sold off large bundles of bad whole loans — one package worth $200 million and the other worth $500 million — but those sales have not affected pricing.
"People have already factored in the 90-day moratorium," Kopcak said. In the whole-loan market there was a pullback in the range of 3 to 4 points, "so if the market was trading at 62 cents of current value, now it's 58 cents," he said.
Moody's Investors Service said last month after the initial problems surfaced that it expected document defects to delay or prevent some home foreclosures by servicers. As a result, the rating agency expects foreclosure timetables to extend by at least three to six months.
That means servicers will incur more carrying costs on loans, some of which may be passed on to the residential mortgage-backed securities trusts, reducing the amount ultimately recovered through a property sale, Moody's said.
Moody's has put the ratings for six servicers — Bank of America, Wells Fargo, IndyMac Mortgage Services, Bayview Loan Servicing, MetLife Home Loans and Litton Loan Servicing — (a Goldman Sachs unit) under review.
But Moody's said its ratings for the securities themselves already consider a "back-end loss scenario" with an average resolution time of 22 to 24 months for loans currently in foreclosure.
Foreclosure problems are also an obstacle to the revival of the primary market for nonagency MBS, which has had just one new issue since the credit crisis: a jumbo loan deal from a California real estate investment trust.
Michael Youngblood, a principal at Five Bridges Advisors LLC, a mortgage research analytics and advisory firm, said financial institutions considering new issues "will have to rethink their compensation structure, as well as the economics of securitization."
He said future deals will have to have higher levels of protection for all classes of securities; that could mean changes in a bond's payment structure or the amount of reserves set aside to absorb losses.
