Do investors really understand mortgage securities? If not, how stable can the market remain? Two veteran Wall Street researchers, in separate reports, are asking these questions and coming to potentially troubling conclusions.
Andrew Jones, mortgage group vice president at Duff & Phelps Inc., says a number of new mortgage investors lack a basic understanding of credit support. Peter Rubinstein, senior vice president of mortgage research at PaineWebber Inc., sees a general move toward less support and wonders if investors are being adequately compensated. Credit support is insurance that mortgage securities often carry to cover projected loan defaults. Credit rating agencies require the buttress-through extra capital, a surety wrap, or another backup measure-to rate a deal. Without a rating, or an agency guarantee, investors won't touch mortgage securities unless they carry a lot of extra yield that is costly to lenders.
Mr. Jones and Mr. Rubinstein do not come to the same conclusions when discussing credit support. In fact, Mr. Jones disagrees with Mr. Rubinstein's premise that credit rating agencies may be setting support levels too low.
But the researchers do share a similar concern. Now that mortgage securities are again popular-having recovered from a dramatic slide a couple of years ago-analysts want to identify potential problems before they become real troubles.
Mr. Jones is concerned about corporate bond investors who, in search of higher yields, are now chasing mortgage securities. Some of these investors don't grasp that a larger credit enhancement doesn't mean extra safety among mortgage securities with the same ratings, he said.
For example, a solid loan portfolio could need to keep 2% of the face value of its holdings available to absorb losses, while an identically rated security backed by a shakier pool of loans could need 6% or 7%. Investing in the pools with larger enhancements "is sort of like rewarding people who provide riskier collateral" at the expense of those who are well established and well regarded, Mr. Jones said in a recent interview.
In most cases, the established names are major mortgage lenders, like those owned by banks, while the less-entrenched operations are new entrants looking to capitalize on certain loan types.
Mr. Rubinstein is also troubled by what he sees in the market. He says he fears the recent trend toward less credit support for mortgage securities will lead to less safety for bond buyers. For instance, jumbo loan deals that used to require 6% to 7% support are now required by ratings agencies to have only 4% to 5% support.
He acknowledged that the advent of credit scoring has made the practice of evaluating loans more precise, and lower credit requirements in many cases may be adequate.
But he also said credit rating agencies have become so competitive that they may try to win business by requiring less support from lenders.
Mr. Rubinstein said he will spend this summer evaluating the risk profile of new securities by examining the performance of several hundred thousand loans.
"The question is not whether support levels should have declined, but rather, have they declined too far?" he said.
