Mortgage securities backed by balloon loans are generally regarded as too risky, but a top Bear, Stearns & Co. executive now says this conventional wisdom is wrong.
Dale Westhoff, senior managing director in mortgage research at Bear Stearns, said too many investors are letting the bad experience of 1993 control their analysis of balloon pass-throughs, obscuring the attractive characteristics of these securities.
Balloon mortgages typically have terms of five, seven, or 10 years and must be refinanced when they mature.
The desirable features are most marked on balloons that trade at a discount, he said, but older loans selling at a premium also offer value.
In a report describing a new valuation model, Mr. Westhoff and fellow mortgage analyst John Miller said that, until recently, insufficient information had been available to evaluate several important features of balloons.
Now, however, the information available has improved dramatically in both quality and quantity, the analysts said.
Their most surprising finding, by their own evaluation, was that balloon borrowers are less likely to refinance in response to low interest rates than those who have 30-year mortgages. This behavior continues until the refinancing incentive reaches 200 basis points.
"The reason is that balloon borrowers must realize financial gains from a refinance transaction over a shorter period," Mr. Westhoff and Mr. Miller wrote in their report.
Mr. Westhoff said this contradicts the belief of many investors, who expect balloon mortgages to prepay faster in all interest rate environments.
The belief arose out of investors' experience in 1993 when balloons prepaid at very high speeds, Mr. Westhoff said. He added a caveat: When interest rates finally become attractive enough to stimulate balloon refinancing, prepayment speeds soon surpass those of 30-year loans.
The Bear Stearns analysis also shows that balloon mortgages exhibit rapid seasoning, which benefits investors.
This behavior, according to Mr. Westhoff and Mr. Miller, is explained by the high level of turnover in balloons.
From an investor's point of view, Mr. Westhoff and Mr. Miller wrote, the high base level of prepayments and short final maturity of balloon mortgages are attractive, reducing asset-liability management costs.
The two analysts said they believe that seasoned high-coupon balloons now offer value because the worst-case market assumptions on prepayments overstate the likely outcome.