It’s been 10 years since the global market meltdown ravaged investors and rattled confidence in the financial services industry, but the products at the centre of it are making a comeback.
Mortgage-backed securities (MBS) are complex products that tapped into the US housing bubble prior to the 2008 crisis. Although they were assigned the highest rating by credit-rating agencies, they didn’t anticipate a potential collapse in house prices.
Loaded up with subprime mortgages and payment default risks, the investments crashed when the housing market collapsed, leaving many fingers burnt.
Cut to the present, and market watchers believe that times have changed, and it’s time to revisit the sector.
It's different this time
To begin with, even though the global residential MBS market is still dominated by the US, regulations related to the origination and securitisation of mortgage loans have tightened since the financial crisis.
‘The most egregious high-risk sub-prime structures are no longer being originated,’ said Vijay Chander, executive director-fixed income for the Asia Securities Industry and Financial Markets Association (Asifma).
‘There is more disclosure of underlying collateral and closer monitoring of the credit ratings processes for mortgage structures,’ he added.
In the pre-crisis days, mortgage lenders were doling out ‘ninja’ loans, which were loans extended to borrowers with no jobs, income or assets. Subprime lending ground to a halt after the crisis, although media reports earlier this year noted that similar loans could be making a comeback under the guise of ‘non-prime’ lending.
In terms of the types of MBS, the market today is naturally dominated by agency-backed MBS. These structures are either guaranteed by the government or an agency of the government and are mainly vulnerable to interest rate risk.
The market today is split between agency-backed securities and credit risk transfer (CRT) securities, said Bryan Goh, chief investment officer of Swiss private bank Bordier & Cie Singapore. These CRT securities are partially guaranteed by US government-sponsored enterprises Fannie Mae and Freddie Mac.
‘We think the agency CRT market is the go to place for safe yield,’ he said.
Meanwhile, non-agency MBS issuance has ground to a trickle in the past 10 years. These ‘private label’ securities do not have an agency guarantee, and as a result, are highly vulnerable to mortgage credit risk.
According to Ginnie Mae data, the bulk of the MBS outstanding are agency MBS, with foreign holdings of US agency MBS totaling around $890 billion in 2017 – or 14% of total outstanding. Taiwan, China and Japan account for the bulk of the foreigners’ holding of MBS.
‘The split between private and official holdings is approximately 55% private 45% official. In the pre-crisis years, the percentage of private holdings of MBS was much larger relative to now,’ Chander said.
However, there are some developing concerns in the marketplace today.
Many Asian high-net-worth (HNW) investors don’t even know that they are buying MBS as they mostly gain exposure through unconstrained fixed income mutual funds and even some exchange-traded funds.
One of the most popular funds sold through private banks last year was the Pimco GIS Income fund, about 50% of which is invested in US agency and non-agency MBS.
‘Pimco typically invests in agency MBS as a high-quality substitute for investing in US treasuries and invests in non-agency MBS as a substitute for investing in corporate credit risk,’ said Alfred T Murata, mortgage credit portfolio manager and co-lead manager on the Pimco GIS Income fund.
‘With respect to non-agency MBS, Pimco focuses on securities that have resilient return profiles, where one would expect to potentially have positive returns on a hold-to-maturity basis even in the event that there was a significant decline in housing prices,’ he said.
Murata said that not only have lending standards for non-agency MBS tightened significantly since 2008, the housing prices in the US are approximately 20% below ‘fair value’, which leads to reduced residential credit risk.
‘The recent, rapid increase in interest rates has negatively impacted the agency MBS market, which have recently underperformed treasuries. We view this underperformance to be temporary and have taken advantage of this underperformance to add agency MBS,’ he added.
Do your homework
The fear is that because these structures sit within funds, they could be lower on a private bank’s product risk-profiling matrix. As a result, inexperienced investors could be unwittingly gaining exposure to the product.
‘I don’t think Asian HNW investors were aware of collateralised loan obligations and MBS in their portfolios and most discovered them after the fact when the crisis unfolded,’ Goh said. 'Currently I do not think Asian HNW are very up to date on securitisations and leveraged finance.’
Another issue, Chander said, is that the US Federal Reserve is a massive player in the MBS market. ‘If the Fed increases the pace of unwinding of its large MBS holdings, MBS portfolios could be adversely impacted,’ he said.
What is more concerning is that many in the current cohort of Asian private bankers have never dealt with the product and are unaware of the risks.
‘In the context of their history, MBS has grown up, and being reformed to address the very problems that placed them at the centre of the 2007 crisis. Lightning doesn’t strike twice in the same place, but it can strike close, so you have to know what you are buying,’ Goh concluded.
This article was first published in the November issue of the Citywire Private Wealth magazine.