This was written by someone really smart who manages several billions of dollars.
The RMBS market has been, in our view, the most disrupted and systematically cheap corner of the fixed income universe for the past few years. The buyer base transformation (from ratings-based holders to credit specialists) taking place in the massive (>$1 trillion) Non-Agency market has resulted in securities priced to quite adverse outcomes that appear to be at odds with observable housing market trends over the longer term. High returns (to long average lives) are achievable without improvement in housing.
Since the spring of 2011, the distressed Non-Agency RMBS landscape has become an increasingly broken market where (dramatically lower) prices have become more and more detached from (steady to improving) fundamentals. We are regularly buying securities at 25-35% discounts to trading levels from earlier this year.
The state of disruption in the distressed RMBS market is relatively stark. It isn’t very often that the market presents us with a chance to buy senior debt securities with 20%+ return potential that offer:
- Very low principal risk (IRRs to maturity are slightly positive even in the event of catastrophic housing deterioration from current depressed levels). We believe these securities are priced to withstand more in the way of economic/housing deterioration than just about any other asset category in which we invest.
- Very high (~1,000-1,500+) loss-adjusted credit spreads to long average lives (spreads would be even higher if we used less conservative assumptions with regard to defaults, loss severities, prepayments, etc.)
- Relative value (loss-adjusted yields in distressed RMBS are substantially higher than nominal yields in other asset classes)
- Exposure to an asset class that is naturally (and significantly) improving in credit quality as the worst borrowers continue to default; as these pools become less distressed in credit quality, it is likely that they will also become less distressed in price as they begin to appeal to a broader base of investors and become priced to less severe scenarios and/or lower yields; another way of thinking about this is that credit improvement can occur without housing market improvement)
- Exposure to an asset class that has never endured a distressed cycle, and where traditional investors lack the credit background necessary to underwrite this risk. Much of the highest return profile collateral is found within the SubPrime and Pay Option ARM sectors. These are among the most complicated areas of the market, where credit expertise and security selection are critical, emerging variables such as put-back settlements and modifications take on amplified importance, and collateral is often only available in small size. Due in part to these factors, PPIP managers and mutual fund complexes have been less active in these areas.
- Positive leverage to US dollar debasement / inflation (which would tend to boost homeowner equity, slowing default rates and increasing recoveries)
- High current yields (the static yield on our RMBS portfolio is ~11%, which helps to dampen return volatility)
- Rapid return of cash (many securities, by virtue of seniority, amortize in excess of 20-30% per year; recouping our investment quickly allows us to reduce our dependence on a friendly back-end housing/economic environment)
- Free options on voter-friendly policy initiatives (principal modifications designed to keep people in their homes are increasing in frequency and effectiveness; we are buying securities that should benefit from the lower default, higher recovery, higher prepayment environment that could be expected to result from a scenario in which borrowers have higher home equity)
- Free options on litigation (mortgage put-back settlements). Our portfolio stands to benefit meaningfully if the Bank of America settlement unfolds as planned, and there is a very reasonable chance that this settlement will be revised upward and that other banks will be compelled to offer similar consideration.
In spring 2011, distressed Non-Agency RMBS prices began to fall precipitously. Importantly, the selloff occurred in the absence of unforeseen deterioration in housing fundamentals. Rather, the initial downdraft arose from supply fatigue attributable to the Federal Reserve’s disorderly liquidation of its $31 billion Maiden Lane II portfolio (which consists mostly of SubPrime, Alt-A and Pay Option ARMs) and well-telegraphed additional supply from other players (such as Dexia’s >$7 billion portfolio). Many market participants have relatively short term investment horizons, and were disinclined to buy or hold assets with short term mark-to-market risk when they knew additional supply of those assets was due to hit the market in the near future.
Subsequent to this flood of supply, the severe risk-off climate in August/September weighed further on prices (especially as general de-risking and uncertainty around capital requirements resulted in reduced participation from Wall Street investment banks).
Like most markets, certain parts of the mortgage arena are overbought while others are either under appreciated or thinly sponsored. However, on the whole we believe certain portions of this asset class are poised over the next couple of years to generate higher returns with less risk than virtually any other sector in which we operate. The asymmetry embedded in these assets at current prices (positive yields to maturity even in a severe left tail scenario, with quite high total return potential in the event of reflation or even a perpetuation of the status quo) stands out starkly versus the rest of the RMBS market as well as other asset classes. In this uncertain macro environment, we believe that assets with these kinds of return profiles (where left tails can be cut off but right tail options are substantial) will be increasingly coveted. Scarcity value should also not be ignored – long-dated (5-10+ years), high loss-adjusted spread (>1,000 bps) debt with positive leverage to inflation is hard to find at the moment outside of distressed Non-Agencies (over time, pension funds and insurance companies struggling to meet liabilities should find this asset class difficult to ignore).
The mortgage arena is one in which we have generated excellent returns without leverage across vastly different environments for the housing market and broader economy. Our first foray into the space was in 2005, when we began buying protection on single-name SubPrime ABS. Our short positions peaked at just under $1 billion notional, on which we ended up making north of $700M in profits. Soon after, one of our larger investors requested an RMBS-only separate account, which began investing in January 2008. This account was up (net of fees and without leverage) +17.7% in 2008, +82.8% in 2009, and +20.4% in 2010, and it is up +0.9% year-to-date through November 25th. Our allocation to RMBS within our multi-strategy funds has also grown significantly. At present, we manage about $4.3 billion (market value) in mortgage securities across all funds, about $3.9 billion of which is in Non-Agencies. The recent selloff (again, a function mostly of near-term technicals rather than fundamentals) has created an attractive opportunity to add incremental exposure.
We have been deliberately targeting some of the most distressed mortgage pools that were originated at the peak of the housing market (2005-2007) and the trough of lending standards. The reason we are focused on these poor credit quality pools is that they require a great deal of credit expertise, and most of the mortgage investor base does not employ a credit-intensive approach. Before 2008, the mortgage space was dominated by ratings-based buyers (insurance companies, banks, pensions etc. that needed to buy AAA assets). Credit rating, not credit quality, was the primary criteria for investment. The process of ratings downgrades a few years ago is one of the primary reasons this opportunity exists – the major holders of this debt became forced sellers in droves once it was downgraded. Moreover, they were largely sellers into a vacuum because there was not a well-established distressed mortgage investor base (this is the first nationwide distressed cycle in the mortgage market).
A credit-intensive approach to the space leads us to believe that current prices do not reflect the substantial returns likely to be reaped from these distressed mortgage pools. This is largely a function of the fact that the Non-Agency asset class is huge (over $1 trillion), and the marginal movers/determiners of price tend to be the largest participants (Pimco, Blackrock, TCW, etc.), members of the long-only community that, due to the vast sums of capital they have to deploy, are compelled to take a somewhat macro, less credit-intensive approach to mortgage security analysis. If these large asset managers tore apart every $5M security for sale and stress-tested it for several hundred default, recovery, prepay and modification scenarios (as we do), they would find it difficult to put their money to work). To some degree they need to buy and sell in bulk and apply more blunt methods of security valuation. These dominant methods of mortgage security valuation tend to set prices, and (in our view) fail to appreciate various forms of optionality (on fundamentals, interest rates and policies) embedded in the