Q&A with Emily Hollis

Emily Hollis
January 17, 2008 | COMMENTS

Q: I read your article on FHLMC and their unrealized security losses. On one hand, I am scared to invest in anything; on the other hand, I am seeing yields close to 6 percent on securities backed by non-conforming loans. Are those safe? I don't want to be hit with losses.

Your fear is exactly why there is a growing spread between Treasury rates and other investment alternatives. But remember, there is a vast difference between unrealized losses and actual principal losses as defaults are realized.

AAA non-conforming first-lien mortgage loans are trading at wide spread variances, specifically from 150 basis points over the relative Treasury to as wide as 300 basis points. We have been buying select non-conforming loans after rigorous analysis for those credit unions that understand the risk. Although a key determinant of yield is the projected weighted average life, spreads vary even amongst equal weighted average maturity securities. Although you don't mention what type of non-conforming loans you are considering, those yielding “close to 6 percent” are generally backed by hybrid adjustable-rate mortgage loans*. The chart below shows the dramatic widening of AAA-rated securities backed by 5/1 hybrid mortgage loans.

Although these adjustable-rate mortgage loans can have high average FICO scores, it is imperative to conduct a thorough analysis to assess the risk. An investor needs to understand the underlying collateral and support of the bond prior to purchase instead of simply relying on the rating.

Credit support can be measured several ways:

• The first dollar loss credit default rate (CDR)
• The dollar credit enhancement of the investment pool
• The credit coverage ratio

The first dollar loss CDR is a calculation which shows how much of the pool would have to default at an assumed loss recovery rate prior to losing principal. There are asset-backed securities held by credit unions in the industry that consist of 25 percent subprime loans. Credit enhancements are so high on these types of securities that defaults would have to rise to 100 percent of the mortgage pool with a 50 percent loss recovery rate prior to principal losses. Even with the subprime loans, investors should feel very comfortable holding on to these types of securities for the chances of 100 percent of the pool defaulting is remote.

The dollar credit enhancement is the dollar amount of credit supporting the security. The credit support coverage ratio is a ratio which provides market participants the ability to determine the support coverage, based on assumptions for the performance of the loans within the delinquency pipeline.

AAA-rated securities backed by hybrid mortgages can have credit enhancements as high as 13 percent. That credit enhancement percentage allows for a 12 percent CDR combined with a 30 percent loss severity prior to any principal loss to the investor.

It is difficult to imagine that loans with average FICO scores of 750 would have such severe losses; however, these loan rates will adjust higher should interest rates rise, in which case the mortgage holder might not be able to keep up. This is indeed why the FOMC is keeping rates low in an attempt to restrain defaults from their continual rise.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.

* Hybrid mortgage loans are adjustable rate mortgages that are fixed for a period of time, generally, 3, 5, 7, or 10 years after which they float off of an index and typically reset on an annual basis thereafter.