Caveat Emptor: Let the Buyer Beware

Kevin P. Chiappetta, CFA
April 15, 2009 | COMMENTS

For every winner there is a loser. Someone makes money on a trade when someone else loses money.

These axioms, while sometimes true, have been making their way around several credit unions in the last year in order to justify investment portfolio managers moving into new asset classes. One of the sectors that credit unions are exploring is the private label mortgage-backed security (MBS) market.

Yes, this is the same market that locked up in 2008, resulting in hefty losses at many institutions in and outside of the credit union system. Since the market values for these securities tanked in 2007 and 2008, many portfolio managers looking to capture higher returns have been evaluating this sector. This would enable them to reap excess returns in a time when interest margins are squeezed and non-interest expenses are eating up more of their revenues.

To realize excess returns, you have to buy low and sell higher. To follow that principle, you can search for securities that have fallen out of favor, but there is more to the story. Let's explore the sector to discover which other factors you should consider before venturing into this asset class.

Analyze mortgage-backed securities carefully

First, let's investigate the securities' mechanics. These MBSs are issued by private companies and are backed by pools of mortgages. Since the issuers are not government-sponsored entities like Freddie Mac or Fannie Mae, they need to be analyzed and rated by nationally recognized statistical rating organizations (NRSRO) as to their relative creditworthiness. The NRSRO firms have downgraded many of the MBSs, which has, in turn, triggered investors and their brokers to peruse the markets looking for bargains.

Investors have realized that as ratings decline, the MBS prices have also declined. It stands to reason that as the risk of principal loss increases, the price investors are willing to pay reflects that risk. Savvy investors are looking to exploit the discrepancy between the ratings and the prices. When markets become disjointed, opportunities exist to purchase assets at prices below intrinsic value, or the present value of the security's future cash flow.

Let's presume that Moody's has downgraded an MBS to a Ba rating, which implies that there is a “substantial credit risk.” Since we cannot assign a dollar value to this risk, we will presume that an investor can expect to receive 85 cents of every principal dollar to be paid, or a loss of 15 cents of every dollar. If the NRSRO and investor have properly quantified all of this MBS's risks, the investor should be willing to pay a dollar price of 85 cents (again, we presume that all present value of cash flows equals current price), collect the interest and receive 85 cents.

If the investor can purchase the security today for a price below 85 cents, the investor could collect exceptional gains. And therein lies the attraction: potential excess returns.

Since this market's liquidity is nearly non-existent, many believe that the dollar prices quoted are well below value and that excess returns are not only possible, but quite likely. The rating reflects the likelihood of receiving 100 cents of each dollar in par value, not the 85 cents invested in our example. Therefore, using the rating to direct us to the price we are willing to pay should allow us to look at these securities as a way of extracting returns above what can be earned in other markets. If the market improves, the opportunity to earn above market rates with returns of principal north of 85 cents becomes real.

Not so fast in today's marketplace…

Now that we have established the mechanics of the profit potential, we must review the reality of today's marketplace. Earlier we presumed that the securities' ratings reflect the likelihood of timely repayment of principal and interest. Today, this assumption couldn't be further from reality.

The NRSRO ratings associated with MBSs do not reflect the market's anticipation of the repayment of principal. The appearance of the pricing discrepancy (and of the profit potential of owning these MBSs in the first place) is predicated on the rating accurately reflecting the MBSs' creditworthiness. While this article does not focus on securities' creditworthiness, suffice it to say that the ultimate return of principal to investors is currently suspect and not accurately reflected by the ratings.

The ratings on these MBSs presume that each investor has purchased the security at par. Therefore, if investors can purchase an MBS in today's market at significant discounts to par value, they can build in a margin of error to the security's rating. If I were to purchase an MBS for 85 cents—let's assume it is rated with a high likelihood of losing five cents on every dollar invested—that calculation is built on the assumption that the loss is five cents on 100 cents invested. Therefore, I can assume that the return I will receive is 95 cents for every 85 cents invested. This and other factors have caused people to investigate MBSs.

There are several challenges to this line of thinking. Rather than relying on its credit rating to determine value, we should establish each MBS's value by analyzing:

• the complexity of its cash flows
• the particular order of priority under various credit events
• the recent and future payment rate of the borrowers in each trust

As previously stated, this market sector is loaded with complicating factors embedded in each security.

• Mortgage collateral backs a trust.
• Trusts are divided into tranches.
• Tranches each carry unique characteristics that determine who gets paid, when they get paid and in what order.

Understanding these factors requires a great deal of research with systems that are not available to most credit unions. Out-thinking this market without the proper tools is next to impossible. Consider these caveats:

1. Relying on a third party (presumably the MBS seller) to evaluate these characteristics before purchase leads to obvious conflicts of interest and puts the very conclusions of the research in question.
2. Relying on ratings to help value the security's worth is a riskier proposition now than most investors understood even one year ago.

MBS ratings continue to degrade as credit behaviors change in a rapidly deteriorating economy. As job losses mount and more borrowers struggle to pay their mortgages, collateral that backs the MBSs will perform poorly and the bond losses will become more likely.

As this happens, the NRSROs will recognize the performance with bond downgrades. These downgrades will change the calculation on loss probability, timing of principal return and current value of the MBSs. As those who have held these MBSs over the last several months can attest, this is not a pleasant market event.

Gems in a mountain of garbage

Finally, please note that we are a highly regulated industry. As such, there are clear rules under which we are required to operate. Investing in lower-rated securities does not fit in well with this type of regulatory environment. Owning these lower-rated MBSs may require prior approval from the NCUA or state regulators and given the environment, obtaining this approval will not be easy.

It is easy, however, to get excited about finding gems in a mountain of garbage, which explains the enthusiasm on display when investigating these MBSs. It is important to remember that our primary focus as credit union investment managers is different from other investors. Our primary purpose is to safeguard excess reserves for future loans and gain the maximum available return within the guidelines of internal policy and external regulation.

As a result, the search for excess returns within this sector does not likely fit within the constraints established for most of us.

Kevin P. Chiappetta, CFA, is Senior Portfolio Manager, Balance Sheet Solutions, LLC. Contact the author at kevin.chiappetta@balancesheetsolutions.org or 800-782-2431, ext 2715.