Many equity investors will point to the end of the ‘bull trap’ rally in October 2007. Equity markets had proven one of the biggest naysayers during the early stages of developments, belligerently climbing back from a summer slump to challenge new all-time highs in the autumn, despite sentiment indicators suggesting we were approaching peak bearishness.
From a similar perspective, those that chose to shelter in safe haven assets will doubtless recall the second week of March 2008 when gold traded above USD 1000 per ounce for the first time in history. Meanwhile, others may point to the collapse of Lehman Brothers in September 2008 as the apocalyptic event that changed the financial landscape permanently.
However, for those of us who specialise in investing in mortgage-backed securities (MBS), the GFC’s ‘tin’ anniversary has unquestionably come and gone already. On Wednesday August 9, 2007, BNP Paribas froze three of its funds because it was unable to value the MBS held within their portfolios. In a world in which everything had its price, credit risk, it appeared, was the major exception. Their statement included the following: “The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly, regardless of their quality or credit rating...”
There are two main types of MBS: ‘Agency’ and ‘non-agency’. The former are effectively government backed and are more secure but offer lower rates of return and thus generally offer yields at tight spreads to Treasuries. Conversely, the latter are issued by private institutions, are privately insured or not insured at all, and are therefore subject to credit risk, but potentially may deliver significantly greater rewards.
Before the boom in sub-prime lending in the early stages of the new millennium, we were comfortable with the concept of judiciously absorbing credit risk in return for the higher yields associated with it. However, sub-prime proliferated incredibly quickly because so many parties had vested interests in its expansion. Government officials used policy tools to gain popularity by promoting home ownership, mortgage originators and investment banks collected large fees, investors overlooked credit standards in exchange for yields that could be levered into high returns on equity, and so on.
Global banks had a large appetite for subprime mortgages because the regulatory reserve requirements made it more attractive for banks to hold highly rated subprime mortgage securities, rather than simply issuing mortgages to bank customers directly using their own credit underwriting. In fact, the capital arbitrage was so great that banks effectively became dependent on mortgages originated by other non-bank, high volume lenders. However, the poor quality of these loans was overlooked by many investors as long as the securities at the top of the capital structure attracted the highest-quality ratings; they always did as these were the most senior tranches and the rating agencies never contemplated a scenario in which so many loans in any given pool would default that the losses could reach that high up in the capital structure.
‘The Chinese use two brush strokes to write the word “crisis”. One brush stroke stands for danger; the other for opportunity.’
John F. Kennedy
As it became clear to us that credit risk was becoming increasingly mispriced, we focused on the agency side of the market which offered a different set of opportunities, by taking mortgage prepayment risk and interest rate risk, but not credit risk. Then, when the subprime bubble burst in 2007, all appetite for credit risk diminished sharply and, since our capital remained intact, we were able to benefit from investing where the fundamental dislocations were greatest.
To be honest, we felt bad about the unfortunate losses suffered by others, but we did what any judicious and specialist investor would have done in the circumstances. With the MBS arena in total disarray and many investors left with substantial losses, this proved a very auspicious time to re-engage in the non-agency segment of the market.
Almost inevitably, the sub-prime crisis ultimately served as the harshest form of quality control. Since then, only those individuals with the highest credit ratings are able to obtain mortgages. Additionally, the number of new houses being built is still below the long-term average, meaning that both house prices and mortgage collateral are increasing in value and credit quality is very high.
With the mortgage and housing markets well supported, we believe this is the ideal opportunity to increasingly take on mortgage credit risk. Our investment approach is naturally conservative. Consequently, we tend to invest in securities that are high in the capital structure where we aim to harvest robust and stable returns with low volatility and a sound risk / reward trade off.
However, we remain mindful of the importance of being sufficiently flexible to take advantage of opportunities in both agency and non-agency MBS, with market conditions largely dictating the appropriate split. Consequently, our investors do not have to figure out whether there are better risk-adjusted rewards to be garnered from taking on credit (non- agency) or prepayment (agency) risk – we make those decisions for them.