A Little Risk is What I Need (in My Portfolio)
The American investing public is a fickle bunch. Fund managers and stockbrokers must feel crazy when there is a sudden shift in the economic spectrum, or when data about the economy shifts from positive, to neutral, and then negative. The phrase “flight to safety” never meant so much as it has since the post-recession of 2008. It seemed as though every other day in periodicals or on the news wire that there was “a flight to safety as investors fled stocks and piled their profits into treasuries. “ It was unbelievably predictable, as for every two to three days of consecutive gains, that there would be the proverbial “flight to safety.” In recent days the flight has been halted, as there appears to be a more consistent appetite for risk, particularly with regards to the mortgage market.
The Wall Street Journal recently reported that of the 10 largest bond funds in the nation at the end of 2013, the four with the highest trajectory of growth were funds with portfolios weighted with 20% of their assets as bonds rated as “junk bonds.” Yes, that was 20%. The US Federal Reserve, the British Bank of England, and the European Central Bank’s obsession with low interest rates has pretty much forced the hands of the investing public around the world. With Certificates of Deposits (CDs) earning a paltry 1.2%, money market funds at 0.4%, and savings accounts offering dismal rates of .80%, investors fled “safety” and moved into the waiting arms of risk of all asset classes. Emerging markets like China, India, Malaysia, Venezuela, and even Chad received some foreign investment. Gold became a darling of the markets again, and tech startups became the rage. Recently, even riskier mortgage-backed securities (MBS) are starting to show up on the radar screens of investors as well.
Prior to Memorial Day 2014, Fannie Mae offered $1.6 Billion in residential MBS. It was so oversubscribed that the government securities entity was able to cut the interest rate yield on the bonds twice and still sold out. This set of securities was the third risk sharing class that Fannie Mae had issued since the down turn. Ironically, what makes this decision different than others is that the investors of these securities were willing to share in the risk of default. In the past, Fannie Mae and Freddie Mac’s central edict was to securitize debt and issue a guarantee on the underlying securities to backstop the originators from losses; now, this is not the case. This latest issuance involves sharing the risk. In fact, some of the MBS loans included borrowers with the high propensity to default (those with down payments as little as 3% of the purchase price). The amazing factoid to this scenario is that this portion of the $1.6 billion bond issue drew 19 times the bids needed to complete the sale!
Some of these MBS bonds were rated pure junk, and others were just a hair above junk. No matter what the rating was, there is no flight to security here. There was only flight from yields that were below inflation and a growing need to be at least 1.00% above treasuries! The trend appears to be poised to continue for the next three to five years as the artificially engineered low-rate environment is forcing investors of all sorts to do things that they normally would not do. But let’s consider the moneymakers as well.
If you are securitizing a loan and selling it to the secondary market, you are telling your originators (e.g. banks, mortgage bankers, and other providers of capital) what loan products are selling the most frequently. Therefore, mortgage lenders of all sorts are finding out that loans with higher LTVs and lower credit scores are being purchased in record volumes and that interest rate yields are being cut due to the overwhelming demand. This translates into banks and brokers starting to offer loans with even lower FICO scores, less documentation, and higher LTVs on different product types and occupancies to see if the market will buy it. Thus, the pendulum has swung back to aggressive product offerings and underwriting guidelines again. Some will say this is a good decision, as many deals were DOA. Conversely, others will say it’s a bad decision because of the damage that it caused. Some, like myself, see both sides, and can see the need for less documentation with a little discipline and regulation to prevent over levered insanity.
In summary, this recent Fannie Mae bond sale is a testament of flight from safety and time travel back to the future. The market has asked for riskier debt. Its voracious appetite is not enough. Given the sell out of such a riskier slice of the MBS pie, what is the market willing to digest next? Will it be stated income loans, bank statement loans, 90% commercial loans, or EZ qualifier construction loans? Given where rates are now, I think there is a market for just about anything that securitizers will sell and investors will eat it up. I think that if a $1 billion dollar offering of stated income apartment loans on the West Coast hit the market today, it would be sold in five minutes. I’ll take my slice of risky lending market optimism sunny side up.
Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance; he can be reached at firstname.lastname@example.org.