A secondary mortgage market expert I think extremely highly of emailed me last night with the following terse take on the state of the financial markets:
I think we're on the cusp of another sewer break on the news front ... get your waders on ...
No kidding. While March may have represented the worst of the credit crunch thus far, May and June are looking to shape up as particularly troublesome for a side of the mortgage market that, so far, has seen relatively benign activity. Reuters' Al Yoon knocks yet another story out the park Thurday morning:
Investors who thought they were safe owning guaranteed mortgage-backed securities in the wake of steep credit losses from other MBS are now grappling with a different kind of risk. Models that predict payments on bonds issued and protected by Fannie Mae, Freddie Mac and Ginnie Mae have been far off the mark in recent months, resulting in increased risk to investors in the $4.5 trillion "agency" MBS market. Errors are happening for the same reason credit loss forecasters failed to prepare investors for the subprime mortgage meltdown: it has never happened before.
As HW grows (hint: subscribe to our coming magazine!), we'll be tracking this more closely ourselves; we've been hearing about just how bloody May was for agency MBS for a few weeks now. In particular, prepayments didn't just slow. They came to near standstill by Wall Street prepayment research standards. When HW first started in late 2006, I spent alot of time writing about how prepayment modelers had failed to account for credit and collateral risk effectively in most of their models; what we're seeing now is the flip side of that same coin. In pure prepayment terms, triggers are blowing up faster than most models have been set up to handle -- and that's hurting even the most staid of agency MBS investors. More from Reuters and Yoon on the matter at hand:
Wall Street banks that spend countless hours trying to measure that risk for clients have seen data stray from their forecasts by unusually large amounts. A 20 percent drop in May prepayments sharply exceeded expectations, leading to a collective groan among analysts. May data "was a shock to everybody," said Arthur Frank, head of MBS research at Deutsche Bank in New York. Vagaries of falling prices and tight credit have "wreaked havoc" on models that were created during the heydey of refinancing, analysts at Merrill Lynch & Co. said in a recent research note ... "An unprecedented housing market will produce unprecedented prepayments and defaults," said Dale Westhoff, a managing director at JPMorgan Chase & Co. in New York, who has been refining models for 18 years. "We've already seen that on the default side. On the prepayment side, the May numbers are starting to reflect this new environment."
With due deference to Deutsche and JPMorgan, not everyone has been surprised by the prepayment shift. UBS immediately comes to mind, for one, having read their weekly MBS research for some time now. There's also Stamford, Conn.-based Structured Portfolio Management, which in mid-April said it was shifting its asset allocation strategy in the belief that prepayments would slow dramatically in subsequent months. (No word on how they've done with that approach, but I can safely bet the answer is "not badly.") And, of course, we should note that HW's well-known contributor Linda Lowell noted in early May that prepayment-based strategies needed to move to the forefront for MBS traders -- "the data underlying prepayment models reflects relaxation of credit standards and risk-based pricing, not the current tightening trend," she wrote then.