Mortgage-backed securities have had a very bad rap in recent years, thanks to their central role in the devastating 2008 financial crash. But are they really inherently toxic? James Fernyhough spoke to John Carey, of BNP Paribas, to find out.
To anyone who has even the vaguest grasp of what caused the financial collapse of 2008, those three little words, when joined together in that order, take on a menacing significance. It was mortgage-backed securities, or MBSs, that almost singlehandedly set off the financial crisis that brought the global economy to its knees.
Eight years on, most developed economies are still struggling with sluggish growth, high unemployment, inadequate wages, crippling levels of national debt, extreme market volatility, interest rates pushing into negative territory – the list goes on.
Given the pain those littles bundles of housing debt caused the world, if a fund manager were to appear on your doorstep holding the brochure for a specialist MBS fund and smiling, you’d be a fool to do anything other than slam the door in her face. Wouldn’t you?
Not according to John Carey.
Carey manages exactly that kind of fund for BNP Paribas – known as the BNP Paribas Flexi I US Mortgage Fund – and he argues that, far from being toxic and dangerous, mortgage-backed securities are among the least risky assets around. And it’s not as crazy as it sounds.
The reason they are so safe, he says, is because, first of all, the MBSs his fund buys are not “subprime” – meaning the primary borrowers have been carefully vetted; and second, the MBSs are guaranteed by the US government, via the ‘government-sponsored enterprises’ (GSEs) Fannie Mae and Freddie Mac. “And if you’re comfortable with the US Treasury as a creditor and a counter party,” says Carey, “you should be comfortable with the GSEs as a counter party.”
Fannie and Freddie – heroes or villains?
Fannie Mae and Freddie Mac, and their lesser known sister Ginnie Mae, are generally considered to be among the main culprits behind the 2008 crash. But while they’re names carry a negative resonance just as powerful as “mortgage-backed securities”, what they do is not widely understood.
Ironically, given their culpability in the 2008 crash, the GSEs actually originated as one of the solutions to a mega financial crisis, the Great Depression of the 1920s and ‘30s.
Fannie Mae, otherwise known as the Federal National Mortgage Association, or FNMA (hence the rather twee name that stuck), was set up by the US federal government in 1938 as part of President Franklin D. Roosevelt’s New Deal. Its purpose was simple: to make it easier for the average American to get on the property ladder.
It did this by buying mortgage debt off banks and selling that debt on to secondary investors, thus taking the loan off the bank or mortgage lender’s balance sheet, and freeing them up to give more home loans.
The Federal Home Loan Mortgage Corporation, or Freddie Mac, was created in 1970. Freddie did the same thing as Fannie, and was created to extend the mortgage-buying activity and introduce competition.
Both agencies were publicly floated around that time, but remained under the auspices of the federal government, with an implicit promise that, if they got into trouble, the government would bail them out.
Freddie and Fannie were so successful that other private players wanted a piece of the action. In the lead-up to 2008, mortgage lenders found it so easy to offload their mortgages to MBS providers that they became very cavalier about who they lent to, issuing what were known as “NINJA” loans – which stood for “no income, job or asset verification”. These were the infamous “subprime mortgages”.
Then came the defaults, followed by the inevitable bailout.
Why things have changed
According to Carey, three things have changed since 2008: banks have given up issuing ninja loans; the housing market has picked up; and, most importantly, Fannie and Freddie are once again government-owned, and now guarantee the MBSs they sell.
This, says Carey, means the delinquency or default risk is eliminated. “In an agency pool when the borrower gets to 90 days delinquent – that is, the borrower has missed three payments – that loan is repurchased [by Fannie or Freddie] out of the pool of mortgages at a price of par.” This, he says, contrasts with the subprime MBS situation.
“In the subprime space, you would have to deal with the trials and tribulations of removing that borrower from the house, re-marketing that house, all of the legal and marketing costs. You oftentimes have to pay a sales commission to the real estate agent when you go to sell that house.” In other words, you would end up getting much less than you bargained for.
Given the GSEs are owned by the US Treasury, Carey says these guarantees are pretty much as good as a guarantee gets, putting them almost on a par with US Treasury bonds.
Carey admits, however, that his MBS fund is not quite as safe a bet as a triple-A rated bond fund. The fund’s main risk, he says, is the uncertainty over the timing of repayments. Where a government bond gives a clear, reliable timetable for coupon payments, MBSs do not.
“With US agency mortgages, the borrowers have the ability to pay off their mortgage in part or in full at any time without any reason, and without any kind of a penalty,” he says. This is known in the business as “housing turnover”.
“Maybe [the mortgage holder] had a job change, or they may have become an empty nester where they’re selling their house in West Chester or Connecticut and moving to a sunny sandy place like Florida or California; they may have a growing family, and [they want] a bigger house in a neighbourhood that’s got a good school system. And so they sell their house, they take the proceeds, they retire their mortgage, and they move to a new place.”
All these events are unpredictable, and this creates a risk.
Another, even greater, risk, says Carey, comes from the downward movement of interest rates. Because mortgage holders can pay off their mortgage at any time, there is nothing to stop them refinancing their home when rates drop. That would mean borrowing the same amount of money, but on interest rates of, say, 4% rather than 5%, and using that money to pay off the higher rate mortgage. It’s a no-brainer for the mortgage holder, but rather inconvenient for the MBS investor.
“We think that we’ve got a 30 year mortgage, we’re going to be earning a nice 5% coupon,” says Carey. “But then rates fall, and just at the wrong time the borrower essentially calls the mortgage away from us. We have a pre-payment event and we’re also stuck with a reinvestment problem where we have to take that capital and redeploy it in a lower interest rate environment.” In other words: weaker returns.
But MBSs are compensated for this risk, he says, with yield about 100 basis points higher than a Treasury security of similar duration.
Overcoming the toxic reputation
Despite the strong case he makes for the virtues of his fund, Carey has no illusions about the reputation of mortgage-backed securities. “It’s still a dirty word,” he admits.
So how does he go about selling the strategy to potential distributors?
Originally this wasn’t an issue, as the fund, which Carey has been running in various forms since 1998, was only available to internal clients. It’s only over the last couple of years that the fund has been marketed to external clients. Now it is available in a Luxembourg-domiciled UCITS structure, which Carey says makes it “a lot more accessible to the average European investor”.
As for his pitch to these international investors, Carey says: “It’s a relatively low duration, high-quality government-guaranteed asset class that provides some incremental yield, and hasn’t had the same sort of volatility that we’ve seen in some of the credit asset classes.”
He adds that in the post-2008 regulatory framework, MBSs look particularly good, given that banks are subject to far more stringent capital requirements. Beyond that, Carey points to the fund’s performance, which in the last 10 years has beaten the US MBS index by around 200 basis points, and the US Treasuries index by about 300 basis points.
So, do you dare?
John Carey is head of Structured Securities for Fischer Francis Trees & Watts, a wholly- owned subsidiary of BNP Paribas. He is based in New York. FFTW provides active, fixed income strategies, via single and multi-currency mandates across global, US and emerging markets, to institutional investors around the world.