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Boardroom view.


What do ITT and Westinghouse have in common with high-yielding, privately issued, mortgage-backed securities (MBS)? Well, they buy them.

As it turns out, the two conglomerates are among only four to six major buyers of what are called "B-pieces" of MBS offerings that feature senior/subordinated structures. At least that's the story from one of the other major buyers of these high-yielding mortgage securities--Claus Lund, director, mortgage-backed securities portfolio with SunAmerica Investments, Los Angeles.

Lund spoke at a panel on structured transactions at the 1991 Western Secondary Mortgage Market Conference sponsored by the California League of Savings Institutions. Lund referred to ITT and Westinghouse as "probably the two largest competitors in this market" that his company runs up against in bidding for these pieces of structured MBS offerings.

The senior/subordinated structure is a design incorporated in private MBS offerings to build credit enhancement into an offering without relying on outside sources, such as pool insurance or letters of credit. The offerings typically have an A-piece or senior piece, which typically gets the very highest investment grade ratings. And then the offerings have subordinated pieces that start with a B-class and can extend down the alphabet to other

smaller pieces that make up the subordinated parts of the offering. The A-piece can glean a top-grade rating from the rating agencies because the subordinated classes are structured to absorb the hits first from any defaults and foreclosures on the collateral. Thus, investments in the subordinated classes are subject to higher risks and likewise carry substantially higher yields.

How high are the yields? Well, Lund implied they are higher than the actual risks from these securities. The way he put it, there are "risk-arbitrage" opportunities with unrated B-pieces because the market is not efficiently pricing the true risk. One audience member pressed him as to what the target rate of return was on a B-portfolio. Lund's response was: "I think the correct number would be |high'". He added, "We've been one of the few buyers and we've been rewarded quite richly for that."

Furthermore, it appears this market may not be confined to deep-pocket investors. Another panelist representing a money-management firm mostly for pension funds reported that his company holds roughly $10 billion in these type assets. Furthermore, William Powers, executive vice president for Pacific Investment Management Company, Newport Beach, California, said, "We still have our buying shoes on." The $10 billion stake represents roughly 2 to 4 percent of this entire market, Powers said. Power's firm manages $32 billion in assets and more than 85 percent of the holdings are in the fixed-income market. PIMCO, as the firm is called, is "investing for people's pensions" so the goal is to exceed investment expectations "with no surprises," according to Powers. "We can't rely on rating agencies or Wall Street to do our credit homework for us."

So, how is the private MBS market performing overall in the wake of the recent recession, and what is the volume of new offerings? It appears this market is on track for a record year, according to Howard Esaki, assistant vice president, structured finance department, Moody's Investors Service. Esaki said $17 billion of new, private pass-throughs were issued in this year's first half alone, compared to $25 billion for all of 1990. Volume in 1991 is on track for $35 billion in total offerings. What's driving the private MBS offering boom? Thrifts are selling off a lot of loans in structured offerings, and added to that is the Resolution Trust Corporate with its $1 billion a month in private MBS offerings.

Senior/subordinated transactions made up roughly half the deals in the first half of this year, as they did in 1990, Esaki said. Even though production in the primary market is predominantly fixed-rate, only about half the deals this year in the private pass-through market involve fixed-rate collateral.

Many of the same trends visible in other aspects of the business are having some affect on the private pass-through market. Delinquencies are up, business is more concentrated in fewer hands and cramdowns are rearing their ugly head. Esaki said the delinquencies on the ARMs supporting private pass-throughs were close to 6 percent, while fixed-rate loans backing private pass-throughs were roughly 3 percent, and 15-year loans had a modest 1.5 percent delinquency rate. On the matter of issuer concentration, in 1990 the top five issuers had more than half the total volume and the same trend is expected to continue this year and beyond, Esaki said. And finally, Moody's has recognized the growing risk from cramdowns in bankruptcy proceedings and has raised its bankruptcy coverage for offerings seeking credit ratings, according to Esaki. He said because investors are "very concerned about the risk" and bankruptcies are on the rise, the rating agency had to make an adjustment to cover what could emerge as a significant new source of risk for investors in private MBS securities. Interestingly, in mid-July when Esaki reported that Moody's had made this policy change, Standard & Poor's had yet to adopt a similar policy. Cramdowns arise when borrowers file for bankruptcy and their mortgage balance is divided into a secured claim, reflecting a lower, current appraised value of their homes, and an unsecured claim where the lender has to get in line with countless other unsecured creditors and where the return on the dollar is meager.

The panel's consensus view was that investor demand is growing for the subordinated pieces of these private pass-throughs. And as Michael O'Hanlon, managing director--mortgage finance, Lehman Brothers, said, "the range of yields is enormous." Lund, of SunAmerica, said, "you often hear prices ranging 300 to 600 basis points for B-pieces."

Lund said his firm invests "both in senior pieces and subordinated pieces. But it is more interesting and challenging investing in subordinated pieces than in double-A rated pieces." Lund says his firm buys B-pieces from old issues and from new transactions. But if they are buying the pieces from new deals they want to be involved with structuring the B-piece from the very beginning. Lund said his firm often says up-front they reserve the right to reject certain loans and "that's not always popular--especially if the issuer is a mortgage banker type. They prefer to sell 100 percent of their production." He added that "foremost in our concern is LTVs and that includes the distribution of LTVs."

Another thing that is probably not all that popular with mortgage bankers is the standard agreement SunAmerica seeks to strike with servicers of these B-pieces. Lund said, "The servicer we see more as performing a subservicer function. They can't just service as if it was their own portfolio." SunAmerica' standard agreement insists that it has the right to terminate the servicer with cause, the company imposes its own set of reporting requirements and for any transfers of this servicing, SunAmerica insists on approving the new servicer.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:investing in mortgage-backed securities
Author:Hewitt, Janet Reilley
Publication:Mortgage Banking
Date:Sep 1, 1991
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