The fall-out from subprime – challenge or opportunity?
A year on from the credit crunch it is time to evaluate where portfolios are standing. At first glance it certainly appears to be a gloomy picture. We believe tighter credit conditions, increased defaults on loans and mortgages by consumers and bank write-downs will continue to create a challenging environment in the year ahead.
The housing market looks like it will continue to deteriorate and the rate at which home prices are declining will accelerate. Much uncertainty remains as to how far the decline will go, but we foresee further rating downgrades and selling pressures on securities backed by subprime loans as efforts by central banks to mitigate damage have limited impact on the slowdown in growth. Widened credit spreads Massive de-leveraging caused by subprime losses has contributed to significantly wider risk and liquidity premiums. However, we believe the current market dislocation is creating some attractive security selection opportunities in mortgage sectors that have been indiscriminately punished. Little distinction is being made between securities that have experienced (or will experience) real cash flow problems (credit losses) and those that are structurally well insulated from credit losses. Many high-quality mortgage backed securities/asset backed securities are trading at discounts not supported by fundamentals, and for managers performing the necessary credit work, there are some attractive security selection opportunities. We believe house price declines and increasing delinquency rates will continue, causing continued investor fears, liquidity challenges and further investment opportunities in 2008/9. Commercial mortgages Considering the continuing risks presented by the sub-prime market, it may make sense to consider commercial mortgages rather than the domestic market. AAA-rated commercial mortgage backed security spreads have widened on expectations of balance sheet reductions and credit deterioration but, until recently, have generally outperformed other mortgage credit products. While we believe AAA-rated super-senior classes from the highest quality mortgages should be well protected from stressed collateral losses, because of increasing headline risk. We do however feel that the dramatic spread-widening experienced by the sector in January may have created some value. We believe it is wise to consider increasing exposure to AAA-rated commercial mortgage backed securities, by choosing an asset management house which places a strong emphasis on security selection in the sector. Mortgage risks With regards to subordinate BBB-rated CMBS, despite recent widening, we believe spreads do not adequately reflect the deterioration in underwriting quality and credit enhancement; we expect continued underperformance in the subordinate CMBS sector and continue to believe that the higher level of risk exists within the lower-rated parts of the capital structure. Therefore, we remain cautious on mortgage credit. While we believe the lower-rated (< AAA) segment of the subprime market has nearly bottomed, recovery prospects are dismal and the risk-reward from these securities is still unattractive. We would expect opportunities to arise further down the capital structure at a later point when the impairments of the collateral in this segment become more apparent. Clearly the market is in the grip of a prolonged period of uncertainty and it is thus with caution that we approach the discussion of opportunity. But for those who study the fundamentals of individual securities carefully, there may be benefits from considering investing in high quality but indiscriminately priced mortgage sectors.
