Académique Documents
Professionnel Documents
Culture Documents
We recommend a moderate underweight to fixed rates versus a barbell of hybrids and CMBS, an overweight to 15-year mortgages and look for ways to source call protection.
Srinivas Modukuri 212-526-8311 Prime MBS Vikas Shilpiekandula Prasanth Subramanian Jose John Eric Wang Olga Gorodetsky Sub-Prime MBS Akhil Mago Jasraj Vaidya Rahul Sabarwal ABS CDOs Michael Koss Non-mortgage ABS David Covey Brian Zola Dan Mingelgrin CMBS Neil Barve Aaron Bryson Prepayments Stefano Risa Phanwadee Khananusapkul
PRIME MBS
15
We favor owning hybrids versus fixed-rates and non-agencies over TBAs. In credit, we recommend moving up-in-borrower-quality and down-in-rating. NON PRIME MBS 17
We expect credit concerns to dominate 2007, resulting in significant negative headlines in the sector and advocate an overall defensive posture in 2007. ABS CDOs 19
Coming off a year in which ABS CDO spread volatility was relatively low, 2007 is gearing up to be a year in which tiering emerges, fundamentals come to the forefront, and spreads soften further. NON-MORTGAGE ABS 20
In 2007, we look for consumer credit to weaken but the impact on bond valuations to be limited because non-mortgage ABS should act as a safe haven for investors.
CMBS 21
Commercial real estate markets should withstand the residential slowdown, with some risk to the downside. We like AAA CMBS; underweight BBB/BBB-.
PLEASE SEE IMPORTANT ANALYST CERTIFICATION(S) ON THE BACK COVER OF THIS REPORT.
CONTACTS STRATEGIES
Srinivas Modukuri ................................................................................................. 212-526-8311............................... modukuri@lehman.com
Coordinator
Monica Vizzio ........................................................................................................ 212-526-2020..................................mvizzio@lehman.com
MBS
Vikas Shilpiekandula ............................................................................................ 212-526-8311.................................. vshilpie@lehman.com Prasanth Subramanian ............................................................................................ 212-526-8311............................... psubrama@lehman.com Jose John ................................................................................................................ 212-526-8311...................................... jjohn@lehman.com Eric Wang............................................................................................................... 212-526-8311.................................... ewang@lehman.com Olga Gorodetsky .................................................................................................... 212-526-8311................................ ogorodet@lehman.com
ABS
David Covey........................................................................................................... 212-526-8312................................... dcovey@lehman.com Michael Koss.......................................................................................................... 212-526-8312 ................................. mkoss@lehman.com Akhil Mago ............................................................................................................ 212-526-8312.................................. akmago@lehman.com Brian Zola............................................................................................................... 212-526-8312...................................... bzola@lehman.com Jasraj Vaidya .......................................................................................................... 212-526-8312................................... jvaidya@lehman.com Rahul Sabarwal ...................................................................................................... 212-526-8312................................ rsabarwa@lehman.com
CMBS
Neil Barve .............................................................................................................. 212-526-8313....................................nbarve@lehman.com Aaron Bryson ......................................................................................................... 212-526-8313................................. aarbryso@lehman.com
QUANTITATIVE RESEARCH
Stefano Risa ........................................................................................................... 212-526-6681....................................... srisa@lehman.com
Residential Prepayments
Stefano Risa ........................................................................................................... 212-526-6681....................................... srisa@lehman.com Phanwadee Khananusapkul .................................................................................... 212-526-6681............................... pkhananu@lehman.com Ning Chen .............................................................................................................. 212-526-6681.................................... nichen@lehman.com Min Fan .................................................................................................................. 212-526-6681..................................... mifan@lehman.com
Residential Credit
Dick Kazarian......................................................................................................... 212-526-9487......................... dick.kazarian@lehman.com Vivien Huang ......................................................................................................... 212-526-2629.......................... vivien.huang@lehman.com Omer Brav.............................................................................................................. 212-526-1302.................................. ombrav@lehman.com Jake Katz ................................................................................................................ 212-526-9114..................................... jakatz@lehman.com
ABS
Dan Mingelgrin ...................................................................................................... 212-526-7764................................dmingelg@lehman.com Gaetan Ciampini..................................................................................................... 212-526-5751.................................. cgaetan@lehman.com
CMBS
Wei Jin ................................................................................................................... 212 526-9956 .................................... bawoo@lehman.com
OVERVIEW
A BRIEF HISTORY OF TIME Interesting Developments on the Macro Picture Rate hikes, housing slowdown, low volatility, tight spreads Before we turn to our outlook for 2007, let us go through the mandatory recap of 2006. We had expected the past year to be largely a macro story and were not disappointed. There has been a growing dichotomy between the Fed and the capital markets. In the face of strong economic data, the Fed hiked rates by 100bp and has retained inflation as the primary risk. With a fairly sharp slowdown in housing, the capital markets disagree and are pricing in close to 80% probability of the Fed easing by the summer. Despite this uncertainty on the macro front, selling volatility to earn carry is still very much in vogue. Implied volatility has been on a steady decline over the past year (for the most part) and realized volatility has obliged correspondingly as well. Spreads are at the tight end of their historical range, liquidity premiums are low and the overriding theme of too much capital chasing too few assets has dominated for the most of last year. Strong Year for Securitized Products, Leveraged Portfolio Up 8% in 2006 Strong performance in MBS and CMBS Against this backdrop, it is no surprise that securitized products turned in a good year (Figure 1). The Securitized Index was the top performer among the major sectors of the aggregate Index, besting swaps by 67bp in curve-adjusted excess returns through midDecember. Within securitized products, both MBS (70bp) and CMBS (61bp) enjoyed comparable performance while ABS (35bp) was a rare laggard. The drivers of outperformance were the usual suspects. Decline in implied volatility helped in 1H06, especially for MBS. During 2H06, spread tightening was the primary factor driving returns as a combination of overseas and CDO demand helped all spread sectors. Our leveraged portfolio enjoyed a decent but not a great year (Figure 2). Through midDecember, we posted an ROE of close to 8%slightly lower than the 9% in 2005. Our best three trades were our overweight to MTA BBBs with protection on sub-prime CDS, buying 2005 IOs vs. 2003s and our recommendation to buy 5.5% IOs curve hedged. Similarly, the worst three trades were our recommendation to go up in coupon through the FN 6/5 swap, selling mortgages versus hybrids and CMBS in the first quarter and buying the DW 5/4.5 swap in June. See the flow products section for details.
Figure 2
% ROE 20% 16% 12% 8% 10.0% 18.0%
2H06 29 33 10 16 4 -3 9 -1
YTD 67 70 35 61 32 20 41 17
38 37 25 45 28 23 32 18
9.5%
8.6%
THE STATE OF AFFAIRS WITH THE HOUSING MARKET Recent HPA Softening is Significant and Will Likely Persist Nearly 25% of MSAs are reporting price declines With housing being a strong overriding theme for 2007, it makes sense to take stock of recent developments and outline our baseline expectations for the coming year. At the risk of stating the obvious, there has been a dramatic softening in the housing market over the past few months. The headline home price appreciation (HPA) declined from 12.3% in 4Q05 to 3.5% in 3Q06 on an annualized basis at the national level. While national home prices are still appreciating, there are three reasons why our outlook for 2007 is pessimistic. First, the recent decline in HPA is sharp from a historical standpoint. There have been few instances in the past when the headline number dropped by 4% in two consecutive quarters. Given that home prices typically have long cycles, we dont think we are close to the bottom yet. Second, while the national HPA is still positive, close to 25% of the MSAs are currently reporting price declines, compared with just 4% in 4Q05 (Figure 3). Similarly, the number of MSAs recording gains in excess of 20% has declined from 20% in 4Q05 to about 4% in 3Q06. This points to serious structural weakness and housing is unlikely to rebound soon.
Figure 3. Nearly a Quarter of MSAs with Negative HPA in 3Q06
HPA Buckets <0% 1-10% 10-20% >20% National HPA
Source: OFHEO.
Baseline Forecast for 2007: Expect Housing to Stay Flat We expect housing to be flat in 2007 Third, and the most bearish sign from our perspective, is the make up of the MSAs reporting price declines. In Figure 4, we sorted MSAs by their cumulative HPA from 2003-2005 and looked at their reported HPA in 2006. The hot MSAs have seen the highest slowdown but have still reported price gains above the national average. For instance, the top percentile, which saw a cumulative price appreciation of 60% from 2003-2005, still recorded an HPA of 8% in 2006. Predominantly, the MSAs that did not enjoy price gains over the past few years are now suffering price declines. The housing froth hasnt been entirely taken out and our outlook for HPA remains bleak. From our perspective, we expect HPA to be flat to slightly up for 2007 and most of the subsequent analysis/recommendations are based on that assumption.
Figure 4. Hottest Markets Have Seen the Largest Correction in HPA
MSAs Bottom 10 10-25 25-50 50-75 75-90
th th th th th th
Avg HPA '06 YTD 1.6% 3.3% 5.6% 8.5% 9.7% 8.1%
Top 10
Source: OFHEO
SUPPLY OUTLOOK 2007: LOWER CASHOUTS, WEAK UNDERWRITING Will Cashout Refinancings Persist at Current Levels? Equity extraction declined to $575 billion in 2006; cashouts partially offset decline in purchase activity The impact of a softer housing market on origination volumes has been mixed. Purchase activity has declined by close to 25% over the year (as expected) but refinancing volumes have been surprisingly resilient (Figure 5). Most of that has been due to cashout refinancings that accounted for close to $1 trillion of originations in 2006. With home prices stalling and the median new rate of a cashout refi materially higher than the old mortgage, we dont expect this trend to persist. Barring a significant rally in mortgage rates, we expect origination volumes to decline an additional 10%-15% in 2007. For those interested in the macro picture, here is a quick update on the equity extraction story. We expected equity extraction in 2006 to decline to $500 billion from the high of $800 billion in 2005. Through Q3, we estimate annualized equity extraction of around $575 billionmost of the difference owing to cashout refinancings. Looking forward, we expect equity extraction to decline to below $400 billion in 2007 and a corresponding adverse impact on the consumer.
Figure 5. Originations and Cashout Refinancings over the Past Three Years ($ billion)
Total 3,912 2,772 3,026 2,579 Originations Cashout Refi 923 721 936 897 Equity Extracted Total Cashout Refi 656 41 733 64 792 151 575 220
Proliferation of Non-Traditional Products Underwriting has deteriorated significantly in 2006 The proliferation of non-traditional products continued unabated in 2006 with ARMs/non-amortizing products accounting for close to 45% of originations. We dont view this as a problem per se. So long as the underwriting remains prudent, product innovation is not an issue and we expect non-amortizing loans to remain popular over the coming year as well. What does concern us is the steady deterioration in credit fundamental over the past year. Sub-prime loans accounted for more than a quarter of all originations (Figure 6). Similar trends are true for most measures of weaker credit originations like CLTV. Excess capacity in the mortgage banking industry, coupled with a dramatically lower risk aversion in the capital markets, has taken it toll on underwriting standards. As we discuss further on, the impact of lax underwriting is beginning to show in recent collateral performance. However, till mortgage credit spreads widen to reflect that, we expect recent origination trends to persist.
Figure 6. Proliferation of Non-traditional Products
40 30 20 10 0 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06
%Sub-prime
%CLTV >90
DEMAND OUTLOOK 2007: SAME AS 2006, RISKS TO THE DOWNSIDE Better Demand than Expected in 2006 Bank and overseas purchases surprised us to the upside in 2006 On the demand front, for the most part, the picture was better than our expectations. Bank holdings of mortgages (commercial and savings) grew by $200 billion in 2006 compared with our expectations of $125 billion (Figure 7). Our predicted slowdown in deposit growth did not quite materialize. Overseas demand was another factor that we underestimated: $125 billion growth in holdings compared with $75 billion in expectations. The lone demand factor that we managed to get right was from GSEs. As expected, their holdings stabilized in 2006 compared with a $145 billion decline in 2005.
Figure 7. Net Additions of Mortgages (Loans + Securities) ($ billion)
2002 Comm. Banks Savings Banks GSEs Overseas Total As % of Net Issuance 246 5 162 29 442 71% 2003 129 46 184 22 381 50% 2004 189 142 15 59 405 51% 2005 128 52 -145 100 134 14% 2006 75 75 -10 93 234 45% 2006 (Annld) 101 100 -13 124 312 45%
Will It Spill Over to 2007? Uncertainty around bank demand in 07 due to shrinking margins Looking into 2007, the picture looks pretty muddled to us. Bank demand for mortgages should be helped by continued asset growth as well as a bond market that looks fairly dovish (the markets are assigning a very low probability of any Fed tightening). On the flip side, the flat yield curve has significantly reduced the appeal of adding duration from a carry standpoint (Figure 8). Similarly, overseas demand for mortgages should be helped by continued deficits as well as substitution of reserve holdings into mortgages. At the same time, the recent currency fluctuations throws some uncertainty around that pictureespecially considering that private flows tend to be well correlated with central bank interventions. Overall, we think that the positives outweigh the negatives and expect the sector to benefit from sustained strong demand factors. We think there is less confusion around GSEs and expect another year of steady portfolios with modest growth.
Figure 8.
6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 31-Dec-93
19-A pr-97 06-A ug-00 Spread Along Forw ards Spread w ith Fed on Hold
24-Nov-03
13-Mar-07
30-Jun-10
VOLATILITY OUTLOOK 2007: DONT BET THE RANCH A Moderate Year for Selling Volatility While positive, returns from a short gamma trade were significantly lower in 06 Against a backdrop of a search for assets, it is no surprise that sellers of volatility were plenty in 2006. Longer dated volatility (2y5y, 3y10y) has declined close to 3 vega over the year. Similarly, realized volatility was also very tame. Over the year, realized volatility on 5y and 10y swap rates remained well below 75bp/y with a few exceptions. That said, the premium for selling convexity has also been fairly modest this year (Figure 9). As a result, returns from a short gamma trade in 2006 were between 1/2 to 1/3 of those enjoyed in 2004 and 2005. Will 2007 be Better or Worse? The macro picture and decline in implied vol. make us nervous around shorting volatility in 07 Will 2007 remain another year of low realized volatility and declining implied volatility? With little in the way of demand from mortgage convexity players and enough capital in the system, the technical picture for a short volatility trade looks good. On the flip side, the current premium for selling volatility doesnt look encouraging. Implied volatility for longer dated swaptions is close to all time lows. Short dated options are also pricing in expectations of low realized volatility, the recent modest uptick notwithstanding. Overall, the macro picture really concerns us on selling volatility. There is a fair amount of uncertainty around the direction of the Fedmarkets are pricing in significant eases over the year and the official directive from the Fed is still around inflation risks. It remains to be seen if the Fed follows the market or if bond prices will have to readjust. To the extent it is the latter, using 1996 as a benchmark, the potential for spikes in volatility is quite high (Figure 10). On balance, we will yield to greed for now and go with a core short volatility strategy. That said, we recommend only a modest position in this trade. From our standpoint, the risk/reward is more in favor of selling liquidity through core longs in CMBS and hybrid asset classes.
03-96 05-96 08-96 10-96 USD 3M 5Y Realised BP V ol (Lef t) Predicted 3m LIBOR(6 months ago) Realized 3m LIBOR
Source: Shows returns on selling 1mx5yr straddles every day and closing out the position at the end of the next day and reopen a new position. Transaction costs are ignored. 2006 numbers are annualized.
PREPAYMENT OUTLOOK 2007: VALUE IN CALL PROTECTION Pronounced Decline in HPA Related Prepayments We expect 2% CPR decline in prime MBS turnover and a 10% drop in subprime prepays Moving on to the fundamentals of the sector, the impact of HPA on prepayments has been moderate to significant, so far. In prime mortgages, discount prepayments have declined moderately by 2%-3% CPR in aggregate (Figure 11). The declines have been more pronounced in the hot MSAs, which have seen the highest slowdown in HPA. In sub-prime, pre-reset prepayments have declined by close to 10% CPR. However, most of the slowdown has resulted from the steady increase in market rates. Adjusted for that, prepayments have remained sticky, no doubt due to the strong cashout refinancing environment. Looking into 2007, we expect prime discount prepayments to decline an additional 2% CPR in a flat(tish) housing market. In the liquid agency MBS market, current pricing of IOs/coupon swaps already reflects expectations of a flat housing market. In sub-prime, as the softer HPA catches up and cashout refis abate, we expect speeds to slow down by another 10% CPR. While market pricing doesnt seem to reflect that, the primary impact of that is on credit as opposed to prepayments.
Figure 11.
Sector Agcy (FN) Jumbo Alt-A Sub-prime
Value in Collateral with Call Protection The market appears to be ignoring call risk completely We think the more interesting opportunities on the prepayment front are in call protection stories. Due to a combination of focus on the macro picture and benign refinancings in the recent past, the markets seem to be ignoring call risk (Figure 12). That is especially true for collateral with prepayment penalties. We believe that even a modest rally in rates will bring these refi protection stories to the forefront and look attractive at current levels.
Figure 12. Source Call Protection through Weaker Credit, and Penalty Pools
Prepay Diff. for 50bp Refi Incentive Current Market Pay-up $100 3yr penalty Agency Hybrids Conforming Alt-A vs Jumbo Fixed Conforming Alt-A vs Jumbo Hybrids Premium Pools California: Fixed Premium Pools California: Hybrids 13-15CPR 10CPR 8CPR 5-7CPR 5CPR 1-2/32nd $101 6-7/32nd $102 16/32nd $100 0-06 0-08 0-05 Pay-up at even OAS $101 0-15+ 0-09 0-08 0-04+ 0-03 $102 1-06+ 0-17 0-13 0-07+ 0-05
CREDIT OUTLOOK 2007: HOW BAD IS BAD? Bracing for a Credit Downturn Cumulative defaults on 06 subprime collateral can top 30% even in a benign housing outcome As reflected in our ominous title, our mortgage credit outlook for 2007 is quite bearish. There are two troubling factors, in our mind. First, underwriting standards have deteriorated sharply over the recent past with 06 originations looking about 50% worse than their 03/04 counterparts from a loss standpoint. Second, a soft housing market may exacerbate losses further as these borrowers are unlikely to be bailed out by rising home prices. We expect cumulative defaults on 06 vintages to top 30% if housing stays flat for a year and grows at 5% thereafter (Figure 13). While most of these defaults are set to occur over a longer period, the expected defaults over the coming year is still significant.
Figure 13. Subprime Cumulative Defaults on 2/28s, Experience vs. Expected
Historical Vintage 2004 2005 2006 1-12 mo 1.1% 1.5% 2.5%* 12-24 mo 2.6% 4.0%* 1H07 1.6% 2.4% 1.8% Expected 2H07 1.4% 2.4% 2.6% Lifetime 14.0% 20.0% 31.0%
Source: LoanPerformance, Lehman Brothers Defaults are defined as terminations from a 60+ delinquent state. *-projected for the period
Going for a Core Short in Mortgage Credit for 2007 Dramatic increase in potential downgrades in 2007 Despite all the recent focus on sub-prime collateral performance, spreads down the capital structure do not reflect the magnitude by which losses can increase on the newer vintages. Our valuations suggest generic BBB spreads to be close to 350bp and BBBaround 550bp. We are choosing to short mortgage credit for three reasons. First, unlike in the past when we were concerned about losses down the road, this time around we are seeing significant delinquencies/losses materialize. Second, with the rating agencies getting very proactive around downgrades, we estimate that a significant proportion of sub-prime BBBs are exposed to negative action over the coming months (Figure 14). This could be the type of headline risk that softens the CDO bid. Third, the growth in the synthetics market has been a significant development in ABS and has the potential to affect spreads. It is sometimes a little odd to view spread volatility in the still developing CDS market as representative of aggregate credit pricing. At the same time, the advent of CDS has increased market awareness of credit issues and provided investors with a tool to express such views.
Figure 14.
1000 800 600 400 200 0 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 Actual Dow ngrades
Source: Lehman Brothers; historical data based on Moodys.
5% HPA
0% HPA
PUTTING IT ALL TOGETHER: SUMMARY SECTOR VIEWS FOR 2007 The Mortgage Basis: Initiating a Modest Short Position Starting with the biggest component of the securitized universe, we are starting the new year with a modest short. While the demand and volatility picture looks mixed, historically tight spreads to swaps leave us bearish on the basis. Our preferred trade is to own a combination of CMBS and hybrids against 30-year fixed rate TBAs. Prime Structured MBS: The Mortgage Sector of Choice We like owning hybrids due to a combination of relatively attractive valuations and a favorable supply/demand outlook. Own hybrids versus premium fixed rate MBS as well as swaps. We also favor selling liquidity through a core long position in the non-agency basis. In addition, we like call protection stories in structured MBS. Mortgage Credit: Favor Prime over Sub-prime With concerns around credit performance over the coming months, we favor shorting sub-prime credit both outright as well as versus prime. Our trade du jour is to buy alt-A and Option ARM subordinates versus their sub-prime counterparts. High Quality ABS: Remains a Safe Haven The world of consumer ABS should remain a safe haven asset class for yet another year. Despite tight spreads, we stay with a core overweightespecially versus short maturity agency debentures. The political picture has implications for student loans. CMBS: Overweight AAAs, Underweight BBBs Finally, within CMBS, we like AAAs as a core liquidity play against swaps, agency debentures and fixed rate MBS. At a CDS spread of 50bp, we like a core short in BBB CMBS. While the correlation with residential credit may be weak, we believe that the lower carry bleed justifies it.
Figure 15. Summary of Levered Portfolio Positions
Trade 1 2 3 4 5 6 7 8 9 10 11 Sell Mortgages vs. Hybrids/CMBS Buy FN 5.5 Fly Synthetic Premium 6s vs. TBAs Overweight DW 5.5/FN 6.0 swap convexity hedged Buy GN2/FN 6 Swap Buy LLB 6s vs. TBA Buy New Production GD 6.5s vs. TBA Buy 2004 FN 5s vs. TBA Jumbo 5/1 5.5 vs. Swaps Jumbo 6s vs. TBA 6s MTA BBBs vs. Sub-Prime BBB
Equity
10 15 10 20 10 10 10 10 30 10 15
Leverage
10 25 20 25 20 20 20 20 20 20 5
Comments
Modest underweight to the basis vs. other securitized sectors. Both wings of the fly look rich. IO valuations cheaper than premiums Overweight 15yrs but not one-for-one Buy GN premiums as a source of call protection LLB collateral for call protection New production in 6.5s is high SATO, will cure slower in a slower housing marker. Production in FN 5s should boost valuations of seasoned collateral Overweight basis through hybrids Overweight Non-Agencies MTA Credit vs. Sub-Prime
10
PRIME MBS Basis Intra-sector Credit Overweight hybrids versus fixed-rates and non-agencies over TBAs. AAA mezzanine MTA floaters stand out as the most attractive cash product. Source call protection through penalty pools in hybrids, conforming alt-As in fixed-rates, and premium California pools. We favor moving up-in-borrower-credit, down-in-rating. Own alt-A BBs and buy protection on subprime BBB-s. Be wary of high CLTV purchase loans; avoid credit exposure to alt-B pools. In option ARMs, we recommend owning subordinates off XS/OC structures.
NON PRIME MBS Sub-prime Overweight 1-3 year AAA Floaters versus Consumer ABS due to the 5-15bp carry pickup with minimal AFC risk. 1H05/2H05 subordinates look attractive versus the 2004/2006 vintages after factoring in differences in underwriting, built-up equity and structure. Favor cashout heavy deals versus purchase & full doc versus stated doc due to higher subordination than historical experience. Box trade: Long 06-2 BBB/06-1 BBB- paired with short 06-2 BBB-/06-1 BBB, to express a view on capital structure mispricing regardless of HPA. Move up-in-credit; increased focus on fundamentals; tiering to emerge.
NON-MORTGAGE ABS Intra-sector Overweight Seasoned Premium Priced Stafford Loans Prepayment speeds should decline more than the market is currently pricing in and seasoned bonds are likely to benefit from borrower burnout; Underweight Subprime Credit Cards With tiering non-existent, favor prime top tier issuers, which will be less affected if collateral performance weakens; Overweight Esoteric ABS ABS portfolio managers can diversify their risk profile with whole business and insurance ABS.
CMBS Basis Overweight CMBS; attractive versus swaps, agencies and corporates; look to any technical-driven spread widening as a buying opportunity. Underweight BBBs; Overweight AAAs through A; underwriting trends are not favorable for newer vintage BBB/BBB- securities given credit support, CDO technicals remain strong, but there is limited scope for further spread tightening. Buy 5-year AAA versus 3-year and 10-year SD AAA; Buy AM classes versus super duper-AJ combo; Buy newer vintage CL IOs; Buy 2002-2003 vintage CP IOs versus front-payers; Buy protection on CMBX.2.BBB, offset negative carry with leveraged 10-year AAA SD; Sell protection on CMBX.1.BBB-, buy protection on CMBX.2.BBB; Buy AAA 5-year CMBS, buy protection on CDX.NA.IG.7, pay on interest rate swap.
11
Intra-sector
2006 REVIEW Mortgages outperformed in 2006 Agency MBS posted 122bp in excess returns versus Treasuries through November. Spreads ground tighter most of the yearwith the notable exception of Q2, when inflation fears led to an overall bond market selloff and wider mortgage spreads. Spread tightening was the dominant driver of excess returns in the second half of the year. The decline of implied volatility over the course of the year contributed around 30bp in excess returns with most of these returns coming in the first half of the year. The carry on the index over swaps net of convexity losses was only 2bp. The first half of the year saw a collapse in GN valuations. Overseas selling in H1 and a general lack of sponsorship caused the GNMA index to underperform conventionals by 103bp. Despite negative $57 billion of net issuance, the 15-year sector lagged the overall basis tightening, as investors preferred more volatility and spread duration exposure. 2006 was another strong year of Trust issuance with year-to-date issuance totalling close to $37 billion. The strongest performing Trusts over the course of the year were the low WALA trusts. IO performance versus current coupon collateral was negative across the board. However, similar to the last couple of years, a bulk of this underperformance resulted from the flatter curve. SUPPLY AND DEMAND IN 2007 Slowing supply and ample demand support mortgage basis We expect the housing slowdown to reduce supply. This is set to be counterbalanced by hybrid-to-fixed and cashout refinancing in a slowdown-induced rate rally. On the demand side, overseas, banks and corporate crossover investors should make up for the lack of growth in GSE portfolios. Overall, the supply/demand picture for mortgages looks positive. However, given that demand will come primarily from macro investors, we believe the potential for spread volatility is high. RECOMMENDED TRADES Trade 1: Sell FN 5.5s vs. Jumbo 5.5% 5/1 Hybrids + 10yr CMBS. Low volatility but rich valuations call for substitution If the low realized volatility environment holds, the returns from owning mortgages could be attractive. We do not recommend being short carry over the next year. However, given the tight level of mortgage spreads and low levels of implied volatility, our recommendation for the mortgage basis is to create substitutes for fixed-rate mortgages using hybrids and CMBS. The trade loses around 2+/32nds in carry a year. It would provide protection in any extreme rate event. In our levered portfolio, we are allocating a fairly modest sized position to this trade with $15 million in equity. Trade 2: Buy FN 5.5 Fly Wings Could Cheapen Market is mispricing premiums In 2006, the change in deliverables on FN 6s is worth about 26bp in OAS and this explains the relative OAS tightening of 20bp vs. FN 5.5s. We argue that the market has ignored the worse quality deliverables in premiums, and recommend being long lower coupons on a curve hedged basis and recommend selling the FN 6.0/5.5 swap. Lower rates today compared with earlier in the year should cause increased issuance in the lower coupons. Moreover, with coupon swaps expected to be more compressed over
12
the course of the year, servicers are likely to retain more servicing creating a larger proportion of lower coupons. We recommend positioning for a cheapening in the FN 5 deliverable by being long FN 5.5/5.0 swap. Putting our two recommended coupon swap trades together, we recommend buying the FN 5.5 fly. Trade 3: IOs are Cheap to Up in Coupon IOs are cheaper than coupon swaps While coupon swaps look rich on an OAS basis, we think Trust IOs look cheaper than higher coupon passthroughs. In Figure 17, we show a regression residual of the prices of synthetic 6s created off of TBA 5.5s and FHT-237 IOs versus prices of TBA 6s. Based on this regression, we think the synthetic security looks about 3/32nds cheap. In the levered portfolio we recommend buying 100% FN 5.5s with 9% FHT-240 IOs hedged with 115 TBA 6s and are looking for an upside of 3/32nds. We would recommend using swaps to duration hedge IO positions as opposed to passthroughs because this provides some protection in the event of a large rate move and subsequent widening of mortgages. Trade 4: Long 15-Year versus 30-Year Convexity Hedged 15-years pick 10bp in OAS versus 30-year 15-year valuations have not kept pace with the overall tightening of 30-year valuations since mid-July. With the relative spreads widening the 15-year picks up close to 10bp in OAS versus its 30-year counterpart today. However, we do not recommend that investors hold on to the long gamma and negative carry positions in owning 15-year versus 30year one for one. Instead, we recommend buying 15-year and selling enough 30-year to be convexity neutral and offsetting the remainder of the curve and duration risk using swaps. We recommend the trade through the DW 5.5/FN 6.0 swap. Trade 5: Long GN/FN Swaps as a Source of Call Protection GNs offer cheap call protection At current market payups of 12/32nds on the GN2/FN 6 swap, the explicit guarantee of GNMAs, the lower delay on payments, the weaker credit nature of these pools and lower loansizes are being undervalued. We think the fair price of this collateral is close to current rate levels. Even if the market prices in only 60% of this payup we think the upside of 7-8/32nds is very attractive. Trade 6,7,8: Specified Pool Trades Buy LLB FN 6s: We retain our current recommendation in our levered portfolio to source call protection through LLB collateral. While payups on this collateral have increased fairly significantly over the past couple of weeks with LLB 6s trading up close to half a point to TBAs, we think the collateral is still trading at under 50% of fair value. We recommend hedging the position to 110% of TBA durations. Buy New WALA FN 6.5s: Given the rally in rates any new production in 6.5s will be high SATO pools and are likely to be from credit impaired borrowers. Given weakening housing fundamentals the credit curing in this collateral will be extended. The payups on new WALA FN 6.5s are nominal at around 1/32nds. We recommend buying new WALA FN 6.5s and selling TBAs against it. Buy 2004 5s versus TBAs: We expect total new production of about $10 billion in FN 5s by February. This new production has been originated in a fairly weak housing market and is likely to season much slower than the older vintages. 2004 vintage 5s are currently trading at a payup of 6/32nds to TBA. If the TBA cheapens to a 2 WALA deliverable by February, we think the payup on seasoned pools should go up 3-4/32nds.
13
Most of the action in 2006 took place in the discount space. As home prices were hitting the brakes, purchase activity also quickly declined to levels last seen in 2000. Correspondingly, FN 4.5s of 03 slowed significantly and came in at a more reasonable 7.3% CPR down from 9.9% CPR in the previous year, with almost half of the decline likely HPA-related. We believe there is more to go. While purchase activity has already slowed, cashout refinancing is still at an all time high, not to mention that HPA could slow further. As we mentioned last year, most of the effects of this HPA slowdown will be felt over 2007 and maybe 2008, as new cohorts get originated in a low HPA environment. New discounts are in fact most affected by slowing HPA (Figure 1). A slower HPA not only lowers the overall prepayments, but also the seasoning rate of discount cohorts. In our full outlook we show how this effect is even larger for GN and in general high LTV collateral. Bad credits (high SATO) pools are also among the most affected by changing HPA. In recent years high SATO premiums in high HPA areas actually prepaid faster than regular credits of same in-the-money-ness. For more details please refer to our full outlook.
35%
25%
Source: FNMA, FHLM, Lehman Brothers. All 30-year non-penalty non-relo FRM conventional collateral. September 2003-June 2006, 50 bps discounts.
Source: FNMA, FHLM, Lehman Brothers. 30-year FRM collateral, WALA 12-18, September 2003 June 2006.
14
15
Prepayments: Dont Ignore Refinancings Slower HPA will slow both turnover and refinancings, especially on weaker credits. The slowdown in housing has yet to be reflected in credit performance, but has definitely affected prepayments. Products with higher concentration of hot MSAs such as jumbos and option ARMs have seen a bigger drop in speeds than agencies/subprime pools which are more geographically diverse. This is because the largest drops in HPA rates have been in regions with relatively strong housing markets thus far. Aggregate turnover has slowed down 1%-2% CPR while refinancings have dropped by 4%-5% CPR. That said, resilient cashout activity has cushioned the drop in speeds thus far and we expect to see further drops in speeds in 2007 even if HPA stays at current levels. Given that we have been in a purchase environment for the past two years, the market is ignoring call protection stories. As we discuss in the relative value section, there are significant opportunities in the prime sector. Credit: Move Up-in-Borrower-Credit, Down-in-Rating Favor Alt-A and Option ARMs, Stay Wary of Alt-B. Delinquencies on prime originations have surged in recent months, although the magnitude of increase is nowhere comparable with that in the subprime market. That said, the uptick in delinquencies is largely explained by the deterioration in underwritingthe effect of slower HPA has yet to be reflected in credit performance. We expect alt-A and option ARM performance to hold up much better a slower housing market than subprime pools. We are, however, wary of alt-B exposure, where initial stage delinquency trends appear to be closer to the subprime market (Figure 4). Portfolio Positioning for 2007 We favor agency hybrids over fixed-rate TBAs, recommend selling liquidity through the non-agency fixed-rate basis, strongly believe the market is discounting call protection stories especially in penalty pools, and in credit, favor BBBs off option ARMs and lower-rated subordinates off alt-A vs BBB- off subprime.
Figure 1. Top Trades in Prime MBS Trade
Favor Hybrids versus Fixed-rates: Long Agency 5/1s and 10yr CMBS versus Agency TBA Sell Liquidity through non-agency basis (Jumbo 6%)
Rationale
Hybrids stand to benefit from inclusion in U.S. Aggregate Index, currently at significant spread pick versus agency TBAs. As TBA loan sizes have increased, convexity differences between jumbos and TBAs has converged, making the jumbo basis attractive at 0-25 back. The market is discounting call risk in mortgages: pay-ups in penalty pools are only 30-40% of even OAS pay-ups, weaker credit alt-A paper is expected to be significantly less callable in a softer housing market. At L+25bp, AAA mezz floaters off option ARM collateral are the most attractive short duration asset on an OAS basis. Though seasoned hybrids have tightened significantly over the last few months, hybrids with more than 15 months to reset continue to look attractive. Rating agency levels are aggressive on 80/20s, purchase, limited documentation loans, especially on lower FICOs all characteristics of Alt-B. Moreover, delinquencies on alt-B collateral of 2006 vintage have been high, due to deterioration in collateral characteristics and underwriting standards. Option ARM collateral is expected to outperform sub-prime collateral in a sustained housing slowdown. Identical OC floor (50bp of original balance) on both option ARM and sub-prime deals provide significant protection to option ARM subordinates.
Source Call protection through Penalty pools in hybrids, conforming balance weaker credit pools in fixed-rates
AAA mezz off option ARMs and 12 wala 3/1s are good Cash Substitutes. Investors seeking yield should favor non-agency hard cap floaters versus those off agency for additional 10bp pick in DM. Prime Credit: Favor Alt-A over Alt-B; Move Down in rating in Alt-A and shifting interest structures
Cross-sector Credit: Favor BBB off option ARM XS/OC structures versus BBB off sub-prime (1:1). Go long BBs off Alt-A fixed-rates hedged with BBB- sub-prime (1:4)
16
PORTFOLIO POSITIONING IN 2007 leading us to recommend an overall defensive posture. We advocate an overall defensive posture in 2007, and recommend moving up the capital structure. However, we continue to expect tiering to increase in 2007 based on crossvintage, capital structure and credit views which should provide significant opportunities for intra-sector relative value. We highlight our key trade recommendations below. Basis Call: Overweight 1-3yr AAA Floaters versus Consumer ABS We believe that 1-3 year AAA HEL floaters look attractive versus the consumer ABS sectors due to a 5-15bp pickup in carry with minimal additional risk. Cross Capital Structure: Move to AAA/AAs from Single-A/BBBs We advocate a defensive posture by moving up the capital structure due to negative headline news around weaker credit/prepayment performance, a sharp tick-up in downgrade activity and pressure on originator/servicer profitability. Cross Vintage Favor cashout heavy deals vs. purchase & deal with high full documentation concentrations since rating agency is lower than historical experience. Credit Trades Favor cashout heavy deals vs. purchase & full doc vs stated doc since rating agency required subordination on purchase & state doc loans is lower than historical experience. Synthetics We recommend being short the ABX 06-2 BBB- versus the 06-2 BBB and pairing it with an opposite view on the 06-1 index, i.e. short 06-1 BBB and long 06-1 BBB- to neutralize any directionality to HPA and express a view on capital structure mispricing.
HEL Portfolio Positioning in 2007
Views Basis Capital Structure Trade Overweight 1-3yr AAA Floaters versus Consumer ABS Move to AAA/AAs from single-As/BBBs, outright short BBB-s Long HEL BBBs, short CDO single-As/AAs carry neutral Favor 2005 versus 2006 and 2004, 2H03 and 1H04 look the weakest Favor cashout heavy deals vs. purchase, overweight full doc heavy deals Long high IO% deals from the 2004-1H05 vintage Synthetics Rationale 5-20 bp pickup in carry, minimal AFC risk (1-2bp), supply technicals look positive, GSE sponsorship to continue. Potential weakening in CDO demand following headline data around prepays/credit and downgrades. Outright short on 2H06 BBB- attractive based on current spreads implying about a 15% probability of negative HPA. Fair spread on CDO single-A/AAs much wider than current levels because of high leverage to HPA. Significantly lower HPA leverage as a result of built-up equity on 2005, weak tails on 2H03/1H04 because of negative excess spread, high FRM% and passing triggers, 2006 underwriting looks weak. Rating agency subordination levels for purchase loans and limited documentation loans are lower than historical experience. Rating agencies do not factor in faster post-reset speeds on IOs by 10%-15% CPR as a result of higher FICOs, loan balance, payment shocks and built-up equity.
Cross Sector
Cross Vintage
Credit Stories
Box trade: Long 06-2 BBB/06-1 BBB- paired BBB/BBB- basis on ABX 06-2 is tighter than fair value, neutralizing the HPA with short 06-2 BBB-/06-1 BBB directionality by pairing with an opposite view on 06-1. Long BB+, short BBB- carry neutral as out of the money protection to weak housing Good alternative to shorting single-A outright, trade breaks even in cashflow terms below 0HPA, does not rely on mark to market P&L vs. single-A short
18
Relative Value Up in credit: We advocate moving up in credit in both high grade and mezzanine transactions. Given the uncertainty regarding the outlook for HPA over the coming year, we do not believe current pricing fully incorporates the downside risk from any deviation from the base case. Focus on structure: While our overall bias is to be up in credit, we do believe there are significant opportunities within a given rating based solely on structural differences. We recommend taking a closer look at differences between traditional trigger, trigger holiday, and triggerless structures.
19
for details)
AT BOTH ENDS OF THE RISK/REWARD SPECTRUM Highlights of 2006 2006 saw a continued improvement in commercial real estate fundamentals, as vacancy rates fell, incomes rose, and CMBS delinquencies declined. Property values continued their upward trajectory in the face of a slowing residential market. We saw another blockbuster issuance year for CMBS, with around $200 billion in domestic supply, but the quality deteriorated because of more aggressive underwriting. Meanwhile, the credit curve flattened dramatically, despite lower credit support, because of strong credit performance and a persistent bid for BBB/BBB- paper from CDO issuers. Overall, CMBS outperformed other core fixed-income sectors in 2006. Key Themes for 2007 We expect some of the themes from 2006 to continue into 2007: strong capital inflows, heavy issuance, and aggressive underwriting. However, heading into 2006, there were no real question marks regarding credit fundamentals. The coast does not look quite as clear coming into 2007, with the weakness in the housing market and its potential to derail the commercial real estate recovery. Key themes we see for the coming year: CRE should withstand residential slowdown, but some risk to downside. A key question is whether the residential investment and price slowdown will spill over into the commercial market, which has apparently remained immune so far. Our base-case forecast remains that the residential slowdown will be largely contained and commercial real estate markets will be minimally affected, with downside risks. Continued inflow of capital into CRE, but less potential for significant price appreciation. Commercial real estate is likely to remain a preferred destination for investment capital in 2007. However, recent cap rate/spread compression leaves less upside potential for property values; income growth is likely to be the main driver of future performance. Another strong issuance year for CMBS, but without much improvement in underwriting. Issuance momentum should continue well into 2007. We expect domestic issuance in the coming year to grow 5%-10% from 2006 levels. While fixed-rate conduit/fusion transactions should dominate, we expect an increase in the share of floating-rate transactions. We dont expect a substantial improvement in underwriting standards any time soon, even if BBB/BBB- spreads trend wider in 2007. CMBS still attractive versus core fixed-income sectors. CMBS continues to look attractive relative to other fixed-income sectors. Across the major U.S. Aggregate Index components, CMBS offers a sizeable spread advantage and strong convexity profile compared with similar-quality asset classes. Buyers of protection eventually to come out of hiding. We expect to see increased marginal demand to buy credit protection, as the potential for further spread tightening among lower-rated classes is limited at current levels.
Relative Value We have sharply divergent views for the high and low ends of the CMBS capital structure.
December 12, 2006 21
We maintain our overweight recommendation for AAA CMBS, which we believe has excellent credit and convexity characteristics and makes up the bulk of the CMBS universe. We view the mild spread widening over the past month in AAA CMBS as a buying opportunity, and look for 10-year 30% AAA spreads to once again test the 20 bp mark in the first-half of 2007. We favor AAA CMBS relative to agencies and corporates. Across the AAA stack, we find value in the 5-year part of the curve and in AM classes. We also like AAs and As, which should perform more in line with AAAs.
And BBB/BBB-s at the Other
Meanwhile, we remain negative on BBB/BBB- classes owing to the confluence of declining credit support levels, underwriting standards, and credit spreads. The CMBS credit curve flattened dramatically in 2006, despite a continued decline in BBB/BBBcredit support levels. A closer look at historical loss dispersion across transactions tells us that the average deal loss needs to be only 1.5%-2.0% (which could happen even without a major credit debacle) for the breakeven number of BBB/BBB- classes in the market portfolio to take a loss, given current spreads. Negative carry from buy protection trades can be partially offset by long positions in the more senior part of the capital structure. Summary of our Trade Recommendations
Basis Overweight CMBS; attractive versus swaps, agencies, and corporates; look to any technical-driven spread widening as a buying opportunity Credit Curve Underweight BBBs; overweight AAAs through A; underwriting trends are not favorable for newer vintage BBB/BBBsecurities given credit support; CDO technicals remain strong, but there is limited scope for further spread tightening. Trade Ideas Cash Only 1) Buy 5-year AAA versus 3- and 10-year SD AAA 2) Buy AM classes versus super duper-AJ combo: AM should price closer to super-dupers than to AJ 3) Buy newer vintage CL IOs: extension upside 4) Buy 2002-2003 vintage CP IOs versus front-payers: spread pickup; steady cash flows; high CDR break points Cash/Synthetic 5) Buy protection on CMBX.2.BBB; offset negative carry with leveraged 10-year AAA SD 6) Sell protection on CMBX.1.BBB-, buy protection on CMBX.2.BBB; positive carry, comparable quality Cross-Sector 7) Buy AAA 5-year CMBS, buy protection on CDX.NA.IG.7, pay on interest rate swap 8) Buy AAA CMBS versus agency debentures
22
Analyst Certification The views expressed in this report accurately reflect the personal views of Prasanth Subramanian, Neil Barve, Jose John, Michael Koss, Vikas Reddy Shilpiekandula, Akhil Mago and Jasraj Vaidya, the primary analysts responsible for this report, about the subject securities or issuers referred to herein, and no part of such analysts' compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies discussed in its research reports. As a result, investors should be aware that the firm may have a conflict of interest. To the extent that any historical pricing information was obtained from Lehman Brothers trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Lehman Brothers' global policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. To obtain copies of fixed income research reports published by Lehman Brothers (vmonchi@lehman.com; 212-526-3173) or clients may go to https://live.lehman.com/. Company-Specific Disclosures Lehman Brothers Inc. or one of its affiliates has managed or co-managed a public offering of securities or Rule 144A offering of securities for the following issuers within the past twelve months: the Federal Home Loan Mortgage Corporation (FHLMC), the Federal National Mortgage Association (FNMA), and the Government National Mortgage Association (GNMA). These companies are current investment banking clients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services. Legal Disclaimer This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers"). Lehman Brothers Inc. accepts responsibility for the content of this material in connection with its distribution in the United States. This material has been approved by Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch ("LBIS"). Where this material is distributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. An investor should consult his Lehman Brothers' representative regarding the suitability of the product and take into account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. Any U.S. person who receives this material and places an order as result of information contained herein should do so only through Lehman Brothers Inc. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. With exception of the disclosures relating to Lehman Brothers, this report is based on current public information that Lehman Brothers considers reliable, but we do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers' Fixed Income Research Department and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers' entity in your home jurisdiction. please contact Valerie Monchi