Scott Simon Discusses PIMCO’s View on the U.S. Housing Market
This is a very good article.
Check out the commentary on CDOs.
Also note that delinquencies are really understated.
Q: Why would a slowdown in voluntary prepayments mean losses over a longer period? Lower prepayments usually mean that MBS may repay principal more slowly but they do not typically cause actual losses.
Simon: In the past few years, when borrowers have had trouble making their mortgage payments, some lenders have allowed the borrowers to take equity out of their homes and refinance. Therefore, these borrowers didn’t count as delinquencies in the official data; they showed up as voluntary prepayments instead. This trend has resulted lately in the lowest losses we’ve ever seen in the mortgage market. We think that the historical data currently understates delinquencies and overstates voluntary prepayments by a very substantial margin. The Federal Reserve Bank of St. Louis published a paper along these lines this summer.1 This practice should wind down as interest rates rise and housing slows.
Q: As the delinquencies and losses on mortgages flow through to subordinated mortgage- and asset-backed securities, who will be affected? Who buys these securities?
Simon: The interesting part about these private label subordinate pieces is that for the most part, they’ve ended up in CDOs [collateralized debt obligations] and have been sold outside the U.S. Subordinated pieces are trading at their most expensive levels ever primarily because of the demand from structured deals—CDOs.
Q: Why are CDOs so attracted to subordinated mortgage-backed securities? Is it simply the yield?
Simon: Absolutely. For a given rating, these subordinated securities tend to have higher yields than other securities. There is so much liquidity worldwide trying to get incremental yield, both in the U.S. and abroad. This is just a natural extension of that.
By the way, you’ve had three years of the lowest delinquencies in mortgage market history, so it’s not as though you’ve done badly as an investor in subordinated MBS so far. But if housing and the economy slow, the CDOs have taken on the risk of potential losses. In a sense, these CDOs are underwriting the risk in the mortgage market. The lender is the person in line to lose money. While CDOs often have higher yields for a given rating level, they also usually have higher risk for a given rating level.
Because the investors are CDOs, the bonds are outside the banking system, and the regulatory agencies cannot police the market. That has been a frustration for the regulators—they can’t do as much about the situation as they had hoped.
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