Mortgage market's other pitfall asserts itself

By Al Yoon - Analysis

NEW YORK (Reuters) - Investors who thought they were safe owning guaranteed mortgage-backed securities in the wake of steep credit losses from other MBS are now grappling with a different kind of risk.

Models that predict payments on bonds issued and protected by Fannie Mae, Freddie Mac and Ginnie Mae have been far off the mark in recent months, resulting in increased risk to investors in the $4.5 trillion "agency" MBS market.

Errors are happening for the same reason credit loss forecasters failed to prepare investors for the subprime mortgage meltdown: it has never happened before.

This has opened up unexpected losses on assets considered super-safe for a broad investor base that includes central banks, Wall Street dealers, and retirement savings plans.

The U.S. housing market downturn is already the worst since the Great Depression, and is showing few signs of recovery.

Falling home prices and tighter credit conditions have sharply slowed some payments from MBS to investors, turning the bonds into longer term investments that carry more interest-rate risk.

Wall Street banks that spend countless hours trying to measure that risk for clients have seen data stray from their forecasts by unusually large amounts. A 20 percent drop in May prepayments sharply exceeded expectations, leading to a collective groan among analysts.

May data "was a shock to everybody," said Arthur Frank, head of MBS research at Deutsche Bank in New York. Vagaries of falling prices and tight credit have "wreaked havoc" on models that were created during the heydey of refinancing, analysts at Merrill Lynch & Co. said in a recent research note.

Analysts watch so-called "prepayments," or the return of principal on a MBS before it matures. A prepayment results when a home is sold or a loan is refinanced. But with home prices falling and mortgage costs up, prepayment triggers are few.

"An unprecedented housing market will produce unprecedented prepayments and defaults," said Dale Westhoff, a managing director at JPMorgan Chase & Co. in New York, who has been refining models for 18 years. "We've already seen that on the default side. On the prepayment side, the May numbers are starting to reflect this new environment."

For MBS investors, wrong assumptions on prepayments can bring unexpected losses. Slower prepayments extends expected lives of MBS, forcing the bonds to behave like longer-term securities whose prices fall faster when interest rates rise.

Prepayment uncertainty exacerbates what has been a rocky road for MBS, which have lagged returns on U.S. Treasury debt by 0.72 percentage point in the month to June 17, according to Lehman Brothers. The index covers MBS backed by Fannie Mae, Freddie Mac and the government, and excludes subprime and other mortgage bond that pass credit risk from issuer to investor.

Prepayments on mortgages, that if refinanced could save at least 0.75 percentage point on their rate, have dropped as low as 15 percent, according to Merrill Lynch & Co. That compares with 80 percent in 2003's refinancing wave, and 35 percent at times in 2001-2006 when refinancing was less attractive.

The housing turnover rate is below the average 6.25 percent and headed to historic lows below 5 percent, Westhoff said.

"A couple of (percent) can make a difference" for a money manager, said Todd Abraham, co-head of government and mortgage investments at Federated Investors in Pittsburgh, which manages more than $300 billion. But "in big turns in the market, prepayments slow or fast are typically going to be wrong, and you as a manager have to expect that," he said.