Jeff Kong Featured in Wealth & Finance Magazine as Hedge Fund Manager of the Month

Jeff Kong Featured in Wealth & Finance Magazine as Hedge Fund Manager of the Month - please turn to page 18...

http://www.wealthandfinance-intl.com/wealth---finance-june-2016

Story Time with Tradex: Understanding Mortgage Cohort “Stories”

Story Time with Tradex: Understanding Mortgage Cohort “Stories”

Not all mortgages are made the same. Some mortgages are small, and some are large. Others are young, and others are old. Some are rich and some are poor. In this brief write-up, we attempt to clarify common mortgage collateral stories and the anticipated effects on prepayments and valuation.

While most fixed income products have known cash flows, mortgage backed securities do not because they are dependent upon homeowner behavior that can be difficult to predict. Each month, a homeowner faces a choice of paying, refinancing, or defaulting on the mortgage. While these decisions should be relatively easy to predict based on rate incentive, empirical evidence suggests that borrowers do not always act rationally to maximize economic utility, making prepayment analysis both a behavioral and economic study. Since thousands of loans are pooled into a single pass-through, the law of large numbers should in theory reduce noise from irrational homeowner actions, or lack thereof. However, certain ‘cohorts’ of homeowners may collectively act in an irrational manner. The stratification of homeowner characteristics into a single security often facilitates prepayment analysis.

Collateral Story Proliferation

Following the financial crisis, the FHFA developed the HARP program[1] to help American homeowners refinance into mortgages with more affordable monthly payments. This program eventually led to an exponential growth of collateral stories, and increased the knowledge necessary to accurately value and anticipate these cash flows. Examples of story collateral include MHA Program (HARP), loan balance, seasoned, geographic exposure, mortgage purpose (relocation, investor, etc.), FICO, Third Party Origination, and many others. These collateral types will often exhibit prepayment behavior that vary from their generic counterparts due to differing degrees of refi sensitivity.

HARP Program

In March 2009, the FHFA introduced the Home Affordable Refinance Program to, “provide access to low-cost refinancing for responsible homeowners suffering from falling home prices¹.” The program allowed responsible homeowners to refinance their loans despite having loan to value (LTV) ratios above 80%. Simply stated, as home prices fell, LTV ratios increased dramatically and homeowners could not take advantage of falling mortgage rates due to low or negative home equity. The HARP I and II programs served as a remedy to this issue and led to a meaningful increase in prepayment speeds on HARP eligible collateral. Many of these HARP loans were subsequently securitized into a new pool and designated as “MHA 80”, “MHA 90”, etc. pools. Investors viewed these pools as call protected[2] since a borrower who refinanced under the program would be ineligible to access the HARP program again. Initially, these pools carried lower risk premium. However, as home prices rebounded and LTVs fell, the pools began to prepay faster as mortgage rates remained low.

Loan Balance

While the average loan size in a new mortgage is approximately $268k[3], some pools are composed of loans whose original size is below 85k, while others are greater than 417k. The first case, “LLBs”, are Low Loan Balance pools. Investors often view LLBs as call protected because the total dollar savings of refinancing is less on small loans. These homeowners are thus less likely to refinance and, in theory, LLB pools should have more stable and predictable cash flow. The result of lower expected prepayments and greater degree of cash flow predictability leads to higher relative valuation and smaller risk premium. This collateral type is often highly desirable when interest rates decline. On the other end of the spectrum, Jumbo loans will have higher dollar savings than smaller loan balance collateral given the same rate incentive. Thus, bonds backed by Jumbo loans often have a larger risk premium as those borrowers have greater incentives to refinance.

Seasoned (burnout)

Collateral seasoning refers to the age of the underlying loans in a mortgage pool. Most new loans have mortgage rates that are at or around prevailing market rates and those borrowers have no rate incentive to refi. Post origination, mortgage rates will change as bank borrowing costs increase or decrease. Over time, a mortgage pool may experience periods in which homeowners have significant incentives to refinance. Many borrowers will refinance and will exit the pool. What remains is mortgage loans that have above-market coupons that are deep in the money. For some reason, the homeowners remaining in the pool have not refinanced their loans despite the financial incentive to do so. We often refer to this phenomenon as burnout, and this seasoned collateral tends to have a muted response to increases in refi incentive. Furthermore, seasoned collateral often has a steady prepayment profile and investors often place a low risk premium on this collateral type.

Geographic Exposure

The colloquialism, “all politics is local” comes to mind when considering the geographic distribution of underlying mortgage loans. While economic activity is often summarized at the US level, this economic activity is an amalgamation of local economies at the MSA (Metropolitan Statistical Area) and state level. Some of these economies may be expanding, while others may be shrinking. This activity directly affects borrowers’ income and home value, ultimately affecting prepayment behavior. Geographic stories, or “GEOs” for short, typically contain 100% borrowers from a certain state, such as California, NY, TX, etc. California borrowers tend to be more sophisticated and own larger homes. Thus, they are highly sensitive to rate incentives. CA bonds typically carry a higher risk premium than say, NY, TX, or PR (Puerto Rico) bonds. When investing in GEO stories, it is prudent to be aware of homeowner and mortgage attributes as it directly influences cash flow. For example, recent declines in oil prices has negatively impacted shale states’ economies. This may translate into lower HPA, less turnover and muted refinancing incentive.

Conclusion

In the wake of the financial crisis, the number and complexity of collateral stories has significantly increased. As a result, investment managers must be cognizant of the various collateral types and have an understanding of how they affect prepayment behavior and MBS valuation. While this editorial provides some clarification of collateral stories, we encourage our readers to research mortgage collateral stories further and to have a dialogue with the investment team at Tradex.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] Collectively HARP I and HARP II. https://www.fanniemae.com/singlefamily/making-home-affordable

[2] Call protection refers to the call option held by the homeowner. If prevailing mortgage rates are lower than a homeowner’s mortgage rate, the homeowner may exercise the call option and refinance into cheaper loans.

[3] MBA US Conventional Refinance Average Loan Size Index

Tradex Global Short-Biased High Yield Fund Ranked #1 Fixed Income - HY Fund in November by BarclayHedge

In November, the Tradex Global Short-Biased High Yield Fund was ranked in the Top 10 for the 5th time in the last 6 months by BarclayHedge, this time appearing as the #1 "Fixed Income - High Yield" Fund. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

Tradex Global Short-Biased High Yield Fund Ranked #3 Fixed Income - HY Fund in July by BarclayHedge

In July, the Tradex Global Short-Biased High Yield Fund was ranked for the 2nd month in a row by BarclayHedge, this time appearing as the #3 "Fixed Income - High Yield" Fund.  Please see the below award:

This fund was ranked based on the data in Barclay Hedge's hedge fund database

FLASH UPDATE: Global growth concerns add to uncertainty surrounding Fed liftoff

TRV Mid-Month Commentary | August 2015

Comment:
The news cycle for the first half of August has been dominated by global growth concerns following the People’s Bank of China’s surprise decision to devalue the Yuan that resulted in the largest one day decline in two decades. Global markets largely saw the move as a play to increase export activity, spurring fears of a decline in global growth that set the tone for a risk-off mentality.

Global economic concerns have also caused investors to contemplate whether the Fed will move in September, and July’s change in Non-Farm Payrolls provided little guidance to potential Fed policy as the numbers came in at expectations. We note that the market has turned more bearish on a September hike as the Fed Funds futures market implies a 36% probability of such an occurrence[1], down from near 50% a few weeks ago. Although the Fed’s most recent Dot Plot[2] implies two hikes in 2015, we are less certain of this outcome following recent news.  Despite the uncertainty surrounding a September hike, 10yr yields managed to increase 2 bps to 2.18 while 5yr yields increased 7bps resulting in a 5bp 10/5 bear flattener.

In this backdrop, securitized credit faced headwinds as spreads were pushed wider and weaker credits underperformed due to a steepening of the credit curve.  While weakened sentiment regarding the global economy has had an impact on the credit instruments, the US housing and economic fundamentals remain supportive.  We view these dips as buying opportunities with the expectation that fundamentals will ultimately drive spreads tighter.  At current levels, there is value in last cash flow tranches of GSE credit risk transfer bonds as well as in BBB-rated single family rental securitizations.  Non-traditional ABS such as aircraft, NPLs, and marketplace lending transactions offer incremental yield and have weathered the recent volatility quite well due to strong investor demand.

Recent market action and the risk-off sentiment has likewise affected hedged return on the mortgage basis: hedged with 5yr Treasuries, premium 4.0s widened 2 ticks, while widening 8 and 5 ticks versus the 10yr and Treasury Curve hedges, respectively. Premium 4.5s, however, performed poorly against bullet and curve hedges having widened between 7 and 10 ticks. Since August 1^st, the basis has cheapened between 5 and 9 ticks owing to deteriorating rolls, low level of rates and diminishing bank, oversea and REIT demand. We consider the timing may perhaps be ripe for a tactical long position, but our long-term view leans much more bearish. We tread cautiously at this juncture and look to September for clarity.

Since the end of June, we note that the mortgage rate has fallen 27 bps and that the refi index continues to climb from its June low. That said, we expect a 5-10% decline in prepayments from July to August on lower turnover and refi activity, particularly for cuspy 3.5s and 4.0s of 2013 & 2014. While this sounds counterintuitive, it is important to mention that the Refi Index is a leading indicator and refi applications take some time to work its way through the pipeline. Over the last couple of months, option-adjusted spreads on IOs and Inverse IOs have remained relatively stable. However, a surprise decision from the Fed could temporarily cause spreads to dislocate and provide advantageous volatility.

As September looms, we continue to find pockets of opportunity in our markets but remain cautious due to potential knee-jerk reactions. Overall, we think the coming months will yield abundant opportunity.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] http://bit.ly/1DtLVLk

[2] http://1.usa.gov/1LfLfSK