Beruflich Dokumente
Kultur Dokumente
Bear, Stearns & Co. Inc. 383 Madison Avenue New York, New York 10179 (212) 272-2000 www.bearstearns.com
Coordinators:
Steven Abrahams, Rates Markets Gyan Sinha, Credit Markets Victor Consoli, Corporate Credit Markets
Outlook 2007
Rates: The Resilient Rates Market...................................................................... 3
The Fed and foreign investors continue to have a firm grip on the U.S. rates markets, although the road ahead looks rougher than last years stretch.
Print
Economics
John Ryding Conrad DeQuadros Elena Volovelsky Meghna Mittal David Boberski David Boberski Jon Blumenfeld (212) 272-4221 (212) 272-4026 (212) 272-4447 (212) 272-1961 (212) 272-1507 (212) 272-1507 (212) 272-2993 (212) 272-2206 (212) 272-3082 (212) 272-9858 (212) 272-1490 (212) 272-9858 (212) 272-1978 (212) 272-7431 (212) 272-1490 (212) 272-2152
Corporate Credit Strategy: Good, But Not Great, Outlook for Corporate Credit in 2007 .................................................................................................... 8
Another year of solid credit fundamentals and technicals holding spreads in a tight range. Active credit selection in our recommended sectors could provide further upside from our expected return ranges of 4% in high grade and 6.5% in high yield.
Agency MBS
Steven Abrahams Victor Gao
Rate Sectors
Economics ......................................................................................................... 17 Growth, Inflation and Monetary Policy Outlook for 2007 Treasuries/Agencies ......................................................................................... 21 Repo Scrutiny, Steeper Curve and a New GSE Regulation Interest Rate Swaps/Options ........................................................................... 25 Swap Spreads in 2007: Grinding Tighter Volatility in 2007: Watching the Fed Agency MBS...................................................................................................... 31 MBS in 2007: The Case for Tighter Spreads Adjustable Rate Mortgages ............................................................................. 36 Agency Hybrid Outlook 2007
Print
CDOs
Gyan Sinha Karan PS Chabba Andrew Bierbryer Kunal Shah (212) 272-9858 (212) 272-1978 (212) 272-7331
CMBS
Marielle Jan de Beur Naynika Chaubey (212) 272-1679 (212) 272-0894 (212) 272-2662 (212) 272-8054 (212) 272-8234 (212) 272-5944 (212) 272-5349 (212) 272-9040
Prepayments
Dale Westhoff V.S. Srinivasan Steven Bergantino Victor Consoli Michael Mutti Carl Ross
Credit Sectors
Structured Credit ............................................................................................. 38 The Structured Credit Markets in 2007: Opportunities and Challenges CMBS ................................................................................................................ 50 CMBS: A Year of Firsts
Print
Portfolio Strategies
Please see Regulation AC certification and other disclaimers on the last page of this document.
Across the Curve and Across the Grade: Outlook 2007 View Across the Curve
Non-Agency Jumbo2
100 99 52 16
Non-Agency Alt-A2
Structured MBS
ARMs
Agency Hybrid3
Non-Agency Hybrid4
ABS
87 44 -12 2 46 77 37 26 20 47 50 39 2 1 -1 35 18 21 16 11
125 77 -2 14
131 77 0 16
CMBS CDOs
New Issue5 CLO ABS CDO Trust Preferred Government Swap Agency Debt6 Corporate - High Grade7 Corporate - High Yield7
62 83 41 19 45 54 59 38 4 3 0 45 32 32 23 16 16 16 16 17 17
77 95 45 19 60 79 69 35
80 94 86 42
2 55
19
3 75 69 67 51 23 30 31 31 21 21
3 90
5 100 96 95 73
24
30 30 24 31 32
24 24
69 287
93 351
(1) FNMA 15 yr (5.41 cpn) AL spread to LIBOR @ 5 yr; FNMA 30 yr (5.38 cpn) AL spread to LIBOR @ 7.5 yr (2) 'AAA' shown for (from left to right) 15 yr (5.5 cpn) and 30 yr Jumbo (6.0 cpn) and (next row) 30 yr Alt-A (6.25 cpn) (3) Bonds shown from left to right are 3/1 (5.25 cpn), 5/1 (5.25 cpn), and 7/1 (5.5 cpn) (4) Run to Maturity; bonds shown from left to right are 3/1 (5.5 cpn), 5/1 (5.5 cpn), 7/1 (5.75 cpn), and 10/1 (6.0 cpn) (5) 5 yr bond is tight window; 10 yr bond is 30 % super senior (6) Agency spreads are FNMA debt (7) Corporate Index spreads for the following maturities: HG: 1-3 yr, 3-5 yr, 5-7 yr, 7-10 yr, 10-50 yr; HY: 1-5 yr, 5-10 yr, 10+ yr; HY bonds are callable (8) EPM is Econometric Prepayment Model (9) Spread of 6.0% PAC structured off of 30-year Freddie Mac TBA collateral. For historical spreads, go to Relative Value Studio: https://aloha.bearstearns.com/rvs/rvMain.jsp. Contact your sales representative if you do not have access.
By taking spread risk in the first half of the year, and By selling options in the first half as well
Despite prospects for a bumpier road, the rates markets still can rely on persistent global liquidity to help absorb most shocks. The road may get a little rougher, but the market looks resilient. Rates and the Fed The Fed in 2007 is likely Strategy Outlook for the to find itself in a End of 2007 continuing fight with the market over expectations Fed funds: 5.25% 25 bp about policy, with most of the impact coming on the 2-Yr Treasury: 5.00% 25 bp short end of the Treasury curve. Taken at face value, everything the Fed says suggests that through most of next year it expects to keep fed funds at least at 5.25%. The market, however, doubts that. Thats the message implied by 2-year Treasury yields that have traded as low as 4.50% in recent weeks and now stand near 4.70%. The Fed and the markets are at loggerheads. For 2007, my money is on the Fed. The Fed has a clear comparative advantage in this forecasting game. It certainly has as much economic information as anyone. It has as large and as competent a staff of analysts. But unlike most other players, it has incentives to get the path of inflation and growth right and no way to diversify away its risk of being wrong. Fed transparency has upped the ante, with the institutions credibility riding partly on its forecasts of the economy. Information, expertise and incentives are a powerful combination. If the Fed saysas it has repeatedly
Sack, Brian (2003). A Monetary Policy Rule Based on Nominal and Inflation-Indexed Treasury Yields, Finance and Economics Discussion Series Working Paper No. 2003-7, Board of Governors of the Federal Reserve System.
/20 3 /9 03 /2 5 /2 0 04 8/2 8 /1 00 4 8/2 1 1 00 4 /8/ 2 1 /2 00 4 7/2 4 /1 00 5 9/2 0 7 /8 0 5 /20 9 /2 05 8 1 2 /2 00 /19 5 /2 3 /1 0 05 0/2 5 /3 00 6 1/2 8 /2 00 6 1/2 1 1 00 6 /9/ 20 06
Currency policy. China and other Asian exporters link their currencies to the dollar in order to remain the lowcost providers to the U.S. and other dollar-bloc markets. That forces these exporters to buy dollars in order to prevent appreciation of their local currencysomething that would push up the price of their exports in dollar terms. These countries have taken their resulting immense foreign reserves and plowed two-thirds of them right back into U.S. debt. The arrangement has helped both sides: the exporters effectively buy access to the U.S. markets, and the U.S. gets inexpensive money. The international role of the dollar. The dollars role in international trade has created powerful constituencies for keeping other currencies pegged to the greenback. Among central banks, an estimated 66% of the worlds $4.8 trillion in reserves sit in dollar assets, a powerful incentive to preserve the dollars value. In addition, a significant percent of international trade outside of Europe gets priced and settled in dollars even in the absence of a U.S. counterparty, an incentive to avoid the friction of currency volatility. The relative quality of U.S. debt markets. In size, liquidity and diversity, the U.S. debt markets have sizable advantages over other places where global investors might put their funds. At the end of 2005, for instance, the U.S. had $22 trillion in non-government debt outstanding compared to $10 trillion in euro, $2.5 trillion in yen and $1.5 trillion in sterling. U.S. debt also spanned a wider range of rating categories and included significantly more securitized assets than the other markets. Apart from individual credit concerns, the ability to diversify constitutes another source of safety in U.S. debt.
12 /18
Investors in the short end of the U.S. curve should also worry about the path of the European Central Bank. Many analysts see the ECB pushing up euro policy by the end of 2007. Given the good odds of depreciation in the dollar against the euro, any narrowing of the interest rate difference between U.S. and euro rates should encourage flows out of the U.S and into euro, especially for foreign private portfolios not wedded to managing exchange rates. Central banks are another story. The likely tension between the Fed path and a market anticipating an ease should drag yields along the short end of the Treasury curve higherwith a little kicking and screaming along the way. Yields on 2-year Treasuries should end up closer to 5.00% than where they stand today. And the realized volatility of short rates should rise from levels seen in 2006. Rates and Global Flows In 2007, the global Strategy Outlook for the stampede of dollars into End of 2007 U.S. debt may slow, paving the way for a 10-Year Treasury: 4.85% modest and sustained rise 25 bp in 10-year yields into the neighborhood of 4.85% or higher. Foreign investment should still keep yields on the long rates well below levels dictated by economics alone. At times, foreign flows in recent years equivalent to more than 7% of GDP have dragged 10-year yields as much as 95 bp below the levels that economics alone might anticipate.+ Those flows will not turn on a dime, but they may have good reason to throttle back. Foreign inflows have dominated the long end of the curve as the U.S. current account deficit has exploded. The U.S.
None of these factors change quickly, but on the last count the relative quality of U.S. debtthe tide may turn a little in 2007, and not so much in the eyes of central bankers as in the view of foreign private investors. Those investors might start to worry that the U.S. is approaching practical limits to expanding its foreign liabilities. Until just this year, the U.S. was able to cover the costs of its ballooning foreign liabilities simply out of the cash flow from its own foreign investments (Figure 2). In 2005, for example, the U.S. received from foreign assets $17.5 billion more than it paid out for foreign liabilities. Considering the nearly $6 trillion in current account deficits piled up over the last quarter
Warnock, F.E. and V.C. Warnock (2005) International Capital Flows and U.S. Interest Rates, International Finance Discussion Series Working Paper No. 2005-840, Board of Governors of the Federal Reserve System.
Galati, G. and P. Wooldridge (2006) The Euro as a Reserve Currency: A Challenge to the Preeminence of the U.S. Dollar? Bank for International Settlements Working Paper No. 218.
The U.S. and its lenders consequently find themselves like a homeowner and banker watching the borrowers thinning ability to cover mortgage costs. The investment account used to do it. Now the homeowner has to reach into other pockets. And the payment is going up. That could take a little of the fizz out of the economic party. No lender likes that. Any nervousness about the increasing burden of servicing U.S. foreign liabilities is likely to show up first in the flows of foreign private investors. Without a currency to protect, private investors have more leeway than central banks do to sell. Private investors also face improving conditions in other global markets. The pool of foreign currency reserves has made a number of emerging markets countries much safer today than they were five years ago, something reflected in this years generally tighter spreads. The prospects for appreciation in the euro against the dollar could also draw funds into Europe. Nervousness among foreign investors would show up in higher U.S. rates. From January through March 2006, we saw the impact of a drop in foreign inflows into U.S. debt. Foreign investors bought $82 billion fewer Treasuries than they did the year beforealthough foreign portfolios instead invested heavily in spread productsand real yields in the U.S. rose by 35 bp. The year ahead is likely to see more episodes like this.
See Ricardo, R. and F. Sturzenegger (2006). Why the U.S. Current Account Deficit is Sustainable, International Finance, 9 (2), 223-240. For a contrasting view, see Gros, Daniel (2006). Why the U.S. Current Account Deficit is Not Sustainable, International Finance, 9 (2), 241-260.
For a detailed discussion of these factors, see Kobor, A., L. Shi and I. Zelenko (2005). What Determines U.S. Swap Spreads, World Bank Working Paper No. 62.
Recession in the U.S. A U.S. recession would have dramatic implications for both rates and spreads. In rates, recession could spur a sharp steepening of the yield curve with a both a quick drop in short-term rates and a modest rise in long-term rates. The drop in short-term rates would reflect broad expectations of a series of cuts by the Fed. The rise in long-term rates would reflect expectations of a shrinking U.S. current account deficit and less foreign reinvestmentas consumer spending slowed. Recession would normally dictate a drop in longterm rates, but shifting foreign demand would likely make this yet another exception to long-standing rate market rules. In spreads, the prospects of recession would raise concerns about credit and send spreads in swaps and MBS wider.
Beyond these or other unforeseen risks, a flat or inverted yield curve with modest moves in rates and tighter spreads seem in the cards for 2007 and possibly beyond.
Across the Curve and Across the Grade: Outlook 2007 View Across the Grade: Corporate Credit Strategy
5.9 5.9 -0.2 -0.3 -0.6 -1.2 -0.3 -0.3 4.8 4.1 High Yield Scenarios 330 4.7 2.3 0 10 8.0 0.0 -0.5 -0.9 6.6 350 4.8 2.3 20 20 8.0 -1.0 -1.0 -0.9 5.0
Spread UST 10-year Defaults Annual change (bps) Spread UST 10-year Returns attributable to: Coupon Spread UST 10-year Defaults Expected Return (%)
Looking back. In our initial outlook last year, we were far too concerned about the consumer slowing down, the fate of the auto sector, the Fed tightening, and wage and cost inflation putting pressure on corporate profits. We expected a mid-3% high grade return and eventually arrived at a 6% estimate for high yield. We became much more bullish on the credit markets and homebuilders in later July, and for high yield proposed barbelling double-Bs and triple-Cs and fading single-Bs.
Strategies to watch. In a tight-spread, low-volatility, lowdefault-risk credit environment with an inverted/flat yield curve, we expect more leverage to be employed by hedge funds to generate double-digit net portfolio returns out of 6% 8% corporate credit yields. The leverage could be in the form of margin loans, aggressive CDX index selling, structured products or even permanent debt financing, such as hedge funds issuing bonds. The uses of these leverage sources are typically to buy LIBOR+275 leveraged loans or to new issue high yield bonds, or perhaps for CDS protection on an LBO candidate. We anticipate that trading LBO speculation will remain the dominant credit theme until there is some episode of volatility. We like purchasing volatility cheaplysetting up steepener trades on LBO candidates, for example, or buying HiVol protection where we see more LBO risk and funding it by selling the XO crossover index where we think more event risk has been priced in. In general, when carrying out duration-neutral (DVO1-neutral) steepeners we are willing to accept default risk and sell LBO risk, so, for example, we would sell more 3-year CDS to fund buying 5-year CDS (or 5s/7s, 5s/10s). This is consistent with our view that credit curves are biased to steepening. We think that there are fewer natural buyers of short-dated default protection in CDS, and in a low-default environment traders are more comfortable accepting default risk (selling 35-year CDS) to fund the payment of LBO speculation (buying CDS). We would also seek out high grade bond issues with changeof-control or step-up covenants. Such issues often trade at only a 1525-bp premium to similar bonds without covenants, and such premiums can become considerably more valuable in the event of an LBO speculation.
1 2
Cash held by S&P 500 (non-financials) is approximately $750 billion. See Across the Grade, November 7, 2006, The Pension Law Changes and a Few More Thoughts on CPDOs.
Sectors in focus. We suspect that there will be plenty of press advising credit selection (and adverse selection of LBO risk) as the roadmap to Alpha-cityno surprise there. We do think that the credit market has good technical momentum behind it and that fundamentals are good, and we expect investors to be on the hunt for excess spread. We believe that autos, energy, homebuilders, cable, media and telecom offer some of the best relative spreads for their ratings and have a lot of headline risk behind them. With Ford and GM having addressed their liquidity needs, their 200708 default risk is essentially a nonconcern, in our view, making these credits core-holding candidates, if theyre not already. We think that energy is a good defensive sector, with low LBO risk; its downside scenariotrading even with industrialshas already happened. Our high grade energy index now trades even with our industrial index at 117 bps, having been 14 bps inside at the end of 2005. We like the risk-reward in homebuilders, figuring that the sector most likely holds its 2030-bp relative discount to triple- and double-Bs and should gradually tighten as the sector stabilizes. On the downside, the homebuilding
Bear, Stearns High Grade Corporate Index 2006 Sector Trading Ranges as of 12/08/06
180 Current 160 12/31/2005
140 OAS
120
100
80
60
y Te lec om Tr an sp or tat ion Ut ilit ies Liq uid Ind ex gy Fin an cia ls Fin an ce Co ex te us tria ls Ins ur an ce Me dia nCy c riti es ria ls ing fg Cy c Ba nk Ma te En er Es ta -M Ind um er oo ds Se cu ch no log
No
Re al
Ind
Ca pG
Ba sic
Co ns
Co ns
um
Te
er
10
Bear, Stearns High Yield Index (BSIX) 2006 Sector Trading Ranges as of 12/08/06
675 625 575 525 475 OAS 425 375 325 275 225 175
Me dia No nCy c Te lec om Fin an ce En er Mf gR ela Ma te Co mp um er oo ds hn o or tat ns p hc Ut ilit y BB ted gy B e ria ls -M fg Cy c ar e os it log ion y
Current 12/31/2005
He alt
Ca pG
Ba sic
Co ns
Te c
er
Au to
Where could market stress come from? Tight spreads lead many of us to think that we are not being fairly compensated for risk, but the market establishes a price for everything, and when defaults are low, fundamentals are solid and the VIX is under 13 more than two-thirds of the time, you could wait quite a while for the market to offer you better spreads. In the high grade index, spreads have actually widened to 102 from 99, in part corresponding to the 10-year Treasury yield rising to 4.6% from 4.39% a year ago but maintaining the same 1.22 corporate yield to Treasury yield risk premium (e.g., 4.6 + 102 / 4.6). Assuming that the UST 10-year yield moves up to the 4.8%5.1% range from 4.6% today, if high grade creditors remain content with a 22% spread premium, we could see high grade spreads widen by 57 bps. The market could, of course, demand a greater spread premium to hold corporate risk if inflation surges or if confidence corporate profits growth diminishes. We view any potential market stress as likely be episodic, coming from LBO speculation or from the inevitable string of down days in the stock market driven by earnings disappointments or economic data. Recent episodic disruptions have also been caused by unfortunate headlines related to terrorism, hedge fund blow-ups and proposed regulatory changes. But these have all been short-lived distractions, spiking volatility and widening spreads for days to weeks only, and they are a reality of the markets. The larger riskslow probability, in our viewconcern the economy stumbling or the market facing systemic problems like a drop in corporate profit growth, a cluster of defaults, or hedge funds crowding into a mistaken theme.
Co ns
um
Defensive positioning. Insurance comes at a cost, whether from paying default protection premium or from forsaken opportunity. The least expensive defense, in our view, is to increase a portfolios allocation to cash, shorten duration, select bonds with covenants, and overweight lower-viability LBO sectors like financials, railroads, utilities, deep-cyclicals, capital-intensive industries like E&P, and super-cap companies (over $50 billion TEV). A more selective approach could be to define a basket of LBO candidates and set up CDS steepeners in each, funding these steepeners by selling the 5year XO7 CDX index (which, in our view, should demonstrate less correlation to the VIX widening) or selling 3-year IG7 (or 5-year IG4 with 3.5 years remaining), which can generate returns just by rolling down the credit curve. Diversification is another reasonable strategy: consider that there were only seven actual high grade LBOs in 2006, out of 700 issuers across A3- through Baa3-rated high grade index credits (excluding financials and utilities). Albertsons, Kerr-McGee and Knight-Ridder were close to being LBOs and ended up with strategic acquirers. Overall, perhaps the best defensive strategy is diversity and doing your credit homework, applied
Tr a
11
Active LBO Speculation CAR Avis CBS CBS FD Federated GPS Gap JNY Jones Apparel RSH RadioShack RRD RR Donnelley RRD SLE LUV Southwest Airlines TRB Tribune Co. Major High Yield LBOs CVC CSC Holdings Inc. GP Georgia-Pacific Corp. HCA HCA Inc. STN Station Casinos
12
The 2007 Outlook We believe that 2007 will be another good year for the emerging market debt asset class, with a lot depending on the path of the U.S. economy. The path of the U.S. economy has obvious implications for U.S. interest rates, which affect not only the prices of emerging market bonds (denominated in dollars) but also the global flow of funds toward risk assets. It also has an effect on emerging country fundamentals. By now the increase in reserve assets in emerging country central banks is well known. The chart below shows the historical perspective on external debt and foreign exchange reserves in emerging market countriesin effect, a very simplified balance sheet. The chart clearly shows that foreign reserve asset accumulation in emerging market central banks has massively outpaced the rise in external debt. In 1998, reserves as a percentage of external debt stood at roughly 27%, whereas the same ratio in 2007 is expected to approach 100%. Clearly, this is a favorable balance sheet position for emerging countries. 13
1999
2000
2001
2002
2003
2004
2005
2006(e)
2007(f)
We admit that there is a lot of good news priced into the emerging market debt market. But looking simply at likely rating actions, there is the strong possibility of continued good news. The table below lists sovereign credit ratings for the countries in our BSEMIX index, along with rating outlooks. Of the 37 sovereigns in our index, sixteen have a positive rating outlook from at least one of the major rating agencies, and only two have negative outlooks.
BSEMIX Countries: Ratings & Outlook, December 2006
Countries Latin America Argentina Brazil Chile Colombia Costa Rica Dominican Republic /1 Ecuador El Salvador Guatemala Jamaica Mexico Panama Peru Trinidad and Tobago Uruguay /1 Venezuela Asia China Hong Kong Indonesia Korea Malaysia Pakistan Philippines Thailand Vietnam Eastern Europe Hungary /1 Kazakhstan Poland Russia Serbia Ukraine Middle East/Africa Egypt Iraq Lebanon Qatar South Africa Turkey Moody's Rating Outlook B3 Ba2 A2 Ba2 Ba1 B3 Caa1 Baa3 Ba2 B1 Baa1 Ba1 Ba3 Baa1 B3 B2 A2 Aa3 B1 A3 A3 B1 B1 Baa1 Ba3 A1 Baa2 A2 Baa2 NR B1 Ba1 NR B3 Aa3 Baa1 Ba3 STA STA STA STA STA NA POS STA POS STA STA STA POS STA NA STA POS POS STA POS STA STA STA STA STA NA STA STA STA NA POS STA NA NEG STA STA STA Rating B+ BB A BB BB B CCC+ BB+ BB B BBB BB BB+ AB BBA AA BBA AB+ BBBBB+ BB BBB+ BBB BBB+ BBB+ BBBBBB+ NR BA+ BBB+ BBS&P Outlook STA POS STA POS STA POS STA STA STA STA STA STA STA STA STA POS STA STA STA STA STA POS STA STA STA NEG STA STA STA POS STA STA NA NEG STA STA STA Rating B BB A BB BB B BBB+ BB+ NR BBB BB+ BB+ NR B+ BBA AABBA+ ANR BB BBB+ BBBBB+ BBB BBB+ BBB+ BBBBBB+ NR BNR BBB+ BBFitch Outlook STA STA STA POS STA POS STA STA STA STA STA STA STA NA POS STA POS POS STA STA STA NA STA STA STA NEG STA POS STA STA POS STA NA STA NA STA POS
Source: Bloomberg. Legend Key: POS = positive outlook; STA = stable outlook; NEG = negative outlook; NR = not rated; NA = not available; /1 = ratings under review.
14
BSEMIX Expected 12-Month Returns Under Different 10-Year UST Yields and BSEMIX Spread Scenarios
BSEMIX Index Spread Over 10-Year UST (bps) UST 10-Year Yield 4.00% 4.25% 4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 6.00% +130 11.98 10.41 8.87 7.36 5.89 4.46 3.06 1.70 0.36 +140 11.33 9.76 8.23 6.74 5.29 3.87 2.48 1.13 -0.20 +150 10.67 9.12 7.60 6.13 4.68 3.28 1.90 0.56 -0.75 +160 10.01 8.48 6.98 5.51 4.09 2.69 1.33 0.00 -1.29 +170 9.37 7.84 6.36 4.91 3.50 2.11 0.77 -0.55 -1.84 +180 8.73 7.22 5.75 4.31 2.91 1.54 0.21 -1.10 -2.37 +190 8.09 6.60 5.14 3.72 2.33 0.97 -0.35 -1.64 -2.91 +200 7.46 5.98 4.14 3.13 1.75 0.41 -0.90 -2.18 -3.44 +210 6.84 5.37 3.94 2.54 1.18 -0.15 -1.45 -2.72 -3.96
Source; F.A.S.T., EM Fixed Income Research. Note: The current spread of the BSEMIX at the time of writing is +163 bps to U.S. Treasuries. Our base case scenario for 2007 calls for a tightening in spread on the index to +140150 bps.
Regional Outlooks for 2007 In this publication, we stop short of focusing on particular countries, but we would like to provide the reader with some guidance on our views for the major regions in emerging markets. For Latin America, my colleagues Alberto Bernal and Franco Uccelli believe that the main credit driver will be economic growth, since many of the key elections in Latin America are over (Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela). Economic growth will reduce the likelihood of anti-market economic policies. By contrast, my colleagues who cover Eastern Europe, Middle East and Africa (Tim Ash) and Asia (John Stuermer) believe that politics may be the key credit drivers in those regions in 2007. Latin America. We expect 2007 to be yet another good year for the Latin American region, the fifth consecutive one of positive growth, and the fourth consecutive one showing growth of more than 4% year over year, significantly higher than the long-term average growth rate for the region of around 3%. We believe that a combination of high commodity prices, higher investment rates and lower interest rates (that spurs investment and consumption) should allow Latin America to achieve the 4% number. Argentina and Venezuela might decelerate in 2006 due to low investment rates in recent years, but commodity prices are still likely to keep growth rates above trend. Lingering good growth is consistent with stable fiscal stances and continued improvement in debt ratios. We do not think that 2007 will be a year in which we see the same amount of erosion in the supply of bonds (i.e. buybacks) from the Latin America region. We believe that 2007 will be a year in which the demand/supply schedule will be more aligned. Why is that? First, from the perspective of governments, the carry of local bonds tends is higher than the carry on foreign debt, especially under a scenario of real exchange rates appreciating further. Second, we believe that diminishing returns may be entering the equation at this time. Specifically, we believe that the willingness/logic of further reducing external debt may not be that clear any more, at least judging from a social welfare point of view. For example, Brazils net public external debt already stands at 0% of GDP. The logic of further depressing that number may not longer be
fully evident. That said, with fiscal accounts in good order in the region, the likelihood of significant net new issuance from the sovereigns is also unlikely. Asia. There seem to be identifiable potential flashpoints in almost all political systems in Asia over the next year, taking the form of elections to be held in 2007, coup attempts or broadly based efforts to force elected leaders out of power using extra-constitutional means, fracturing of political coalitions or other groupings that have provided a basis for political and policy continuity in past years, and finally, the North Korean bomb. North Korea has proceeded with testing a nuclear bomb, with little immediately observable effect on regional political stability. The 2007 elections in the region will take the form of regularly scheduled elections (presidential and parliamentary elections in Pakistan, parliamentary and local government elections in the Philippines, a presidential election in South Korea, parliamentary elections in Taiwan, crucial state elections in India) or potential snap elections (Malaysia, India). We note that presidential and parliamentary elections are not due in Indonesia until 2009, but many observers believe that political maneuvering by parliamentarians seeking re-election and political positioning by potential presidential candidates will begin in 2007, making any further effort at meaningful economic policy reforms impossible until after 2009. The decision of the Yudhoyono government in September to back off from submitting a bill to parliament that would reform Indonesias controversial labor law might suggest that the 2009 political season has already begun. The most interesting election in 2007 may turn out to be the effort of President Pervez Musharraf to get himself re-elected by Pakistans electoral college. There is a small but real threat that dissatisfaction with economic performance in Asia could spill over into the politics. Although real GDP growth rates have ranged between 5% and 6% or higher in good years, this outcome has been driven more by consumption and exports than by investment, and seems not to be creating employment or driving up living standards as much as the investment-driven growth prior to 1997. Furthermore, Asias export-based economic growth model seems to have created sharp regional or urban/rural
15
16
Conrad DeQuadros (212) 272-4026 / cdequadros@bear.com Meghna Mittal (212) 272-1961 / mamittal@bear.com Postmortem of 2006 Nominal GDP growth thus far in 2006 has run half a percentage point slower than we projected a year ago. Over the first three quarters of 2006, nominal GDP growth has averaged 6.3% versus our projection of 6.8%. This shortfall relative to our forecast has primarily shown up in slower real growth as real GDP growth has averaged 3.4% thus far in 2006 versus our forecast of 3.8% for the year as a whole. After factoring in our estimate of 2%2% for fourth quarter real GDP growth, we expect growth for 2006 to be about 3.2%. This rate of growth, however, appears to be above the economys current potential growth rate as judged by the unemployment rate. In November 2006, the unemployment rate stood at 4.5% versus 5.0% in November 2005. It appears that the potential growth rate for the U.S. has declined significantly. A year ago, our forecast for the unemployment rate for the fourth quarter of 2006 based off a projection of 3.8% growth was 4.7%, which is above the current unemployment rate. The distribution of growth through 2006, however, was more uneven than we anticipated as the drag from residential investment hit strongly after the first quarter. Real GDP growth was 5.6% in the first quarter but has slowed to an estimated average pace of about 2.4% since then, as a decline in residential investment subtracted what appears to be slightly more than one percentage point from real GDP growth. The other sector that has weighed more heavily on growth than we anticipated has been motor vehicle production, as the production of motor vehicles and parts declined at an annualized rate of 8.5% since June. In our judgment, there is no evidence that the weakness in housing and autos has spilled over into the rest of the economy. In the first 10 months of 2006, real consumer spending growth has averaged 3.1% at an annual rate, which has largely matched the 3.0% growth rate in real disposable income. This growth occurred despite a flattening out in wealth creation as household real net worth rose by only $1.4 trillion at an annual rate over the first three quarters of the year versus an average annual increase of $2.9 trillion over the previous three years. At the end of the third quarter, household net worth totaled $54.1 billion, or 5.6 times annual disposable income, suggesting that in aggregate the household sector is in sound financial shape. In short, growth has slowed because of the traditional multiplier impact of reduced residential investment. There is nothing in consumer behavior in 2006 to suggest that a pullback in mortgage equity withdrawal has held back consumer spending and growth.
17
We view the housing market as undergoing a one-time adjustment from unsustainable levels of construction and price appreciation. In our forecast, as this adjustment draws to a close, the dampening effects of lower residential investment are lifted and economic growth picks back up to a modestly above-trend pace. Also helping growth is a reduced drag on real incomes from energy prices, which have pulled back significantly in recent months. We see real GDP growth in 2007 averaging 3.1%, which is in line with the growth rate of consumer spending seen thus far in 2006. A year ago, we would have viewed 3.1% growth as being modestly below potential growth. However, the continued decline in the unemployment rate through 2006 suggests otherwise, and we now project that the unemployment rate will fall to 4% by the end of 2007 from 4% at the present time. The decline in the unemployment rate should put further upward pressure on wage increases, which in turn should help support the growth of household incomes. In our forecast framework, inflation is a function of the stance of monetary policy, not the unemployment rate. However, we view easy money as producing a further moderate rise in core inflation in 2007. We expect core PCE price inflation to rise to 2.7% in 2007 from a projected increase of 2.3% in 2006. Economy-wide inflation in the form of the GDP deflator is seen at 3.0% in 2007, which, combined with real growth of 3.1%, would put nominal GDP growth at 6.2% next year.
18
12-month change; %
2.5
2.0
1.5
Fed Seen Hiking Rates Twice in 2007 If realized, we think our growth, unemployment rate and inflation forecast would likely prompt the Fed to modestly tighten monetary policy in 2007. The Fed has made it clear that policy adjustments are dependent on incoming data relative to its forecast and the three primary variables that the Fed publishes in its forecast are real GDP growth, the unemployment rate and core PCE inflation. In July 2006, the FOMCs central tendency ranges for these variables for 2007 were: 3%3% for real GDP growth; 4%5% for the fourth quarter unemployment rate; and 2%2% for core PCE inflation. While we see real GDP in the FOMCs forecast range for 2007, the Fed has lowered its estimate for potential growth since July and our forecast for the unemployment rate, which is the principal driver of the Feds inflation model, is well below the Feds range. In addition, we see core inflation rising rather than falling in 2007. Under these circumstances, we would expect the Fed to snug rates higher in 2007 and we look for two rate hikes, to 5%, before the end of 2007. However, before the next hike takes place, we believe that growth would have to have picked up to about 3%, the housing market would have to have clearly stabilized, and that core PCE inflation would have to have edged up to at least 2%. We think that the earliest FOMC meeting at which these conditions would be satisfied is likely to be the May meeting. Until then, therefore, we expect that the Fed will hold rates steady at 5%, and maintain its bias to higher inflation and tighter policy. Yields Expect to Rise We recognize that for the last two years, bond yields have been lower than we were expecting as a result of strong foreign (especially official) purchases of U.S. fixed income (particularly out of Asia and, more recently, OPEC). The forward structure of interest rates is pricing in about two
19
2006+ (percent) 5.9 3.2 4.6 2.7 2.3 5.0 4.8 4.8
2007+
* Values are either quarterly changes or quarterly averages + Values are either 4- quarter changes or yearly averages Source: Bear Stearns
20
5.25
Steeper Curve in 2007 Economic indicators are mixed indeed! Traders are making much of news that the ISM manufacturing index has fallen below 50 for the first time since 2003and they should. Throughout the current tightening cycle we have been linking movements in the slope of the curve to the business cycle and emphatically emphasizing that nothing is likely to happen to the shape of the curve until we reach the end of the business cycle. Recent news has certainly changed perceptions about the timing of the end of the cycle, and the curve has steepened toward a well-established range from this fall, between -5 and -10 bp. There is reason to suspect that the curve may soon break out of this range and begin the long march toward substantially positive slopes.
Figure 2. ISM Falls Below 50, First Time Since 2003
65 60 55 50 45 40 35 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06
A reading in ISM below 50 indicates contraction in manufacturing, and while the latest value of 49.5 is a relatively small dip into negative territory, it strongly contradicted the average expectation on the Street of 51.5. There is reason to think that fundamental data and the recent negative expectations of economic performance are tied to the 21
ISM Index
-12 bp
Treasury Repo Scrutiny The Federal Reserve Bank of New York, administrator of the System Open Market Account (SOMA) that lends billions of dollars to Wall Street firms to help alleviate specials in the financing market, has been scrutinizing financing trades for possible manipulation. In a meeting with legal and compliance officers the New York Fed asked Wall Street firms to monitor their Treasury financing activity for trades far below general collateral rates. The Fed considers a financing rate more than 100 bp below general collateral rates as special, and not surprisingly, there have been very few of these trades ever since the meeting. Financing well below general-collateral rates has been characteristic of the note or bond that is cheapest-to-deliver into Treasury futures contracts for many years, but right now everything in the deliverable basket for 10-year Treasury futures is financing above 5%. In a forward contract the impact of lower repo rates and higher note prices are offsetting to some extent. Lower repo rates mean more carry, and lower forward prices. Lower repo rates also imply that the note in question is richening in price, which raises the forward price. However, in the past it has been typical for price increases to outweigh the effect of repo rates, leading prices in the frontmonth Treasury futures contract to rise and calendar spreads to widen over the course of the cycle. For the December/March Treasury futures calendar spread the repo specialness was most important to the 10-year contract, which recently fell from -0.5 to -2.5 ticks, indicating that the market was inverted since the March price was above the December price. If December fails to richen because the CTD note doesnt go special, then it may be difficult for this spread to continue to invert, possibly putting in a floor in the current calendar spread as well as the next several to come. Given that traders are already lining up to dabble in steepeners, there may be added pressure for the spread to move into positive territory. One of the leading factors in widening spreads in off-the-run maturities is repo specialness, especially in the 7-year sector, and if nothing ever goes special again there may be major
Technically speaking, there may be a very mundane reason for the December rally in the 2-year note. Earlier this month there were 48,879 December 2-year contracts delivered at the CBOT, representing $9.8 billion face of notes, out of an almost $25 billion issue. Consider that most of these notes were boxed for delivery days or weeks ago, so the market has already felt the buying pressure to accumulate the positions. The holders of long 2-year note futures, on the other hand, are probably not interested in actually owning the issues and would have preferred a less efficient delivery and to receive the notes later in the month. Traders who received the notes likely sold them to the street on November 30, handing Wall Street traders substantial positions on a day that is yearend for many firms. Knowing that there may be substantial selling of these notes, primarily 4.625 Sep 08, traders may have gotten short this sector in anticipation of a little dip in prices. Traders who were short in anticipation of this rather technical factor may have found themselves offside when the ISM report came out weaker than expected, requiring them to cover their short positions. The curve has already returned to the well-established trading range from earlier this year, centered on -5 bp, and for the rest of December it is unlikely to break out to higher levels. However, we think that the time is nearing to pile into steepening trades but we are waiting for a move through 0 bp before initiating the position. Our expectation is that when the curve starts to climb to steeper levels it will be the start of at least a 100 bp steepening, and were happy to give up the first few basis points as confirmation of the move.
22
Though there hasnt been anything unusual about the behavior of the shape of the curve, the same cant be said of credit spreads. While swaps havent been traded long enough to graph their performance according to the business cycle in the same way we can with Treasuries, there is a long-running series on high quality corporates that we can use as a proxy. Figure 5 shows a long-term history of seasoned AAA
Yield, %
23
24
Investors will continue to reach for higher yields in the context of a steady Fed and low volatility, compressing swap spreads. Credit is likely to be the main story for spreads. As long as demand for spread product stays high, and the economy continues to bump along, there is not much risk for a major widening in spreads. If and when credit begins to deteriorate, spreads could begin to widen.
Swap spreads have come in from their recent wider levels, but have some room to narrow further before they come up against historically narrow levels. As long as the economy remains reasonably firm, yield-hungry investors are likely to continue to buy spread products, pushing swap spreads narrower. At least for the first half of 2007, this should be the dominant flow. After that, it will depend on how the economy responds to the Feds ministrations, with the continued health of corporations first on the list of risks to swap spreads.
Figure 1. Fed Funds Target Rate; 10-year Swap Spreads, A Credit Spreads
250 200 Spread BP 150 100 50 0
b-0 5 b-0 2 b-9 7 b-0 0 b-9 9 b-9 6 b-9 8 b-0 1 b-0 3 b-0 4 b-0 6 Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe
Treasury supply Potential repo specialness Overall level of rates Negative-convexity hedging Shape of the yield curve
Relative Scarcity of Treasuries: Treasury Supply and Repo Specialness On a quarter-to-quarter basis, projections of Treasury supply show a strong connection with swap spreads.
Figure 2. Swap Spreads and Treasury Supply
Qtrly Borrowing Projection (Inverted) -100 -50 0 50 100 150 Projected Actual Spreads 140 120 100 80 60 40 20 0 Spread
7 6 5 4 3 2 1 0
Ju n93
Ju n95
Ju n97
Ju n99
Ju n01
Ju n03
Ju n05
25
Credit: If credit spreads widen, swap spreads are likely to follow. There could be a significant widening in spreads before the Fed acts to stimulate the economy, easing credit and causing rates to fall. The fall in rates would be likely to reignite negative-convexity hedging and it would also likely cause the yield curve to steepen. Both of these effects would put narrowing pressure on spreads, but this would likely be from much wider levels. Deficit Surprises: Deficits in 2006 came in better than had been expected at the end of 2005. If this were to continue, causing Treasury issuance to be reduced, it could eventually translate into wider spreads.
Resid (bp)
12 /18
8/0 12 2 /18 /02 6 /1 8/0 12 3 /18 /03 6 /1 8/0 12 4 /18 /04 6 /1 8/0 12 5 /18 /05 6 /1 8/0 6
6 /1
/01
26
Receive on spreads across the curve, looking for 10-year spreads to enter the mid to high 30s, and 2-year spreads to cross below 30. Keep a careful eye on credit and emerging market spreads for signs of trouble, and pay on spreads if credit begins to deteriorate.
The long-term moderation in interest rates and volatility should continue, so that even when volatility does rise, it is likely not to reach the peaks that have been seen in previous interest rate cycles.
The main risk for higher volatility is a sharp decrease in interest rates, which is most likely to happen in one of two ways:
The Fed stays steady or raises rates, but demand for longdated securities pushes the yield curve more and more inverted. This would increase volatility, but unless the rally could be sustained and extended, the overall effect on volatility would likely be limited. The economy does worse than expected, forcing the Fed to lower rates. This should steepen the yield curve and have the most dramatic effect on volatility.
Long-dated volatility should continue to be pressured downward. Investors looking to enhance yield and callable and structured product issuance are likely to produce supply, while the demand for long-dated vol is likely to remain weak. Later in the year, with a steady supply of mortgages and the possibility of a change in Fed stance that much closer, long-date volatility should find a bottom. Short-dated volatility should be market directional. If the market rallies, short-dated volatility is likely to spike higher from very low levels, falling back if and when rates ease back, although very short-dated options could get a lift from an increase in realized volatility even if rates rise. The volatility surface should continue to reshape even ahead of a change in policy by the Fed, with short-tail volatility rising relative to long-tail volatility.
Volatility Drivers Market risks to volatility are primarily driven by changes in Federal Reserve policy. If the Fed maintains the status quo or even adjusts rates higher in 2007, volatility is likely to remain low and probably go even lower. On the other hand, if the Fed changes stance sooner than expected and begins to lower rates, volatility is likely to increase dramatically. Supply and Demand in volatility are driven by a number of factors. The most prominent of these factors is hedging of mortgage-backed securities, mortgage origination, and mortgage servicing rights. Issuance of callable securities such as Trust Preferred Notes and the growing market in structured notes can also be significant sources of volatility supply. As the mortgage market grows, the size of mortgage servicing portfolios grows with it, increasing demand for options.
27
When the Fed is raising rates or remaining steady after a prolonged period of rate rises, volatility usually falls; When the Fed lowers rates, volatility usually rises; The market will sometimes attempt to anticipate the Fed, for example raising volatility before the Fed actually begins to cut rates.
Volatility BP/Day
8/0
8/0
8/0
12 /18
12 /18
12 /18
12 /18
12 /18
8/0
6 /1
Uncertainty about the timing of Fed policy can eventually boost volatility as the market attempts to anticipate the Fed. Still, the biggest increases to volatility are unlikely to come until it is clear that the Fed is on the verge of cutting rates. One area that has already begun to anticipate the Fed is the volatility surface. Since volatility began to fall in 2004, the entire vol surface has become more and more compressed, with volatilities at various points converging on each other.
Figure 2. Volatility Surface Compression
10 9 8 7 6 5 4 3 2 1 0
This decompression is likely to continue in 2007 even if the overall level of volatility continues to come under selling pressure. Supply and Demand Good demand for mortgages from investors looking to enhance yield should create a steady supply of volatility in 2007. The main risk to this scenario is that interest rates fall sharply, with or without cuts from the Fed. Mortgage-backed securities carry primarily three types of risk:
Volatility BP/Day
Interest-rate risk from mortgages is frequently hedged with other interest rate products, such as Treasury notes or swaps. Because of the size of the mortgage market, hedging of mortgage rate risk can exaggerate rallies or sell-offs in the interest markets, increasing realized volatility.
12 /19
12 4 /19 /04 3 /1 9/0 5 6 /1 9/0 5 9 /1 9/0 12 5 /19 /05 3 /1 9/0 6 6 /1 9/0 6 9 /1 9/0 6
/03
9/0
3 /1
6 /1
9 /1
9/0
9/0
6 /1
6 /1
28
6 /1
6 /1
8/0
12 /19 / 1 2 95 /19 /9 12 6 /19 / 1 2 97 /19 / 1 2 98 /19 /9 12 9 /19 / 1 2 00 /19 /0 12 1 /19 / 1 2 02 /19 / 1 2 03 /19 /0 12 4 /19 /05
/02
/01
/03
/04
/05
4.5 1y 10y Vol 10y Sw ap 4.7 10-year Swap Rate (Inverted 4.9 5.1 5.3 5.5 5.7 5.9 6.1
Once rates go low enough, demand for options comes from several places:
Mortgage Servicers Mortgage servicers own the rights to service mortgages, and the are very active hedgers of interest rate and volatility risks. If the mortgages prepay, the servicers lose the income streams associated with the underlying mortgages. Servicers are very sensitive to the level interest rates, and they are often looked at as barometers of the state of the mortgage market. Servicers are likely to have a much larger need for options if interest falls from current levels. Also, with the overall mortgage market expected to grow 7% in 2007, the size of mortgage servicing portfolios will grow with it. Mortgage Originators Mortgage originators create new loans, and when they do they become short options. This is because borrowers can lockin rates when they apply for a mortgage, forcing the originator into the loan if rates rise, or demanding lower rates if rates fall. When mortgage applications spike higher, mortgage originators can have significant demand for options. This typically happens when refinancing increases. MBS Hedgers Anyone holding a position in mortgage-backed securities can hedge, but many do not, preferring not to give up any of their enhanced yield. Traditionally, GSEs have been the largest active hedgers of MBS, but in recent years they have been less active, both because their portfolios have been shrinking and because the mortgage universe has been out-of-the-money. While hedgers have been quiet, a sufficient fall in rates could bring them back into the market, creating a large bid for
At the end of each of the past three months, as rates have fallen, short-dated options have been bid up. Each time interest rates push lower, even without Fed rate cuts, volatility is likely to rise as market participants hedge against the possibility of a sustained rally that leads to a wave of refinancing. On the other hand, Figure 3 shows that ever lower lows in interest rates are needed to keep swaption premiums rising.
<
4.7 5 5 .0 0 5 .2 5 5 .5 0 5 .7 5 6 .0 0 6 .2 5 6 .5 0 6 .7 5 7 .0 0 7 .2 5 7 .5 0 7 .7 5 8 .0 0
29
All eyes are on the Federal Reserve. With a quiet Fed, volatility should be pressured downward as spread products and MBS remain popular with investors looking to enhance yield through option sales. Short-dated volatility should be highly rate sensitive, rallying whenever the market approaches new lows in yield, and then falling when yields rise. Supply of options, particularly long-dated options, should continue to outstrip demand in 2007, pushing volatilities ever lower, until the Federal Reserve is finally ready to begin cutting rates. We think thats still well in the future. Risks to the Forecast
The Fed: If the economy turns down and the Fed begins to cut rates sooner than expected, volatility is likely to rise dramatically. In this case, short-dated volatility will lead the way, but long-dated volatility is likely to rise sharply as well. The reshaping of the volatility surface will accelerate as well, as short-term interest rates lead the way. Demand for Spread Product: If spread products, including mortgages, become less popular, perhaps due to credit concerns, the supply/demand dynamic in volatility could change. This could occur in a rising rate environment, catching volatility sellers offside and causing a spike higher in both short- and long-date volatility. Geopolitical Risk: Volatility can be very sensitive to external shocks to the market. While it is true that there have been no major shocks since 9/11, any shocks that do occur may have a large effect on volatility.
Trading Strategies
Play for the continued reshaping of the curve by buying short-tail volatility and selling long-tail volatility. For example, buy 3y2y and sell 3y10y. Sell long-dated volatility outright, but protect it by buying low strike receivers or floors when short-dated volatility drops to low levels. Time after time, the market has shown how sensitive short-dated volatility is to the threat of lower interest rates. Later in the year long-dated volatility may have more value.
In the first quarter of 2007, sell or stay short very long-dated volatility, such as 5y30y or 10y10y. These long-dated, longtail volatility structures are the ones supplied to the market by Trust Preferreds or structured products. Hedge by buying shorter tails.
30
MBS Demand
MBS demand depends on the appetite of the key marginal buyers, and foreign investors and banks have been the most important bids in the last year. The bids should continue, possibly joined by investors skittish about credit in mortgagerelated ABS. Demand from Overseas Foreign investors have been one of the bright spots in MBS demand in the last year and look likely remain so in 2007. Those investors look likely to have plenty of new cash in the year ahead, and a good appetite for spread product. One obvious source of cash will be the likely continuing surge in global foreign currency reserves. Measured reserves grew by 20% last year and now stand at close to $4.8 trillion. An estimated 66% of those reserves sit in dollar assets. While there will surely be talk of diversification away from the dollar, the action is likely to be limited given the potential financial and political costs. Foreign reserves should grow again in 2007reserves in China alone could easily grow by $250 billion through foreign direct investment, currency intervention and interest on existing reservesand flow back into U.S. debt. And while flows from private foreign portfolios may weaken a little next year (see The Resilient Rates Markets elsewhere in these pages), they should still be significant. MBS, along with other spread product, should capture a rising share of foreign investment. While foreign purchases of Treasuries this year fell well below earlier levels, foreign purchases of spread productsagency MBS, agency debt and corporate debtran well above (Figure 1). Spread product helps foreign portfolios offset some of the potential losses in dollar portfolios depreciation of the dollar. China, for instance, allowed its currency to appreciate by 3.1% against the dollar this year and should allow further appreciation next
Ja n Ma r Ma y
b Ap r Ju n Au g Oc t Ja n Ma r Ma y
Ju l Se p
Source: TICS
Demand from foreign central banks should remain concentrated in pass-throughs with occasional forays into structure. Demand for foreign banks and insurers should show up mainly in structured MBS. Demand from Banks Net demand for mortgages and MBS from U.S. banks should be as good or better in 2007 as it was in 2006, when large commercial banks added a net $222 billion$148 billion in mortgage loans and $74 billion in MBS. Although an inverted yield curve and rising funding costs should continue to put pressure on bank net interest margins, banks may nevertheless have few alternatives beyond mortgages and MBS for adding spread income. Most of the bank demand for mortgages in 2006 came from a handful of the largest institutions. For example, holdings of both securitized and unsecuritized mortgages at Bank of America through 3Q06 had jumped $17 billion from the start of the yeareven after a $46 billion sale of MBS in September. Total mortgages held by Citigroup rose by $81 billion, with $54 billion of the rise in MBS. And mortgages at JPMorganChase grew by $55 billion, with $49 billion in MBS (Table 1). MBS have become increasingly concentrated in the hands of large banks in recent years, with the top three bank holders of MBS todayBank of America, Wachovia and JPMorganChaseaccounting for 64% of all MBS held by large U.S. commercial banks. The mortgage market has consequently become increasingly subject to the needs of particular balance sheets.
Ju l Se p
Fe
31
Rising funding costs have put pressure on banks margins all year, and thats likely to continue. The national median cost of funds ratio, as reported by the Office of Thrift Supervision, rose from 2.86% at the end of last year up to 3.57% as of October (Figure 2). Cost of funds has risen 83 bp year-overyear through October, nearly the fastest rate of increase since 1995. Deposits have also grown. Large banks took in $104 billion in new deposits in 2006, with small banks adding $154 billion. Next year, banks should not only face rising funding rates, but a rising base of liabilities. Some banks may counter the rising funding costs by allowing assets to mature or prepay and by retiring their most expensive funding, but most will likely add leverage and try to squeeze more margin out of investment opportunities.
Figure 2. Banks Face Progressive Higher Cost of Funding
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Ja n00
Ja n02
Ja n98
Ja n04
Ja n92
Ja n01
Ja n03
Ja n00
Ja n02
Ja n04
32
Ja n05
Ja n06
As banks go hunting for assets, a slowing economy should squeeze the supply of commercial and industrial loans and consumer assets. In the second half of 2006, for example, the growth rate in large bank C&I portfolios fell from 10% in the first half of 2006 to 6% in the second. The growth rate in consumer portfolios moved up marginally from 2% to 3%. But growth in holdings of mortgages and MBS moved from 16% in the first half to 20% in the second. The Feds Survey of Senior Loan Officers corroborates the view that demand for C&I loans is slowing. In the most recent quarter, more banks reported weaker demand for C&I loans than any point since 2003, at the turn of the last recession.
Ja n94
Ja n96
Ja n90
Ja n06
30-Year M BS
15-Year M BS
ARM
With outstanding residential mortgage debt likely to rise by 7%, outstanding agency MBS should rise by roughly that amount although the flow of new pools might fall from last years levels. Total mortgage origination should fall 11% in 2007 as housing turnover slows, bringing issuance of new pools down, too. Issuance in conventional agency MBS should drop from $908 billion this year to $826 billion next. But issuance of agency MBS as a percentage of total MBS issued should remain steady at around 46%. Our projections show that, in percentage terms, hybrid ARM issuance should shrink more than fixed-rate issuance (Table 2).
Table 2. MBS Issuance On Track to Fall in 2007
Issuance All Mortgages All MBS Agency MBS Fixed Agency MBS ARM Agency MBS Source: Bear Stearns Projected 2006 2,990 1,987 908 758 150 Projected 2007 2,666 1,773 826 703 123 Change -11% -11% -9% -7% -18%
MBS Fundamentals
The fundamentals risks in MBS should shift as the housing market slows down in 2007. Slower housing should trim the growth of outstanding mortgage debt and reduce the call risk in MBS. Supply Supply of 30-year MBS rose steadily in 2006, after falling the previous years. Since June, the sector has increased in size by $136 billionthe fastest 5-month increase since 2001 (Figure 4). A flatter yield curvereducing ARM production combined with a shrinking 15-year MBS sector should keep growth in 30-year MBS strong in 2006.
The conforming loan limit will remain unchanged at $417,000 for 2007. Unlike 2006, where a rising loan limit caused more than 15% of the jumbo fixed-rate pass-throughs to be agencyeligible, 2007 should see much less refinancing of jumbo loans into agency loans. This should take away from potential sources of supply. The ARM market has also shown signs of leveling off. The agency hybrid ARM market grew by 9% in 2006, significantly slower than the 15% growth of 2005 and well below its peak of 40% growth in 2003. Although ARMs remain a significant share of new applicationsmainly reflecting the refinancing of old ARMs into newthey should not be a growing share of the agency market. Expect ARM production to slow in 2007 as 30-year fixed-rate mortgages rebound. In 2006, the shrinking universe of Ginnie Mae MBS reversed trend in April and began to grow. Although still a far cry from the beginning of the 1990s, when Ginnie Mae MBS held 40%
33
% New MBS
34
Take basis risk. The good prospects for tighter spreads in the first half of the year argue for taking basis risk in MBS. If demand for foreign portfolios and U.S. banks turns out as strong as we anticipate, the bet should pay-off all year long. Sell call protection. The prospects for muted prepayments in MBS next yeareven in a modest rally make selling call protection attractive. Slowing housing stands to lower speeds in both discount and premium MBS. Some of the normal safe-havens in MBSlower loan balances, specific geography stories and others stand to lose relative value in 2007. Securities that take on call riskIOs, premium pass-throughs and others stand to gain. ***
New Issue CMO Spreads: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ agencymbs_01_121906.pdf Benchmark Trust IO Performance: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ agencymbs_02_121906.pdf Or see the Bear Stearns Research Library
The excess servicing IO market saw eight new dealsfive Fannie Mae Trusts and three Freddie Mac Trustsprice in 2006. The total notional amount was smaller than 2005 although still significant. Excess servicing IOs trade at a sizable concession to Trust IOs due to the lack of a perfect PO hedge in the market, and consequently give even higher carry. Both SunTrust and Wells Fargo securitized strips of excess servicing IOs for the first time in 2006, taking advantage of
35
Across the Curve and Across the Grade: Outlook 2007 Adjustable Rate Mortgages
First, overall mortgage origination has been relatively strong in 2006, when compared with expectations for the same year. Second, the securitization rate for 2006 came in at an alltime high of about 72.5%. Third, increased production in Interest Only hybrids has supported issuance in the hybrid sector.
In 2006, 5/1 hybrids have dominated issuance, constituting about 60% of all hybrid ARM production. This rate held firm even in the second half of 2006 when the slope of the hybrid mortgage curve, defined as the 10/1 ARM rate over the 3/1 ARM rate, was only 20 bp. We believe 5/1 hybrids will continue to dominate issuance among resets in 2007 and once again constitute about 60% of mortgage production (Figure 1) in 2007. Unless the curve can steepen 20-30 bp from current levels, production in 3/1s and short-reset ARMs (1/1) is likely to be minimal in 2007. We expect 3/1 and short-reset issuance to be about 5% of overall production. We expect 7/1 and 10/1 hybrids to constitute about 30% of agency ARM issuance as more borrowers should prefer the interest rate protection, versus pay-up in mortgage rate, provided by these longer resets. Finally, with option ARMs continuing to find better execution in the non-agency sector, we expect option ARM production to be only 5% of the total agency ARM issuance in 2007.
Figure 1. Projected Percentage Agency ARM Issuance in 2007 by Reset
5% 30% Option ARM <5/1 5/1 >5/1 5%
Agency IO hybrids as a percentage of total agency hybrid issuance were above 70% for 2006, compared to 55% in 2005. In the current flat mortgage curve environment, an IO 5/1 hybrid lowers monthly mortgage payments by approximately 15% compared to a level pay 30-year fixed rate mortgage. On the same scale, level pay 5/1 hybrids lower mortgage payments by only 3%. However, over the last three months hybrids as a percentage of total mortgage applications have dipped to a 2-year low of 24%. This leads us to believe that more borrowers are becoming risk averse, preferring to take less interest rate risk on their loans.
60%
36
Supply and demand technicals are pointing towards a substantial tightening of spreads in agency hybrids in the first half of 2007, both on a nominal and OAS basis. As previously discussed, we expect agency hybrid issuance in the next year to be lower by 18%. While supply is expected to be low there are potentially two events in the first half of 2007 that can cause demand for agency hybrids to spike up. The most significant event is the addition of agency hybrids to the Lehman MBS index (10%) and the Lehman Aggregate Fixed Income index (3%), starting April 1, 2007. Our research shows a $25-$45 billion net increase in demand for agency hybrids from institutional investors who will attempt to replicate or outperform the MBS index. Most of the available float in the agency hybrid sector comes from new to slightly aged issuance as a majority of the players in agency hybrids are buy and hold investors, making seasoned paper hard to come by. A second item that may improve liquidity in the agency hybrid sector is the potential introduction of synthetic hybrid ARM forwards. The product is likely to start trading in the first half of 2007. Trading in synthetic hybrid forwards will be on a nominal spread (Z-curve) basis, similar to CDS spreads. This product will give investors the ability to short hybrids and hedge agency or AAA jumbo hybrid MBS. Considering that agency hybrids are trading at their wides for the year, we expect agency hybrids to tighten by 10-15 bp on an OAS basis to 30-year collateral by the end of April 2007.
37
Across the Curve and Across the Grade: Outlook 2007 Structured Credit
The structured credit markets (composed of the private-label RMBS, non-mortgage ABS and CDO sectors) had another banner issuance year in 2006, despite the steady rise in interest rates through most of the first half of the year. The reasons werent hard to identify: the steady drop in risk premia implied continued investor interest in earning spread by selling volatility, which combined with a healthy calendar of issuance in most of the underlying collateral markets, made for a steady pace of activity throughout the year. As we close out 2006, the cost and the consequences of some of the inevitable slippage in underwriting standards have begun to be felt in at least the subprime and near prime segments of the market. In looking ahead to 2007, some of these themes are likely to impact issuance and spreads in the next year. It is our purpose in this outlook to highlight a few of the most salient trends that will occupy investors conversation in the months ahead. Before we delve into the details, it would be useful to our readership to lay out our views on the broader macroeconomic elements for 2007. First, we expect a range-bound interest rate environment in which a stagnant housing market and tame inflation are likely to keep the Federal Reserve on the sidelines. The risks to our forecast, if they exist, are a fed funds rate that is bounded within 25 bp of its current level of 5.25%. Overall housing price appreciation, as measured by the repeat transactions OFHEO index, is likely to fall to just over 4% from its last reported 7.7% level. Housing markets nationwide, and particularly on the coasts and the Southwest, are likely to slow down further to 3% as activity levels and prices adjust to a new equilibrium in rates, affordability, and consumer wages and incomes. In addition, as we mentioned in our outlook at the beginning of this year, 2006 has been characterized, for the most part, by tight spreads, low volatility, and an increasing divergence in performance and spread trends between the corporate and mortgage credit sectors. It is the extent and direction of this divergence, along with innovations in structure and the effect of regulatory changes, that should continue to be one of the overriding themes in 2007.
38
In 2007, funded ABS CDO volume should remain relatively stable while CLOs should continue to show solid growth (7%12%) based on robust credit fundamentals and a large pipeline of leveraged loan issuance. In addition, CRE CDOs and Trust Preferred CDOs should remain growth areas with issuance increasing almost in the order of 40%-50% over this year based on supply trends and fundamental credit characteristics in those sectors.
39
Note: Given HPA Scenarios are observed over the life of the deals
Note: Given HPA Scenarios are observed over the life of the deals
Table 3 gives a similar snapshot for ABX.HE.06-2. The divergence in collateral loss, especially as HPA decreases, highlights the increasing leverage of the 2006 subprime vintage to a slowdown in HPA. Moreover, the change in portfolio expected loss gives some perspective on the expected increase in the correlation of losses with a decrease in HPA. Alt-A RMBS Performance While the performance of subprime loans originated in 2006 and to some extent in 2005 has been poor on a much more systemic scale, performance of loans in the Alt-A space has tended to be much more idiosyncratic. The impact of 100 CLTV no money-down loans has affected collateral performance in this sector too, but in many cases the impact on performance due to these loan attributes has been offset by others like higher FICO so that serious delinquencies are much more idiosyncratic in nature.
Table 4 shows the divergence in performance between a higher GWAC, more risk-layered pool as compared to a collateral pool composed of more traditional Alt-A borrowers with more solid credit attributes.
Table 5. Comparative Collateral Attributes
% Full Doc 6.8 18.5 FICO < 650 12.20% 10.00% % Investor 20.00% 9.20%
FICO Deal 1 (Alt-B) OC Structure Deal 2 (Traditional Alt-A) SeniorSub Structure 702 708
This seems to suggest that deal performance could vary quite widely across the spectrum especially due to the extremely tight credit subordinations in this sector. These subordination levels are typically based more on traditional performance
40
Consumer Credit
The consumer ABS sector has shown robust growth and collateral performance in 2006 supported by a low unemployment rate coupled with the recent ease in energy prices. There have been no negative rating actions on U.S. credit cards and student loans in the past two years. Moreover, even if one were to include other consumer credit sectors, the number of upgrades exceeded downgrades by a ratio of 2:1 over the same period. Going forward, the performance of this sector should depend on, among others, the health of the economy, the direction of unemployment rate, and factors such as energy and home prices. We expect strong demand for consumer ABS from both domestic and international investors and this should continue to keep spreads near historical tight levels. Auto ABS Issuance in the auto ABS sector declined by 10%12% yearto-date to $75 billion compared to the volumes in 2005, primarily due to lower issuance from foreign captives and consolidations in this market. Although one of the Big 3 has been involved in whole auto loan sales to banks which typically hold them in their portfolio as opposed to securitizing them, 26% of this years supply came from the Big 3. Our analysts expect car sales to drop 2%3% in 2007; however, higher issuance from banks and finance companies that continue to use the capital markets for their financing needs, coupled with supply from the Big 3 that is expected to be in line with 2006, should bring issuance to around $85 billion for 2007. With increased competition for business, we expect longer term auto loans (72 or more months) to become popular. Prime auto loan indices as measured by Moodys have posted strong year-over-year performance with a 22% drop in net loss rate and an 11% decline in delinquencies. Meanwhile, the subprime auto loan charge-off indices posted a year-over-year increase during the third quarter of 2006 partly due to seasonal factors. On a macro level, the Manheim Used Vehicle Value Index remains stable as used vehicle sales are driven by job creation and growth. While we expect stable performance in the prime auto sector buoyed by a healthy economy and labor environment, the subprime auto sector could experience some volatility in performance. Other factors that could affect performance in the auto sector remain longer-term loans, high LTV and changes in underwriting standards due to competitive pricing strategies.
41
10% 8% 6% 4% 2% 0%
However, there has been some fraying at the edges as evidenced by the increase in leverage as seen through debt multiples (Current Debt / EBITDA) and interest coverage ratios ((EBITDA Capex) / Interest) that are close to levels prevalent at the beginning of this decade. Moreover, the distribution of loans this year has become more skewed towards higher leverage. This is especially true for large LBO loans where debt multiples increased to 4.9x in 3Q 06, according to S&Ps LCD, from 3.9x in the previous quarter. In fact, it is the robust growth in EBITDA for most corporates, driven by a resilient economy, that has been the one factor that has kept leverage in check in most cases. A similar trend can be seen in the number of covenants in typical first-lien leveraged loans. Not only has the average number of covenants come down but the share of deals with fewer covenants also has increased. However, covenant-lite loans per se, have not found too much traction in the market
42
Ja Ma n -9 y 9 S e -99 Jap -99 Ma n -0 0 S ey-00 pJa 00 Ma n -0 1 S ey-01 p Ja -01 Ma n -0 y 2 S e -02 Jap -02 Ma n -0 3 S ey-03 pJa 03 Ma n -0 y 4 S e -04 Jap -04 Ma n -0 5 S ey-05 pJa 05 Ma n -0 y 6 S e -06 p06
43
ABS CDOs: A New Cycle or End of the Road? Structural Innovations / Derivatives
This year has witnessed a range of innovation not just in the structure of traditional CDO structures but also in that of The ABS CDO sector should continue to provide the most avenues for relative value opportunities through next year. U.S. funded issuance volumes have risen more than 1.5 times
44
45
As the statistics in Table 6 and the previous paragraph show, spreads in the current market are about 200 bp tighter than they were in 2001-2003. While spreads have trended up a bit since the beginning of this year, current levels are still much below those that existed even in early 2005. In addition, spreads on Trust Preferred CDO liabilities have continued to remain tight so that any widening in collateral spreads makes the arbitrage for a pure Bank Trust Preferred CDO structure attractive again. Moreover, robust performance characteristics along with the widening in spreads should maintain strong demand for Trust Preferred securities in the near future, which would balance much of the new supply coming into the market from the refinancing wave.
CRE CDOs
This has been a stellar year for CRE CDOs in terms of issuance as loan originators and investors in the lower pieces of conduit securitizations utilized the CDO technology to lay off risk and the growth of the synthetic market allowed easier access to higher yielding CMBS collateral. Investors continued to exhibit appetite for the product due to the fact that it allows them a pooled or diversified exposure to the relatively more credit sensitive pieces of commercial loans and CMBS securitizations. The sector should continue to exhibit robust growth in issuance next year as more investors become comfortable with the underlying credit quality packaged through the CDO technology and more issuers lay off their B note and mezzanine loan risk through such structures. However, as we elaborate in our CMBS section, investors will need to be more cautious about collateral credit quality going into 2007. Investors across the capital structure will also need to keep an eye out for nuances in CDO structure which might flow from other asset classes (trigger-less deals could be one example) and distribute value unequally across the tranches.
46
5.4
170 160 150 140 130 120 110 100 30y r 5 y r Tsy
3y r
10y r
LC F
N AS
10 y r Treas
Youll note the strong negative correlation between the longer tranches and the 10-year Treasury note. This is intuitive, but doesnt explain the movement in 3-year spreads. The 2s/10s slope, and relative attractiveness of the front end in the inverted curve, explains much of the movement here (Figure 3).
Figure 3. Three-year AAA Sequentials vs. 2s / 10s
A final technical market factor was the bid for PAC companion tranches. With volatility at historically low levels and a flat / inverted curve triggering a search for yield, investors became more active in companion tranches. This demand caused PAC tranches to trade relatively cheap, a market condition that continues today (Figure 5).
Figure 5. Relative Attractiveness, AAA PACs vs. Sequentials
6-month standard deviation
190 180 170 160 150 140 130 120 110 100 3y r 10y r 2s / 10s
00 6
Another technical that in part caused these movements was the large raw loan bid from several banks. As yield levels approached certain bogeys for these investors, they entered the market in size, buying large prime quality loan packages. This reiterates the need for every basis point of yield, as the investors (particularly banks, which are sensitive to flat/ inverted yield curves) took on the added risk of assuming the first basis point of losses in these deals in order to capture that yield. As these buyers have entered the market throughout 2006, they drove spreads on loan packages in to levels that made CMOs uncreateable, tightening new issue and secondary AAA CMO spreads in the process.
So what does this mean for the sector for 2007? Given our views that the front end of the Treasury curve will remain mostly fixed, it is easy to envision an environment where the long end of the curve remains range bound, with a slight upward bias (i.e., 4.40 5.00% 10-year note). Given this rate view, and that some of the 2006 technicals will carry into 2007, these look to be some of the best trades in the sector for the upcoming year:
Trade #1: Buy long AAA Non-Agencies vs. Treasuries. Given an idle Fed and benign volatility, any backup in Treasury rates in the long end should entice yield buyers into the market, tightening this basis once again as during mid-2006. Trade #2: Buy 3 yr AAA PACs vs. Sequentials: While this is a negative-carry trade, the relationship is over 2 standard deviations wide, indicating the relatively cheap price of added convexity here. Also in play is the 2headed technical that any modest sell-off in long end rates should cause short sequentials to widen, while a strong
3 /1 00 6 6/2 0 4 /1 0 6 6/2 0 5 /1 0 6 6/2 0 6 /1 0 6 6/2 0 7 /1 0 6 6/2 0 8 /1 0 6 6/2 0 9 /1 0 6 6/2 1 0 00 6 /16 /2 1 1 0 06 /16 /20 06
/20
6/2
05
0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 -0.30 -0.40 -0.50
12 /23
4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 -3.00 P-S 2-Yr P-S 5-Yr P-S 3-Yr P-S 10-Yr
12 /16
1 /1
2 /1
6/2
0 0/2 5 0 2 /1 0 6 7/2 3 /1 00 6 7/2 4 /1 00 6 4/2 5 /1 00 6 2/2 0 6 /9 0 6 / 20 7 /7 06 / 20 8 /4 06 / 20 9 /1 06 /2 9 /2 0 06 9/2 1 0 00 /27 6 1 1 /20 0 /24 6 /20 06
1 /6
1 /2
/20
2s / 10s sprea
47
Trade #3: Premium 10/1 Hybrid ARMs: The combination of low HPA, piggyback seconds and Interest Only payments have converged to lower speeds on longer reset hybrids, boosting yield, TROR and OASs, the latter from a greater tail value.
The coming year should lead to some interesting relative value trades across the structured credit spectrum. We highlight some of the major relative themes below. 1. Long Residual / Short Mezzanine
Finally, a note on where AAA non-agency spreads are on a historic basis. When spreads are at or near their tights of a 1year range, it is difficult to convince investors of value in a particular sector. However, in the case of non-agency MBS, parallels can be drawn to the ABS markets in terms of a level of comfort being reached in the investor community that provides liquidity and price support. For example, many in the Credit Card ABS sectorafter seeing it rally to multi-year tights in 2002thought spread levels might approach swaps flat, but never break through that. Figure 6 shows that this was a false premise.
Figure 6. Credit Card ABS, Spread to Swaps
35 30 25
Basis Points
The front-ended cash flows on the residual of a mortgage origination imply that in most cases these are reasonably safe due to the fact that defaults in mortgages are typically backended. Even in a vintage like 2006 where there is a higher level of serious delinquencies it will still take originators 1218 months to flush out most of the loans from delinquency to foreclosure to REO and then to default simply because of the operational issues involved. The trade could be structured with a specific sector where investors could short subprime mezzanine bonds against subprime residuals or it could be structured as an up in credit trade where investors short subprime mezzanine bonds against Alt-A residuals. This trade allows investors to express a short opinion on the subprime sector without bleeding excessive negative carry. Another segment of the residual market that is attractively priced is the second-lien market. This segment went through its own growing pains in 2005, with lower FICO collateral significantly underperforming relative to origination expectations. With the ebbing of competitive pressures, new origination today is skewed towards higher FICO and generally more credit-worthy borrowers. Despite the adjustment of the collateral and at fairly realistic loss and prepayment expectations, the residuals in this segment still trade at a mid to high 20% range in yield. This sector will likely tighten as the year goes by. 2. Long BB / Short BBB-
3 yr CC 5 yr CC 10 y r C C
20 15 10 5 0 -5 -10
With swaps/LIBOR denoting a single-A liability, it is very easy to imagine more and more AAA assets tightening toward/ through swaps, especially given the dearth of AAA corporate bonds. Also, credit card ABS can be considered among the prime types of ABS in terms of quality and liquidity. We believe that prime non-agency AAAs can be viewed in a similar light. Compared with the non-agency market of the 1990s, which saw irregular issuance from several unknown shelves, prime jumbo origination has become somewhat homogeneous with regular issuance from several large prime single-originator shelves. Taken together with falling origination levels and an increasing investor base internationally, we believe prime AAA non-agency CMO spreads, even though tight historically, have further to go in 2007 and beyond.
c-0 0 Ju n01 De c-0 1 Ju n02 De c-0 2 Ju n03 De c-0 3 Ju n04 De c-0 4 Ju n05 De c-0 5 Ju n06 De c-0 6
De
This is a trade that takes advantage of a wide technical differential in pricing between two tranches that are next to each other in the deal capital structure and are in most cases separated by just 100 bp200 bp of cumulative losses. Spreads on the BBB- tranche are typically artificially compressed due to the CDO-bid while those on the BB+/BB-flats are artificially wider because they are non-investment grade tranches. The pick-up in spreads on the BBs, anywhere from 700 bp1000 bp in the present environment, seems to be quite excessive for just a 100-150 bp difference in cumulative losses over the BBB-s from similar deals. 3. Long Mortgage Triple-A Floaters
Spreads on AAA Floaters should continue to remain tight as the uncertainty around housing drives investors up in credit. Given our rate view of a continued curve inversion, AAA floater demand should increase in 2007 as a safe place to park money. For example, with current 1-month LIBOR rates at 5.35% and 2 year swap rates at 5.05, an investor would have 48
A more optimistic opinion on housing does not necessarily imply robust performance across the capital structure since a deterioration in underwriting standards could, per se, lead to worse collateral performance. This implies that it still becomes imperative to take a close look at collateral a) Long AAA to A ABS CDOs A strategy to be long the top of the capital structure should provide positive results since in a more optimistic housing scenario most of the risk should be idiosyncratic so that there should not be much of as risk of downgrades or repricings at the top of the capital structure. b) Long ABS CDO Equity / Short Specific Collateral Credits As we mentioned above, it is idiosyncratic risk that should dominate the sector in a bullish HPA scenario and this implies that investments in ABS CDO equity, while attractive could have significant tail risk due to losses in a few deals. This could be mitigated by paying more attention to security selection and by combining the investment with shorts on the index or certain specific credits. CLOs 1. Long CLO Equity
Days
4.
We believe that the fair spread difference between the two indices should be around 235 bp on a mid-to-mid basis. After accounting for a 50-75 bp bid-offer spread this difference comes down to around 175 bp. This makes the current spread levels near their fair value so that any major uptick in the spread differential from here should be viewed as an opportunity to go long the ABX.HE.06-2 and sell the ABX.HE.06-1. ABS CDOs Relative value in the ABS CDO will tend to be driven not just by the level of defaults but to a large extent by the correlation between defaults. This, in turn, should be primarily driven by opinions about the expected direction of the US housing market and expectations about HPA in the next few years. 1. Bearish on Housing a) Short AA / A ABS CDOs Contrary to the underlying mortgage credit sector, up in credit is not necessarily a safe investment under a deteriorating HPA scenario. A typical up in credit
As we mentioned earlier, expectations of a low default rate environment imply that a levered corporate credit investment should provide decent returns. Moreover, the tight liability spreads enable CLO equity investors to lock in low funding rates over the life of the deal and any drift upwards will allow equity investors to increase their yields since their cost of funding remains locked at todays levels.
49
Across the Curve and Across the Grade: Outlook 2007 CMBS
$ billions
918 466
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Issuance Year
CMBS collateral achieved some firsts with interest only loans (IO) and hotel collateral accounting for a bigger piece of the pie than ever before. In 2006 about 75% of the loans in CMBS transactions contained some interest only component, a threefold increase from 2003 when IO loans accounted for only 25% of the market.
Table 1. Interest Only Loan Exposure
Fully Amort. IO then Amort. Interest Only Balloon IO then Balloon Total Source: Trepp, LLC 2002 2.1% 0.0% 2.2% 88.5% 7.3% 100.0% 2003 3.3% 0.1% 8.7% 70.7% 17.2% 100.0% 2004 2.0% 0.0% 14.5% 53.7% 29.8% 100.0% 2005 1.3% 0.2% 26.6% 33.2% 38.8% 100.0% 2006 0.6% 0.3% 32.3% 23.9% 42.8% 100.0%
The first two CMBS synthetic indices were introduced, proving additional liquidity to the non-AAA part of the capital structure. As the year progressed, trading volume in both CMBX.1 and CMBX.2 increased. On some recent occasions, trading volume in CMBS synthetics (CMBX and TRS) has surpassed trading volume in the CMBS cash market.1
Figure 3. BBB- Cash and CMBX Spread History
160 150 140 130 120 110 100 90 80 70 60 C ash BBBC M BX.N A.06.1 BBBC M BX.N A.06.2 BBB-
Hotel loans accounted for 10% of the collateral in new issue transactions this year, the highest concentration since the late 1990s.
50
3 /1 3 3 /2 /0 6 7/0 4 /1 6 0 4 /2 /0 6 4/ 5 /8 0 6 5 /2 /06 2/ 6 /5 0 6 6 /1 /06 9/0 7 /3 6 7 /1 /06 7 7 /3 /0 6 1 8 /1 /0 6 4 8 /2 /0 6 8/0 9 /1 6 1 9 /2 /0 6 5/0 10 6 / 1 0 9/0 6 /23 1 1 /06 / 1 1 6/0 6 /20 1 2 /06 /4/ 06
For more details on the CMBS synthetics market please refer to CMBS Synthetics: AAA Total Return Swaps in the August 8, 2006 Across the Curve and CMBX.NA.06-2: Prospects and Opportunities in the October 24, 2006 Across the Curve.
AAA
AA
BBB
80 60 40 20 0
The most active rating agency this year was Fitch at 1616 rating actions, followed by S&P (1262) and then Moodys (934). Fitch also had the highest upgrade/downgrade ratio of 37.5 to one, more than double the average ratio for the year.
Table 3. 2006 Rating Actions by Rating Agency
Rating Agency Fitch Moodys S&P Total Upgrades 1574 1157 830 3561 Downgrades 42 105 104 251 Upgrade/Downgrade Ratio 37.5:1 11.03:1 7.99:1 14.2:1
The flat credit curve was more a reflection of solid CMBS credit performance rather than a focus on the credit of new issue transactions. During the year, delinquencies on seasoned transactions (aged over one year) declined 52 bp to 1.15% of current balances. The current level of delinquencies is the lowest it has been since late 2000, reflecting the continued positive fundamentals for commercial real estate.2 Record Positive Rating Actions Tighter spreads and a flatter credit curve were also a reflection of a continued positive trend in rating actions. In aggregate, the CMBS market achieved another first with the highest upgrade/downgrade ratio ever recorded for CMBS.
Table 2. Upgrade/Downgrade Ratios for U.S. CMBS
Year of Rating Action 1999 2000 2001 2002 2003 2004 2005 2006 Source: Fitch, Moodys, S&P, Bear Stearns Upgrade/Downgrade Ratio 9.7:1 6.5:1 12.6:1 1.5:1 1.8:1 3.2:1 7.7:1 14.2:1
Ja Man -0 2 Ju r-0 2 S en -0 2 No p -0 2 Fev-02 b-0 Ap 3 r Ju - 03 O c l -03 De t- 03 Mac-03 Ju r-0 4 A un -0 4 No g -0 v 4 Ja -04 A pn -0 5 r Ju - 05 S e l -05 Dep -05 M c-05 Maa r-0 y 6 A u -06 g O c -06 t- 0 6
The vintages with the most upgrades this year were 2003 (696), followed by 2001 (582) and 1999 (434). The original ten-year classes in these transactions are now seven, five, and three-year classes.
Figure 5. 2006 Rating Changes by CMBS Issuance Year
800 700 600 500 400 300 200 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 13 3 41 2 166 6 19 16 30 61 30 14 48 109 20 18 2 308 U pgrade Dow ngrade 434 416 402 366 582 696
For a detailed analysis of 2006 CMBS delinquencies, please see CMBS Delinquencies: A Great Year for Credit in the December 12, 2006 Across the Curve publication.
51
C0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
D 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0 2 0 3 5 0 0 0 0 0 0 0
Total 2 260 424 260 264 393 377 314 351 326 206 174 127 89 88 59 24 35 7 0 13 0 0 3 0 5
11 3,812
Source: Moodys, Fitch, S&P; * All rating actions through November 30, 2006
In 2007, Credit Matters After several years of stellar commercial real estate credit performance where the rising tide lifts all boats, we believe 2007 will mark a year of more market differentiation. Broadly, fundamentals appear solid* and capital flows continue to be robust; however, we believe next year investors will differentiate more among deals based on credit performance. We have already seen some of this market differentiation on credit tranches in the secondary market. In 2007 we anticipate this will become more pronounced in the primary market with a broader spectrum of pricing based on the underlying credit. Growth in CMBS synthetics provides investors with a greater opportunity to take specific views on credit. CMBX and single name CDS provide investors with the liquidity to express credit views on individual deals and specific points in the capital structure that were not previously available. We anticipate increased trading volume in synthetics next year.
U.S. Issuance In terms of issuance, we project 2007 U.S. CMBS issuance will be approximately $250 billion, a 22% growth above 2006 levels. Our projection is based on a regression of the forward 10-year Treasury rate, CMBS and ACLI debt maturities, the growth rate in the Russell/NCREIF Property Index and 2006 issuance volume. Our model was very predictive resulting in an R-squared value of 99.1% when we back tested the data. Based on our issuance projection, CMBS debt maturities next year will only account for 16% of issuance, indicating that liquidity will not be an issue for maturing CMBS loans.
52
150.0 100.0 50.0 15.7 26.4 36.8 74.3 56.6 46.9 67.1 77.8 52.1
*As of December 15, 2006; Excludes agency CMBS and resecuritizations Source: Bear Stearns, Commercial Mortgage Alert
19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 * 20 07
We anticipate that deal size will continue to grow next year with the average fusion deal breaking the $2 billion hurdle. The market should continue to be dominated by fusion and floating rate transactions next year with floaters accounting for a greater part of the market. We anticipate floating rate transactions will account for more than 20% of the new issue market next year. European Issuance
Figure 7. Annual CMBS Issuance Volumes (billions)
80 70 60 50 40 30 20 10 0 2002 2003 2004 2005 2006 2007*
European countries such as Spain are also likely to increase participation in the European CMBS market next year.
Figure 8. Distribution of European CMBS Collateral (%)
60 50 40 % 30 20 10 0 U .K. Italy Germany Other France The N etherlands Jun-03 Jun-05 Jun-04 Jun-06
Relative Value CMBS issuance this December has totalled $30 billion, breaking the record set last year for December issuance. Last December, the market experienced spread widening coupled with a heavy issuance calendar. This year, spreads have held constant in spite of a very active calendar. As we end the year AAA CMBS appear close to fair value when compared to finance company paper and are trading a bit rich to bank paper.
In Europe, we anticipate 2007 CMBS issuance will be approximately 75 billion, a 25% increase over 2006 issuance. In terms of collateral origination, the UK is expected to maintain the greatest market share. Germany is expected to experience an increase in issuance volume. Other
53
* Starting on 10/29/04, the spread series for super-senior 10-year AAAs are used. Prior to that, the spread series for traditional 10-year AAAs are used. Source: Bear Stearns
Single-A CMBS and BBB CMBS are also trading close to fair value when compared to the unsecured REIT debt market.
Figure 10. BBB & Single-A CMBS vs. REIT Spreads to UST
300 250 Spread (bp) 200 150 100 50 0 H igh Grade REIT Index A C M BS BBB C M BS
10 /3 1 /31 /01 4 /3 1/0 2 0 7 /3 /0 2 1 0 1/0 /3 2 1 /31 /02 1 4 /3 /0 3 0/0 7 /3 3 1 0 1/0 /3 3 1 /31 /03 1 4 /3 /0 4 0 7 /3 /0 4 1 0 1/0 /3 4 1 /31 /04 4 /3 1/0 5 0 7 /3 /0 5 1 0 1/0 /3 5 1 /31 /05 4 /3 1/0 6 0 7 /3 /0 6 1 0 1/0 /31 6 /06
11 /2/ 2 /2 0 1 / 5 /2 02 8 /2 /02 1 1 /02 /2/ 2 /2 0 2 / 5 /2 03 / 8 /2 03 1 1 /03 /2/ 2 /2 0 3 5 /2 /04 / 8 /2 04 1 1 /04 /2/ 2 /2 0 4 / 5 /2 05 / 8 /2 05 1 1 /05 /2/ 2 /2 0 5 5 /2 /06 / 8 /2 06 1 1 /06 /2/ 06
For more details see The Case for Seasoned 10-year AAAs in the November 28, 2006 Across the Curve and Amortizing AAAs CMBS: Not All Created Equal in the October 3, 2006 Across the Curve.
54
(economic slowdown, housing market crash, continuing foreign demand, etc.), the bottom line is that the market has a different view on the future path of interest rates than the Fed does.
Figure 2. The Divergence Between 1mo LIBOR and 2yr, 10yr Treasuries
5.60 5.40 5.20 5.00 Yield 4.80 4.60 4.40 4.20 4.00 2y r Tsy 10y r Tsy 1mo LIBOR
De
While the Treasury, agency and swaps curves are all inverted from the front end of the curve to the back, the most striking difference is the disparity between the yield that can be achieved from investing and the cost of borrowing the funds to invest. This negative carry impacts investors of all shapes and sizes as the high cost of borrowing diminishes the potential returns that can be achieved from putting on a particular trade. This is especially true if the inversion remains in place for an extended period of time. As the horizon expands, the impact of carry becomes greater than the impact of price on performance. This especially impacts highly leveraged investors such as hedge funds and many financial institutions that have relied on wholesale funding in the past to help build their balance sheets. Figure 2 demonstrates that this inversion really began to take hold back in July 2006 after the last interest rate hike by the Fed to 5.25%. While there are many economic theories behind the cause of this dislocation
Figure 3 outlines the forward LIBOR curve as of 12/19/06. From this picture we can determine that the market is anticipating a 50 bp reduction in the level of short-term interest rates by the end of 2007. The yield that can be achieved by investing in fixed rate securities is a function of supply and demand and can vary depending on the investment communitys opinion about relative value at any particular point in time. A big part of the decision making process is a view on the future path of interest rates. A bullish view increases demand and moves interest rates lower, where a bearish view decreases demand and moves interest rates higher. The cost of borrowing, however, is very closely related to the target fed funds overnight borrowing rate which is set by the Federal Reserve Bank. This rate is more stable than those found in the fixed rate markets as it is set by a small committee rather than a free market mechanism. An important 55
26 -D e
56
57
58
Spread (bp)
9 /2
140 190 240 290 340 40 90 100 120 140 160 20 40 60 80 0
Spread (bp)
Spread (bp)
100
110
40
50
60
70
80
90
9 /2 10 /6/
C ash
2/0 6 6 9/0
3/ 13 3/ /06 27 4/ /06 10 4/ /06 24 /0 5/ 6 8/0 5/ 6 22 / 6/ 0 6 5 6/ /06 19 /0 7/ 6 3 7/ /06 17 7/ /06 31 8/ /06 14 8/ /06 28 9/ /06 11 9/ /06 25 10 /06 10 / 9/0 /2 6 3 11 /06 / 11 6/0 /2 6 0 12 /06 12 / 4/0 /1 6 8/0 6
0 10 6 /13 /0 10 6 /20 /0 10 6 /27 /0 11 6 /3/ 0 11 6 /10 /0 11 6 /17 /0 11 6 /24 /0 12 6 /1/ 06 12 /8/ 0 12 6 /15 /06
7 /1 7 /2 8/0 6 5/ 8 /1 0 6 8 / /06 8 /1 8 /06 8 /2 5/0 6 2 8 /2 /0 6 9/0 9/ 6 9 /1 5 /06 2 9 /1 /0 6 9 /2 9/0 6 1 0 6/0 6 1 0 /3/0 /1 6 1 0 0 /0 / 6 1 0 17 /0 / 6 1 0 24 /0 /31 6 1 1 /06 1 1 /7/0 / 6 1 1 14 /0 / 6 1 1 21 /0 /2 6 1 2 8 /06 1 2 /5/0 /12 6 /06
Spread (bp)
Spread (bp)
Spread (bp) 100 150 200 250 300 350 400 450 50
9 /2
100 150 200 250 50 0
300
C ash C DS ABX-2
3/ 3 /2 6 /06 0/ 4 /3 0 6 4 /1 /06 7/ 5 /1 0 6 5 /1 /06 5 /2 5/0 6 9 6 /1 /0 6 2 6 /2 /0 6 6 7 /1 /0 6 0 7 /2 /0 6 4/0 8 /7 6 8 /2 /06 1 9 /4/0 6 9 /1 /06 8 1 0 /0 6 1 0 /2/0 /1 6 1 0 6 /0 / 6 1 1 30 /0 /13 6 1 1 /0 /2 6 1 2 7 /0 /11 6 /06 0 10 6 /13 /0 10 6 /20 /0 10 6 /27 /06 11 /3/ 06 11 /10 /0 11 6 /17 /0 11 6 /24 /06 12 /1/ 06 12 /8/ 06 12 /15 /06
7 /1 7 /2 8/0 6 5 8 /1/0 6 8 /8 /06 8 /1 /06 8 /2 5/0 6 8 /2 2/0 6 9 9 /5/0 6 9 /1 /06 9 /1 2/0 6 9 /2 9/0 6 1 0 6/0 6 1 0 /3/0 / 6 1 0 10 /0 /17 6 1 0 /0 / 6 1 0 24 /0 /3 6 1 1 1 /06 1 1 /7/0 / 6 1 1 14 /0 / 6 1 1 21 /0 /2 6 1 2 8 /06 1 2 /5/0 /12 6 /06
650 600
Spread to LIBOR
650
1000
Spread to Swap
ABX.HE.BBB-.06-1 $ 100.09 263 ABX.HE.BBB-.06-2 $ 96.09 391 CMBX.NA.BBB-.1 69.08 CMBX.NA.BBB-.2 84 CMBX.NA.BB.2 189.83
(1) Prime 15 yr (5.50% cpn) ; Prime 30 yr (6.00% cpn); Alt-A 30 yr (6.25% cpn) (2) Corporate Index spreads for High Grade and High Yield; HY bonds are callable (3) 0%-3% quoted in percentage, all other single name tranches quoted in basis points (4) 0% -10%, 10% - 15% quoted in percentage, all other single name tranches quoted in basis points (5) Unrated quoted in dollar price (6) Implied spreads computed using durations calculated from Bear Stearns prepayment and default ramps
59
http://www.bearstearns.com
Hong Kong Bear Stearns Asia Limited 26th Floor, Citibank Tower Citibank Plaza 3 Garden Road, Hong Kong 852-2593-2700 London Bear, Stearns International Limited One Canada Square London E14 5AD England 44-207-516-6000 Lugano Bear, Stearns & Co. Inc. Corso Elvezia 14 P.O. Box 5155 6901 Lugano, Switzerland 41-91-911-7333 Milan Bear, Stearns International Limited Via Pietro Verri 6 20121 Milano Italy 39-02-3030-1730 So Paulo Bear Stearns do Brasil Ltda. Rua Joaquim Floriano, 72 - 8 andar - cj 83 So Paulo, SP Brazil 04534-000 55-11-3457-3200 Shanghai Bear, Stearns & Co. Inc. Representative Office Unit 09, 20th Floor, Building One, Corporate Avenue No. 222 Hu Bin Road Luwan District, Shanghai 200021 Peoples Republic of China 86-21-6340-6600 Singapore Bear Stearns Singapore Pte Limited 30 Raffles Place #21-01 Caltex House Singapore 048622 65-6437-3300 Tokyo Bear Stearns (Japan), Ltd. Shiroyama JT Trust Tower 3-1 Toranomon 4-chome Minato-ku Tokyo 105-6022 Japan 813-3437-7800
DOMESTIC Bear, Stearns & Co. Inc. 383 Madison Avenue New York, NY 10179 (212) 272-2000 www.bearstearns.com
The data underlying the information contained herein has been obtained from sources that we believe are reliable, but we do not guarantee the accuracy of the underlying data or computations based thereon. The information in this report is illustrative and is not intended to predict actual results, which may differ substantially from those reflected herein. Performance analysis is based on certain assumptions with respect to significant factors that may prove not to be as assumed. You should understand the assumptions and evaluate whether they are appropriate for your purposes. Performance results are often based on mathematical models that use inputs to calculate results. As with all models, results may vary significantly depending upon the value of the inputs given. Models used in any analysis may be proprietary making the results difficult for any third party to reproduce. Contact your registered representatives for explanations of any modeling techniques and the inputs employed in this report. The securities referenced herein are more fully described in offering documents prepared by the issuers, which you are strongly urged to request and review. Bear, Stearns & Co. Inc. ("Bear Stearns") and/or its affiliates or employees may have positions, make a market or deal as principal in the securities referred to herein or related instruments, while this document is circulating. During such period, Bear Stearns may engage in transactions with, or provide or seek to provide investment banking or other services to, the issuers identified in this report. Bear Stearns may have managed or co-managed a public offering of securities within the last three years for the issuers identified in this report, including regularly acting as an underwriter for Government Sponsored Enterprise issuers. Directors, officers or employees of Bear Stearns or its affiliates may be directors of such issuers. This document is not a solicitation of any transaction in the securities referred to herein which may made only by prospectus when required by law, in which event you may obtain such prospectus from Bear Stearns. Any opinions expressed herein are subject to change without notice. We act as principal in transactions with you, and accordingly, you must determine the appropriateness for you of such transactions and address any legal, tax or accounting considerations applicable to you. Bear Stearns shall not be a fiduciary or advisor unless we have agreed in writing to receive compensation specifically to act in such capacities. If you are subject to ERISA, this report is being furnished on the condition that it will not form a primary basis for any investment decision.
Copyright 2006 Bear, Stearns & Co. Inc. All rights reserved. Unauthorized duplication, distribution or public display is strictly prohibited by federal law.
(Bear, Stearns & Co. Inc.) Atlanta 3424 Peachtree Road, NE, Suite 1700 Atlanta, GA 30326 (404) 842-4000 Boston One Federal Street Boston, MA 02110 (617) 654-2800 Chicago Three First National Plaza Chicago, IL 60602 (312) 580-4000 Dallas 300 Crescent Court, Suite 200 Dallas, TX 75201 (214) 979-7900 Denver 3200 Cherry Creek South Drive, Suite 260 Denver, CO 80209 (720) 570-2327 Los Angeles 1999 Avenue of the Stars Los Angeles, CA 90067 (310) 201-2600 Memphis 1715 Aaron Brenner Drive, Suite 400 Memphis, TN 38120 (901) 757-6900 San Francisco Citicorp Center One Sansome Street, 41st floor San Francisco, CA 94104 (415) 772-2900 San Juan 270 Muoz Rivera Avenue, 5th Floor Hato Rey, Puerto Rico 00918 (787) 753-2327
INTERNATIONAL
Beijing Bear, Stearns & Co. Inc. Representative Office Room 1608 China World Tower 1 Jian Guo Men Wai Avenue Level 16, Units 06-08 Beijing 100004 People's Republic of China 86-10-6505-5101 Dublin Bear Stearns Bank plc Block 8 Harcourt Center, Floor 3 Charlotte Way Dublin 2 Ireland 353-1-402-6200
The research analysts who prepared this research report hereby certify that the views expressed in this research report accurately reflect the analysts' personal views about the subject companies and their securities. The research analysts also certify that the analysts have not been, are not, and will not be receiving direct or indirect compensation for expressing the specific recommendation(s) or view(s) in this report.