Residential mortgage investments have always been a component of diversified investment portfolios. Typically they have been hidden within bond allocations, whether through a Ginnie Mae fund, an investment grade fund or a money-market fund. Rarely have they been considered a stand-alone asset class.

But that has all changed since the financial collapse of 2008. Residential mortgage securities are no longer the safe and sleepy assets favored by banks and insurance companies. Orphaned from their prior owners, they now trade at distressed prices, and that spells opportunity for many investors.  All told, the changed nature of residential mortgage securities could be viewed as the arrival of a new asset class.

It's also important to note this isn't a market hiccup. Home price depreciation and mortgage defaults continue, and by some indicators, it could take years before the housing and mortgage markets normalize. It makes for an environment that skillful managers-particularly those managing hedge funds, which are more nimble and flexible than traditional investments-can navigate to their advantage.

In summary, today's residential mortgage market represents a stark change from the way things were just a few years ago, according to investment managers.
"I think probably most high-net-worth investors didn't even know it existed as an asset class" before the financial collapse, says Warren Paddock, director of investments at Bluffview Wealth Management.

Home Price Decline
Fundamental housing metrics predominantly explain how residential mortgages went from being stable to distressed investments. The primary cause is the dramatic decline in nationwide home prices, illustrated by the S&P/Case-Shiller 20 Home Price Index. This index peaked in summer 2006 and has since fallen about 30% (Figure 1), triggering record default levels.

Quarterly foreclosure filings have increased from about 300,000 in 2006 to over 900,000 in 2010, according to RealtyTrac. "We're setting new records almost every day in terms of foreclosure activity," says Rick Sharga, senior vice president of RealtyTrac.

Declining home prices are also responsible for negative home equity, which has limited home sale and refinancing activity. A recent study by Moody's Mark Zandi and Yale University's Robert Shiller reports that 31% of mortgages were under water in 2010, compared with 5% in 2006.

While home prices have stabilized and in some cases improved in 2010, the gains may be temporary. In a recent survey by Macromarkets LLC, over 60% of economists, real estate experts and investment and market strategists expected home prices to decline in 2010. As a result of deteriorating fundamentals and continued pessimism, the residential mortgage market remains in distress.

The Best Offense: A Good Defense
These conditions may cause some to steer clear of residential mortgage securities, but for a growing number of investors, such pervasive market pessimism signals opportunity. "We get to assume that the U.S. real estate market in the short run continues to go down, just like the numbers reported in the press are indicating," says Marc Rosenthal, co-portfolio manager of FrontPoint Strategic Credit Strategy. Because the market expects that homeowners will continue to default, the price of non-agency residential mortgage backed securities (RMBS) already factors in continued home price depreciation. This cushion against continued economic weakness is further bolstered by structural credit enhancement, which Rosenthal calls "embedded protection" and a yield that often exceeds 10%. Rosenthal adds that RMBS offers attractive relative value. "In other fixed-income markets, like the corporate bond market and the high-yield market, it feels to us that the pricing is assuming that housing has bottomed," he says. "Even if home prices go down 10% from here, our product still offers the yield in excess of other fixed income products as well as cash flow."

David Knall, an investment advisor and managing director in Stifel Nicholas' Indianapolis office, says the defensive aspects of RMBS provide a margin of safety. "We right now are interested in preservation of capital and making a respectable return," he says. A study by Barclays Capital earlier this year bears out this claim, predicting high-yield corporate bond returns of 5.5% to 6% after accounting for future defaults, versus 7% to 12% loss-adjusted returns in non-agency RMBS.

A Persistent Opportunity
The housing crisis has redefined an enormous asset class. That U.S. residential mortgages have previously escaped notice is surprising, considering that they constitute the nation's second largest investable asset class, valued at $10.8 trillion (Figure 2). To date, limited competition has enhanced returns, partly because many residential mortgage hedge funds were impaired-or disappeared-in 2008. (The same can be said for a number of Wall Street dealers and bank proprietary trading desks .) "It's a large sector, and the hedge funds make up a very small component of it," says Deepak Narula, principal of Metacapital Management.

The asset class is also diverse, offering investors a range of sectors and trading opportunities (see sidebar, Figure 3). Although strategies differ considerably in structure and form, all seek to exploit diverse views regarding prepayment speeds, interest rates, fundamental value and technical dislocations.

Managers continue to see opportunity in the agency RMBS market, for example, because many borrowers lack equity in their homes-resulting in unusually low levels of refinancing and, consequently, slower mortgage repayments. "Declining home prices have held prepayments in check," Narula says. "When it comes to qualifying for refinancing, appraisals show your loan-to-value is too high."

Even for those who have positive home equity, stricter underwriting standards and higher upfront fees have significantly reduced the incentive to refinance. As a result, Wall Street mortgage prepayment models that previously assumed that low mortgage rates lead to high refinancing rates are no longer reliable (Figure 4). "Models do not account for what may happen with declining home prices. Of course, anticipating tighter underwriting is even harder. Clearly, the models got it wrong," says Metacapital's Narula.

Over the last two years, investment managers who correctly predicted that refinancing rates would be lower than the Wall Street models predicted have garnered very high returns. Their strategy? Buying cheap interest-only mortgage bonds from sellers who feared a refinancing wave would cut short the flow of interest payments prematurely. To date, that refinancing wave has not materialized, and the bond buyers have collected handsome cash flows.

Non-agency RMBS is also attractive, albeit for reasons more relative to supply and demand than divergent views on prepayment speeds. Non-agency RMBS has appreciated throughout 2010 thanks to steady demand in combination with amortization and a lack of new issuance. From an outstanding balance of about $1.6 trillion at the beginning of the year, analysts project that the market will contract by $300 billion in 2010, according to a recent report by Goldman Sachs. Supply of new non-agency RMBS is virtually non-existent because of tougher mortgage origination standards and more stringent guidelines for rating agencies. "The rating agencies are very conservative and very concerned about making the same mistake twice," Rosenthal says. "Their credit enhancement levels have increased dramatically. Making new loans and selling them in the securitization market is not a positive economic event, so why would you make new loans? Ultimately, the origination is just ending up on bank portfolios and not being securitized."

Meanwhile, demand has been building for non-agency RMBS among U.S. Treasury-sponsored Public Private Investment Partnerships, hedge funds and bond funds looking for high yields. "You have a very strong technical supply-and-demand dynamic going on in favor of price appreciation in this asset class," Rosenthal says.
Managers are also finding appealing trading opportunities in whole loans. Combining housing market data analysis with on site expertise, whole loan investors have been buying individual mortgages at significant discounts to current property values. With a low purchase price, managers have room to reduce a loan's principal balance, keep the homeowner in the house and still realize a profit when the loan is eventually refinanced, sold or paid off. "There's a lot of opportunity for managers to [add value] in that process by managing those loans. If you go out and buy a stock, I don't see as many opportunities to add value as compared to the whole loan market because of the level of expertise you have to have," Paddock says.

Foreclosure is rarely a first choice, and a possible bottoming in home values in some markets has reduced the risk of repossession. Also, a growing number of managers now specialize in renovating and trading foreclosed properties.

Not All Doom And Gloom
Increasing activity in the refurbishment and retrading of foreclosed mortgage properties is one sign that repair is under way. Other indicators are pointing to a potential revival of the national housing market as soon as next year. The same MacroMarkets LLC survey that indicated a continued home price decline in 2010 also predicts a home price recovery in 2011 (Figure 5). Housing affordability, as measured by the National Association of Realtors (NAR) Home Affordability Index, has reached historically high levels (Figure 6). Additionally, as discouraging as high defaults and foreclosures may be, the borrowers who remain are considerably more creditworthy-a survivorship bias known as "credit burnout." Barclays Capital recently reported that the percentage of subprime borrowers with credit scores over 640 increased last year as those with poorer credit lost their homes. In addition, data from Standard & Poor's and Experian indicate that consumer defaults are now declining across a wide swath of the economy, from auto loans to first and second mortgages (Figure 7). Others take comfort from the fact that a large portion of borrowers have paid on time every month through tough economic times, despite having mortgage balances well in excess of home values. While these trends offer some hope for the housing market, it's important to note that attractive returns on residential mortgage investments do not depend on a housing recovery. Instead, any improvement in the housing market likely represents a bonus. 

Gaining Exposure
Affluent individuals have limited choices for investing broadly in residential mortgages. Buying assets directly is difficult given the level of specialized skill and infrastructure required. A handful of mutual funds, ETFs and REITs capture only narrow slices of the vast mortgage universe. A number of experienced mortgage professionals have launched new vehicles, but most are private structures and have limited track records. "It's new-investors haven't seen this before," Knall says. "This is a whole new set of money managers. We've never had distressed residential securities." Wealth advisors may evaluate these managers themselves, or look to others for expert help, or turn to a residential mortgage fund of funds. "The fund of funds works for a lot of investors because it's a diversified way of getting exposure," Paddock says.

Rethinking Asset Allocation
Since residential mortgage strategies have not previously held a distinct slot in private portfolios, wealth managers may find it difficult to fit the asset class into existing asset-allocation models. Traditional asset allocations generally aggregate mortgages with commercial real estate or ignore them altogether, and the relative illiquidity of hedge funds leaves many advisors hesitant to invest. In the July 2008 issue of The Financial Times, PIMCO's Mohamed El-Erian highlighted these shortcomings and predicted emerging value in alternative investment strategies during times of investor anxiety. In commenting on the credit crisis, which was starting to reach full bloom at that time, El-Erian suggested that "incredible bargains" would await investors willing to lock up capital, take a long view, and follow a "process that accommodates opportunities that ... do not fit well into traditional classifications of asset classes."

El-Erian's words were prescient. Correlations among several large asset classes reached record-high levels in June as investors fled markets for the safety of U.S. Treasurys, driving the 10-year Treasury yield below 3% for the first time since April 2009. "When there is a flight to quality, there's a flight to [safer] credit. ... perceived credit risk [for agency mortgages] is very low," remarks Narula. Returns in 2010 have converged across most asset classes, but mortgages have been a noteworthy exception (Figure 8). In May and June, months which saw the "Flash Crash," Eurozone instability and dispiriting employment and consumer confidence reports, the HFN Mortgages Index posted positive results while the S&P 500 suffered deep losses.

Opportunity In Uncertain Times
In an environment that Federal Reserve Chairman Ben Bernanke recently called "unusually uncertain," economic expectations have bounced between inflation and deflation, robust recovery and double-dip recession, subjecting traditional asset classes to a cycle of precipitous declines and rapid advances. This volatility has either kept many investors on the sidelines or favored those with a talent for market timing over fundamental analysis. In a post-financial crisis world, there is little consensus about the future.

Even amid uncertainty, most asset classes are priced to reflect economic normalization, and their future performance depends on it. In contrast, residential mortgage assets should perform well in deteriorating conditions-and should preform even better if economic recovery actually takes hold. By assuming the worse of two possible futures, this huge, recently orphaned asset class distinguishes itself as a defensive, worthy and reliable investment for client portfolios.

The Basics Of Residential Mortgage Securities
Residential mortgages are divided into three distinct markets.  Nearly three quarters of U.S. home loans have been packaged into residential mortgage-backed securities (RMBS)-bonds whose coupon and principal payments are funded by the underlying mortgage loan payments.  Most of the nation's housing debt has been bought by one of the three large government sponsored enterprises (GSEs)-Fannie Mae, Freddie Mac or Ginnie Mae-bundled into pools and resold as agency RMBS, which carry a government guarantee. Mortgages not qualified for purchase by one of the agencies may have been similarly packaged and sold in the securities market by banks and other mortgage lenders as non-agency RMBS.  Financial institutions own most of the remaining quarter of the market as non-securitized whole loans that can be bought and sold individually.

Agency RMBS.  Given the government guarantee, there is no question that agency RMBS principal will be repaid, but the timing of that repayment depends on when borrowers pay off their mortgages (primarily by selling their homes or refinancing.)  That timing-the "prepayment speed" in mortgage jargon-is a key driver of returns, particularly for bonds bought at a premium or discount to par.

Non-Agency RMBS.  Non-agency bonds carry no government guarantee but pay higher yields than their agency counterparts to compensate for the additional risk.  In addition, non-agency investors can choose to be somewhat insulated from loss of principal because non-agency RMBS are structured like corporate debt. The most junior bonds suffer losses before those that are senior.  The senior securities are further protected by being first in line to receive principal payments made on the underlying mortgages and liquidation proceeds from defaults. 

Whole Loans.  By purchasing individual mortgages rather than bonds, whole loan buyers step into the shoes of the mortgage lender and servicer.  Whole loan strategies are more operationally intensive than bond investing because they require holders to service loans.  Loan servicing-the business of collecting payments, working with delinquent borrowers, managing foreclosures and other related services-is expensive, more so when loans become troubled.  Whole loan investment managers frequently cite superior servicing capability as a competitive advantage and a meaningful barrier to entry.  Unlike agency RMBS investors, holders of whole loans do not benefit from government guarantees, nor can they rely on junior bondholders to absorb losses. But they do enjoy far more control and an informational advantage. 


Todd Gorelick is managing partner and Ben Brostoff is an analyst at Gorelick Brothers Capital LLC, an investment management firm specializing in alternative investments and residential mortgage strategies. Partners Rael Gorelick and Christopher Skardon and portfolio manager David Piho contributed to this article.