Finding Value in the Mortgage Madness
By: SEI Investment Management Unit
Significant media attention has recently focused on concerns regarding the paperwork for mortgage loans created over the past several years. Specifically, loans are being examined to determine whether the correct procedures were followed and if the necessary documents were executed in the legally prescribed manner in order to foreclose on delinquent borrowers. This issue also calls into question whether the loans, which were bundled together as non-agency mortgage-backed securities1 and sold to investors via a process known as securitization, were underwritten with proper disclosure to the buyers at the time of issuance. Despite the headline noise, SEI’s Fixed Income team believes that active investment managers can still find substantial value in this sector.
Concerns about the processing of mortgage paperwork resulted in the much-publicized temporary halting of foreclosure proceedings by some of the nation’s largest mortgage servicers. Given the information available at time of this publication, it is SEI’s belief that these issues will be resolved. Large mortgage servicers will need to commit additional resources to ensure that the current backlog is appropriately processed. In addition, new procedures will need to be put in place to address any deficiencies in the foreclosure process.
In general, longer timelines in the foreclosure process result in a greater loss on the underlying property, which is a negative for both the banks that hold loans in their portfolio and for bondholders in the non-agency mortgage market. For banks, it means thinner margins on their servicing businesses and a modest increase in loan losses for properties that enter the foreclosure process. For residential mortgage-backed bondholders, it means less at recovery on a foreclosed property, especially for bonds backed by pools with high levels of delinquent loans.
Investment Manager Perspective
While this is relatively new information to the market, the investment managers SEI works with have witnessed the extension of foreclosure timelines and expect those timelines to continue to extend as the volume of delinquent loans exceeds the foreclosure capacity of the servicers. In addition, as a part of routine surveillance and ongoing updating to their models, the investment managers run various stress scenarios that incorporate these lengthened times in foreclosure. While the news is unfortunate and negative headlines will likely persist, we and our managers expect the potential impact to portfolio performance to be minimal.
A second issue centers around the ability of mortgage-backed bondholders to “put back” certain loans, which involves forcing banks to repurchase mortgages and securities related to them. A group led by the New York Federal Reserve and several investment managers is looking to essentially “ask” some of the large originators/banks to take back loans that they deemed to be deficient. For example, the bondholder group might ask for an originator to take back 10 loans out of 100 in a specific deal. The problem is that these 10 loans are currently worth 20 cents on the dollar, and if the originator agrees, it effectively results in an 80% write-down on those loans. The windfall goes to the mortgage-backed security holder, while bank earnings suffer. On paper it looks simple, but in practice it could prove quite challenging, as there are large logistical and legal hurdles that need to be overcome.
As a result, it is likely that the outcome of these types of actions could take years to play out. If the banks in question (Bank of America, Wells Fargo, JP Morgan) were to settle, or if the bondholders were to succeed through a legal remedy, the banking industry would take additional write-downs and security holders would reap the windfall. If the bondholder action is successful, the investment managers SEI oversees believe that write-downs will be manageable for the banks given they will be spread out over a three- to five-year period.
The portfolio managers on SEI’s Fixed Income team are analyzing holdings in the mortgage sector to assess the potential for an adverse impact. However, the non-agency mortgage sector has made a notable contribution to our performance over the past year, and we generally feel that the market still offers attractive opportunities despite the recent headlines on mortgage foreclosures, since prices already reflect poor scenarios. SEI benefits from implementing active management in this space, because the managers we have selected, such as Western and MetWest, have focused on identifying attractive segments and seeking to avoid those that are considered too risky.
Our Fixed Income team has engaged in detailed discussions about the mortgage situation with MetWest, Western and JP Morgan, all of which hold an overweight to the non-agency mortgage sector. Following those discussions, we continue to believe that, despite the recent headlines, good security selection in this sector still offers substantial value. As a result, SEI’s U.S. Fixed Income and Core Fixed Income Funds are maintaining their allocations to non-U.S. mortgage-backed securities and have maintained an overweight to financial debt as well. We will continue to monitor the situation and will provide an update should our views change.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Funds.
SEI Investments Management Corporation (SIMC) is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCo.) SIMC and SIDCo are wholly-owned subsidiaries of SEI Investments Company. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation has ultimate responsibility for the investment performance of the Fund due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement.
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