Josh Rosner clears up my MBS questions

There’s not going to be a lot of new stuff on felixsalmon.com today, mainly because I have to do my taxes. But I did get a phone call this morning from mortgage expert Josh Rosner, and I learned quite a lot.

For one thing, I can now answer the question which has been bugging me for months: What is the relationship between default rates and MBS prices? A vast amount of the commentary about the MBS market has been centered on skyrocketing default rates in the subprime market, and there’s been a decided implication there that if default rates on subprime mortgages go up, then the value of MBSs based on subprime mortgages will naturally go down.

Turns out, it’s not that simple. For one thing, as we saw on Friday, rising default rates can, in theory, actually be good for MBS prices. Rosner didn’t go that far. But he did say that as far as the cashflows from any given MBS are concerned, the default rate on the pool of underlying mortgages is very unlikely to have any real effect on the cashflow to the MBS investors. Ever and always, MBS investors are worried about prepayment first and prepayment second.

Indeed, if you look at what happened to the MBS market in the wake of Hurricane Katrina, pools which were concentrated in the affected states didn’t noticeably underperform pools which weren’t. Investors, it seems, simply don’t worry about the default rates in their MBS pools.

Now this doesn’t mean that MBS investors shouldn’t be worried about default rates. There are two main reasons why they should. The first is that default often ends up as a foreclosure, and a foreclosure is essentially a prepayment. The second is that MBS investors aren’t interested solely in the MBSs they’ve invested in; they’re also interested in the health of the MBS market as a whole. And the future of the MBS market looks a little unhealthy if default rates continue to rise.

Why? Two big reasons. For one thing, if default rates rise, the housing market goes into reverse, and underwriting standards tighten up, then naturally the total supply of MBS coming to market will fall. But for another thing, there’s also the question of all those workouts.

When borrowers go into default, lenders are likely to try to come to some kind of workout agreement, rather than foreclose immediately. That’s because foreclosure often involves loss of principal, and also because of HUD guidelines. Typically, the arrears will be capitalized, and a new mortgage will be written. Now, as Morgenson pointed out in her piece on Sunday,

Academic studies suggest that within the first two years of a workout, re-defaults can approach 25 percent.

Now that’s good, right? You’ve gone from certain default to a mere 25% chance of default. Not so fast: according to Rosner, those workout mortgages are pooled and securitized just like any other mortgages, and often carry the original FICO score as well, and the original underwriting. Investors who buy the new MBSs, says Rosner, have no idea that they’re buying a pool which includes mortgages with a 25% default probability.

Finally, on the ABX index: Rosner looks at it with disdain. It doesn’t, right now, reflect the price movements of any underlying securities, and because it’s the only easy way to play the mortgage market, it attracts volatility like a super-magnet, drawing it away from the rest of the mortgage-backed world. There are lots of reasons to be worried about the future of the mortgage market, but the ABX index is not one of them.