Wednesday, July 22, 2009

A positive credit market sign

Under a POA, a brokerage portfolio that has almost 3/4 of its assets in mortgage backed securities is managed here. Why a broker at Smith Barney in North Carolina built this type of portfolio for an elderly client is a mystery, or an outrage, or maybe a crime(three years ago the portfolio was almost 90% MBS). No matter at this point, it's done.

The mortgage backed securities in this portfolio all have prepayment mechanisms such that while they are all on their face 30 year instruments, in good times they would prepay in full within five to seven years, increments at a time. In bad times it would be slower, in horrendous times they would for the most part freeze. From January 2008 until April 2009 these securities were in deep freeze. The quarterly prepayment flow on, as an example, a $30,000 security would at times come in at less than $10. What is very interesting is that over the last three months the prepayments have begun again. These complex securities are beginning to behave, at least in this respect, as intended and as promised to retail investors who really had no idea what they were getting into.

From this perspective these cash flows are not only good news for the portfolio but also an extremely positive sign for the credit markets. There is activity! This most damaged sector of the credit markets is beginning to function! Much more improvement is needed but how can this not be a good sign.

It should be noted that these securities in a retail portfolio are still for the most part completely illiquid unless they are Fannie, Freddie, or Federal Home Loan Bank, all of which will move but only at material discounts. Everything else can hardly be given away, which is all the more reason that the beginning of prepayments is important. A handful of the securities managed seem to be dying and, while current on interest today, will likely go to zero at some point. Throwing them at the market today with a 20% effective yield finds no takers. Thank you Smith Barney.


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