Revisiting Mortgages

Revisiting Mortgages
The U.S. mortgage market offers unprecedented opportunity

By Chris Dillon, Portfolio Specialist, T. Rowe Price

Like any other financial crisis, the present downturn presents new opportunities.. As a by-product of the current crisis, T. Rowe Price sees compelling opportunities in global fixed income markets. But making the most of these prospects requires careful timing, and in the present market, the signal to go forward comes from the $12 trillion U.S. mortgage market, which precipitated the current global financial and economic crisis.

The U.S. mortgage market revealed its instability in 2003, when accounting issues arose at Fannie Mae and Freddie Mac, leading to a sudden rise in non-agency mortgage origination. At the same time, collateralized debt obligations (CDOs) began to proliferate as Wall Street’s solution to a low-yield world.

These seemingly independent developments became intertwined through securitization, the process that allowed non-agency mortgage providers to rapidly originate mortgages while almost simultaneously selling these loans. The Street, meanwhile, voraciously bought these loans to repackage them into highly profitable CDOs that were, in turn, being widely sold to investors globally.

We now know how this story ended. Once the U.S. housing bubble burst in late 2006, CDO values crashed, securitization screeched to a halt, mortgage troubles spread to other asset-backed sectors, and overall credit issuance was hindered even for good credits, exacerbating the downturn.

Amid these developments, risk was dramatically re-priced across global debt markets, creating compelling investment opportunities. Indeed, many of T. Rowe Price’s U.S. portfolio managers believe that the market environment of early 2009 presented the greatest set of opportunities that they had ever seen, given near-record spread levels.

In early 2009, two primary considerations were at work in our view: the worst global economic contraction since World War II was being experienced in concert with general debt market paralysis that introduced massive illiquidity premiums into non Treasury debt security valuations. In our view, these considerations brought the focus back to the U.S. mortgage market and policy actions by the Obama administration to stabilize it and the overall “shadow banking system.” These policies –along with such initiatives as the Term Asset Backed Loan Facility (TALF) and the Public Private Investment Partnership (PPIP) – helped to not only reduce these illiquidity premiums, but also paved the way for the reopening of debt markets, which has ultimately sparked a strong US “spread” sector rally through the first half of the year.

From a current perspective, we still view the state of the US mortgage market as an integral consideration for institutional investors. It is only through a stabilized mortgage market, for example, that the US housing market can find a bottom, which in turn helps contribute toward economic growth traction. While large illiquidity premiums have already been extracted from US spread sectors, as signs of economic hope emerge (so called "green shoots"), we believe current market valuations continue to warrant positions in Investment Grade Credit, Asset Backed and Commercial Backed securities, Bank Loans and High Yield.

As referenced above, stability in the U.S. housing market is one important prerequisite for economic and capital market recovery and by certain measures that is already beginning to take hold: housing supply is dropping; affordability has returned to 1980s’ levels and, on a global valuation basis, U.S. housing is now considered cheap. Nevertheless, despite these positive indicators, distress remains as foreclosures are still rising. Going forward, we believe the focus must be on three primary issues that have been left on the table: home prices, negative equity and bad "legacy" assets. The faster home prices stop declining, the better and this will require more purchasing incentives among other considerations. None of the programs so far have addressed negative equity, an issue clouded by possible bankruptcy legislation and one that must be resolved so that bad assets can be properly valued.

It is our view that these issues will be resolved in due course and our overall outlook remains constructive—and particularly so for investors with intermediate-to longer-term time horizons.

This material is provided for informational and educational purposes only and not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This opinions and commentary do not take into account the investment objectives of financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. The views contained herein are as of April 2009 and may have changed since that time.

Issued by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services. T. Rowe Price (Canada), Inc. is not registered to provide investment management business in all Canadian provinces. Our investment management services are only available to select clients in those provinces where we are able to provide such services. This material is intended for use by accredited investors only.


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