BofAML: Another bad week for MBS despite attractive valuations

Analysts at Bank of America Merrill Lynch became more negative on securitized investment products this week, following another round of discouraging market and economic data. Chris Flanagan and Jimmy Nguyen, BofAML mortgage-backed securities strategists, said there is “little reason to have anything but a market weight exposure to securitized products, in spite of the attractive nominal valuations.” The analysts said markets have stumbled each summer since 2006 and “driven by major policy errors, this year’s swoon is becoming more 2008, less 2010.” “We have been steadily adjusting our more optimistic view of risk taking securitized products downward over the past month, as the debt ceiling debacle and its devastating market impact became reality,” they said. The analysts recommend paring back exposure to interest-only, agency MBS, as well as moving to a down-in-coupon bias on these bonds. “In credit, our bias is to the highest quality, top-of-the-capital structure bonds,” they said in the BofAML weekly securitization overview. “The environment has become too overwhelmed by uncertainty, particularly on the policy front,” according to Flanagan and Nguyen. “In our view, the pressure to ‘do something’ is now far more likely to result in more desperate or radical measures, even if it is bad policy.” Despite historically low interest rates, mortgage applications continue to decline. Couple that with the Federal Reserve‘s decision to keep the target fed funds rate near zero until 2013, and the BofAML analysts reset “the benign prepayment expectations we have had over the past year.” “The capacity argument we made just last week now appears less likely to stand in the rapidly evolving political and economic environment,” they said. “Just as banks have been pressured to modify existing borrowers, we can look for pressure to be exerted on banks to expand capacity, lower the primary-secondary spread, and refinance high rate borrowers who have faced challenges moving through the refinancing pipeline.” The analysts expect “the simple economic incentives” of refinancing a mortgage to drive expansion with the Fed’s MBS portfolio of largely 30-year, 4.5s and 5s “most adversely exposed to more refinancing.” If refinancing mortgages has become a “core policy objective,” the analysts expect the Fed will be more likely to reinvest MBS proceeds back into MBS. Although the central bank would prefer to avoid boosting MBS holdings, according to the analysts. Write to Jason Philyaw. Follow him on Twitter: @jrphilyaw