Mind the Gap

In 2006, the mortgage-backed securities market couldn’t have been more expensive.

A large segment of the bond market, mortgage-backed securities (sometimes just called “mortgage-backs”) are big bundles of mortgages that are bought and sold by investors. Mortgage-backs were trading at all-time tight (or narrow) yield spreads. The spreads are the difference between the yield an investor could earn on a mortgage-backed security and the yield on a comparable Treasury bond.

Less than a year later, those spreads have more than doubled—the value of mortgage-backs has fallen off the table relative to Treasuries, reaching lows not seen (relatively speaking) since the debt crisis of 1998–2000.

Scott Kirby, manager of the structured assets group at Ameriprise Financial in Minneapolis, is faced with navigating these waters. His group is responsible for managing more than $35 billion in mortgage-backed assets. We caught up with him to talk about how the subprime aftermath affects the average investor.

{Q} We’ve heard a lot about the effect of the mortgage crisis on collateralized debt obligations and other debt instruments, but precious little about the effect it’s had on the traditional mortgage-backed securities market. What’s happening there?

{KIRBY} This has been the most dramatic repricing of assets in this sector that I have seen in my career. If you look at a hierarchy of assets, the highest quality level of mortgage-backed securities are agency pass-throughs, which are securities that are guaranteed by quasi-government agencies such as Freddie Mac and Fannie Mae. This is a very, very liquid market—the largest portion of the fixed-income market. So when investors want to shed risk, it’s a very easy way for them to execute that trade. Investors sell what they can.

{Q} Have mortgage-backed securities taken a hit?

{KIRBY} Yes. What tends to happen is that these assets widen out dramatically; in other words, the spreads relative to the Treasuries gap open. Conversely, when the storm passes, these assets tend to be the first to recover.