What’s hot for 2011: Mortgage-backed securities?

December 9, 2010, 9:39 PM UTC

Remember those toxic assets that nearly wrecked the U.S. financial system back in 2008? They’re back, even though housing isn’t.

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It seems like only yesterday that virtually everyone thought mortgage-backed securities were evil. After all, the securities – backed by mortgages including subprime home loans – helped put the country’s largest banks on the brink and the global economy into a dizzying downward spiral after the housing bust started.

In the years leading up to the financial crisis, as credit boomed in tandem with home sales, Wall Street shored up on mortgage-backed securities. At the time, at least, it was almost easy to see the appeal of betting on securities whose values depended on mortgage payments and housing prices.  But when things went awry, these securities were akin to the plague – not just for Wall Street who reported big losses, but the folks on Main Street who linked the complex financial instruments with their economic woes.

It’s true things are looking better today relative to what they did then, when Lehman Brothers went under and Bank of America (BAC) swept up Merrill Lynch in a panic. But the housing market isn’t exactly rebounding, and the rate of foreclosures hasn’t improved much. The latest Case Schiller Index reported that home prices nationwide declined 2% during the three months ending in September, after having risen 2.4% during the previous quarter. According to Zillow, home prices have lost $1.7 trillion in value in the past year.

Despite the gloom, a modest bright spot linked to housing is emerging on Wall Street. In its 2011 outlook, UBS (UBS) strategists declared that mortgage-backed securities are poised to be an attractive investment. This doesn’t necessarily signal that defaults and foreclosures on home loans will totally recover anytime soon, UBS says. Ironically, some of the factors working against the housing market today are helping make the securities more appealing to investors.

These days, mortgage-backed securities come with relatively less risk, since banks have enforced much stricter lending standards. Fewer people are taking out new home loans, even while mortgage rates have fallen to record lows.

“In our opinion, the situation will change only if the federal government devises an incredibly aggressive program to boost refinancing, or if unemployment falls dramatically,” according to a UBS report highlighting its 2011 outlook on fixed-income. “Neither of these seems likely to happen in the first half, or for that matter the second half, of 2011.”

UBS Strategist Michael Schumacher says banks have been “big buyers” of mortgage-backed securities – a trend that’s been unfolding for the past one to two years. This comes at the same time that banks such as JP Morgan (JPM) and Bank of America are fighting off demands to buy back toxic mortgage-backed assets that they sold during the crisis.

According to data compiled by UBS from Bloomberg and the Federal Reserve, however, it appears the interest has been more modest. US commercial bank holdings of agency mortgage-backed securities (the kind that’s issued and guaranteed by Fannie Mae (FNMA), Freddie Mac (FMCC) and does not include subprime mortgages) was just under $1 trillion on July 2009 and has steadily risen to more than $1.1 trillion November 2010.

Steven Schwarcz, a law and business professor at Duke University, is among those who have long argued that mortgage-backed securities are undervalued. He says the market price on some securities was 22 cents on the dollar in July 2008, far below the real value of 80 and 80 cents on the dollar. According to Barclays Capital index date, securitized debt — including mortgage-backed securities — has outperformed Treasuries by 2.58 percentage points this year.

Analysts at Bank of America Merrill Lynch also recommend buying securitized debt right now, as the market is expected to shrink next year, according to Bloomberg.

The returned faith in mortgage-backed securities might be stirring some chatter on Wall Street. Beyond those confines, even though the worst of the housing crisis is behind us, there isn’t much reason to cheer the state of home mortgages these days.