It’s a countdown to the 2012 National Association of Insurance Commissioners unveiling of the recovery values for the more than $100 billion of non-agency mortgage backed securities held in insurance company portfolios. Despite anticipated model changes that will materially lower recovery values, we expect the non-agency secondary market prices to hold up extremely well.
The National Association of Insurance Commissioners (NAIC) will be releasing their 2012 model recovery values for the non-agency residential mortgage backed securities (RMBS) market on Friday December 21, 2012. The NAIC task force approved a new model in October that will require insurance companies to re-evaluate the amount of capital these entities hold versus their $123 billion non-agency RMBS portfolios. We believe that this new model will result in lower recovery values and higher capital requirements. Despite these changes, we expect the non-agency secondary trading market to remain very well bid and do not anticipate prices declining despite the lower NAIC evaluations.
The new capital requirements will be based on the commission’s economic/housing model with different weightings and more conservative assumptions than in the previous three years. NAIC employs a proprietary model created by PIMCO to generate expected cash flows or recovery values that generate NAIC ratings levels. This model incorporates the following factors: a macro economic model, percentages of the Case Shiller Housing Price index, the National Unemployment Rate, the Consumer Price Index, Gross Domestic Product, a mortgage loan credit model and a capital structure model. All these factors are used in determining the recovery values for each individual security in the NAIC database.
The creation and use of recovery values to set NAIC ratings levels has allowed insurance companies to purchase lower rated and non-investment grade securities as well as to hold legacy assets while requiring less capital to be held against those holdings. These changes have made the non-agency market very attractive to insurance companies with the sophistication to analyze and invest in non-investment grade mortgage backed securities.
We believe that the database release will expand the existing lull of insurance company non-agency RMBS buying through year end, while companies wait and assess the new NAIC recovery levels. In general, we are not forecasting material declines in secondary market prices as changes in demand should be minimal. Insurance companies own approximately 11% of the non-agency residential mortgage backed securities outstanding, according to recent Bank of America data. The size of the insurance portfolio is still a small enough percentage of the overall market where selling and heavier supply would represent modest pressure on prices.
The new weightings and assumptions were released by the NAIC in October, and are listed in Exhibit 1. Four out of the five scenarios are worse than the 2009, 2010 and 2011 models. The base case scenario is essentially unchanged. The primary adjustment added an incremental 10% weight to a housing scenario where prices bottom out a full 60% below 2006 peak valuations. That translates into an incremental 30% drop from current valuations. The table suggests that the more conservatively weighted model will create lower NAIC prices.
We expect senior, Prime bonds to drop anywhere from one to three points, potentially causing recent NAIC 1 purchases to drop into the NAIC 2 category level, and in some cases NAIC 3 level. Alt-A and Subprime bonds could drop in the neighborhood of two to five points. Mezzanine bonds could see valuation levels decline as much as ten points or more. AAM feels that the model penalizes holders of this paper given the 5% rise in national Housing Price Appreciation (HPA) in 2012. We don’t agree with the new approach. However, despite the more conservative model, we believe this should not cause major problems for most senior securities.
Approximately 80% of the $123 billion non-agency RMBS held by insurance companies consists of NAIC 1 and 2 rated bonds. Of these bonds, 72% are currently carried as NAIC 1 and 8% as NAIC 2 rated bonds. The remaining 20% of the insurance companies exposure carries NAIC 3, 4 and 5 ratings (8%, 8% and 4%, respectively). The end result of the implementation of the new model will be lower recovery values for a large number of non-agency RMBS. The model will present downward price recovery pressure on NAIC 3 to 5 rated securities. Conversely, the stronger performing senior bonds will drop substantially less for the NAIC 1 and 2 rated bonds. So come late Friday, we will see exactly how much NAIC evaluations have dropped.
Christopher M. Priebe
Mortgage Backed Securities Trader
For more information, contact:
Colin T. Dowdall, CFA
Director of Marketing and Business Development
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