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| Scott Simon |
Pacific Investment Management Co. plans to avoid the biggest part of the collateralized debt obligation market this year because of tight spreads and concerns sub-prime mortgages are headed for a fall. Scott Simon, managing director and head of the mortgage-backed investing team at PIMCO, said it will not act as a manager on CDOs backed by structured finance assets because there is a lack of arbitrage and he is concerned origination standards at the loan level are too lax. In particular, Simon said aggressive underwriting practices among sub-prime lenders seeking to keep origination levels high have masked the true credit picture of consumer borrowers, by incentivizing those borrowers who may have been on the verge of defaulting to instead refinance. "We think the data from sub-prime over the last five years are meaningless," he noted. As a result of the prepayments, default rates on sub-prime housing loans have been kept artificially low, but as interest rates creep higher, borrowers will not be able to continue refinancing their home, resulting in higher defaults, Simon predicted. "We're going to see a big shift from CPR to CDR," he said, referring to how pools are qualified by constant prepayment rates and constant default rates.
Other investors in mortgage-backed assets are also concerned by the long run in home price increases and what effect softer origination standards may be having on the collateral backing new bond sales. "We have real concerns about the housing market," said Stephen Gallant, senior v.p. at ING Investment Management, adding it has even heard of a rapid rise in mortgage application fraud.
