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DRESS CODE Reading Today's Secondary Market W As lenders work toward resolving secondary market issues both past and present, tapping into the right research is critical. place, and Smith Breeden's analysis provides key insights for the housing finance sector. One World, One Basel III Improves Its Reputation Though the finance industry has been trepidatious when it comes to embracing the many regulatory man- dates within Basel III, Smith Breeden's data indicates that June's final ruling on calculating capital requirements for structured products is already hav- ing a positive impact on U.S. banks. IT'S INFLUENTIAL BECAUSE: The nation's large banks can now commit lower levels of capital to their trading portfolios for residential mortgage- backed securities (RMBS), allowing for enhanced "leverage into the system" now that previous capital require- ments—which Smith Breeden calls "onerous" and "unreasonable"—have been lifted. LOOKING AHEAD: "Over the long-term, this should aid liquidity and valuations in securitized prod- ucts," noted Smith Breeden's Jeffrey Wheeler, CFA. Messy Economy Global financial health, or the lack thereof, is taking its toll on the U.S. economy, and considering the fragile state of the country's housing finance industry, eurozone problems have the potential to severely limit the sector's recovery. However, Smith Breeden believes that the nation is still on track for improvements that will shift "balance of risks to the upside." IT'S INFLUENTIAL BECAUSE: From Main Street to Wall Street, bulging levels of debt are negatively influencing "sentiment and growth," as the U.S. and Europe stay locked in the "wheel of crisis and response." LOOKING AHEAD: Daniel Dektar of Smith Breeden elaborated, "More momen- tous decisions are drawing nearer, but it remains murky as to whether the political will exists to maintain the currency union for the long-term. Also approaching are the 'fiscal cliff' in the U.S., and our own dance of crisis and response. Central banks re- main as accommodative as possible, but the decisions are primarily in the political arena now. Cacophonous headlines await." The Hand that Feeds You The Federal Reserve opted to extend Operation Twist, but the decision resulted in a lackluster environment for investors as mortgage spreads grew wider. Smith Breeden pointed to premature expectations of addi- tional quantitative easing for mortgage prices—which were included in many forecasts—as the chief catalyst, and the company called such predictions "sur- prising." IT'S INFLUENTIAL BECAUSE: Despite fluctuations and unpredict- ability, many continue to be drawn to the "non-credit aspect of agency MBS investing and are loath to be short the sector." LOOKING AHEAD: "With spreads a little wider now, agency MBS appear poised to perform well as long as the Fed maintains the size of its balance sheet," stated Smith Breeden's Timothy Cunneen, CFA. But What's Your Credit Score? Mentioning the differences in credit quality "outcomes between the investment-grade and high-yield markets," Smith Breeden under- scored the fact that significant credit availability and ultra-low interest rates for borrowing was driving up corporate interest in debt markets. IT'S INFLUENTIAL BECAUSE: A growing appetite for high-yield bond and leveraged loan borrowing that is marked for debt refinancing is an important trend to track.LOOKING AHEAD: Smith Breeden revealed, "There is no doubt that some of this activity is being financed through existing cash balances and cash flow generation, but an increasing hen reviewing this summer's secondary market and real estate investment com- mentary from Smith Breeden, one thing is clear: Political pressure both at home and abroad is weighing heavily on the housing finance sector. The global asset manage- ment firm recently released its June-to-July report on the broader financial market- number of issuers are borrowing to fund share repurchases, dividend payments, and acquisitions. The result is a gradual deterioration of corporate balance sheets, leaving companies with less room for error and possibly limiting future growth opportunities." Policies Gone Wild The report from Smith Breeden also referenced a regulatory movement among some local governments that would broaden the scope of eminent domain rules, allowing mortgages to be removed from securitization trusts and modified. The proposed legislation would mandate the trust to sell the loan at a "fair market value" established by the court, after which private capital would be used to fund the purchase, and most modifications of this type would include principal reductions, giving borrowers instant equity and pav- ing the way for refinancing via the Federal Housing Administration. IT'S INFLUENTIAL BECAUSE: Both the local governments and private inves- tors would share in profits garnered via the plan, with multiple variables creating an inherently problem- atic program. LOOKING AHEAD: "Mortgage lending and securities investor trade groups immediately mobilized to protest this plan . . . Overall, this is a high-impact but low probability risk that we will be fol- lowing closely," added Wheeler. THE M REPORT | 15