Eric Jacobson: Hi, I’m Eric Jacobson, Director of Fixed Income Research at Morningstar. I’m here with Bryan Whalen. Bryan is the co-head of the mortgage group at Metropolitan and West Asset Management and now as a result of a recent deal, co-head of the mortgage group for TCW’s high grade bond operation as well. Bryan thanks very much for joining us.
Bryan Whale: Thanks for having me.
Eric Jacobson: So Bryan sort of trial by fire here now with the recent transaction and given the style that TCW run money especially in the TCW total return fund, lots of questions about Metropolitan West Mortgage capabilities. I know your specialty is non agency mortgages. Maybe you could sort of dial back and tell us a little bit about your history in the business and how you came to go into non-agency side of the business in particular.
Bryan Whalen: Sure, well first half of my career in Wall Street I joined Metropolitan West in 2004 and I realize there was an opportunity to expand the platform into the credit side of the business. I was taken some of the experience I had on Wall Street and bringing it over to the by side. That experience in the platform that we built out really lend itself to an opportunity to take advantage of the dislocation in the mortgage market that really started to occur in the middle of 2008. We took our flagship fund MWTRX Metropolitan West total rates return fund and really start to log into that sector, stop post to Lehman Brothers downfall in September of 2008.
It has always started to Dow Industrial Average our way into the sector throughout the end of 2008 and the beginning of 2009 and the run of turn of the yearn in the first quarter of 09, our performance was suffering versus the bench mark but we definitely recognize just the fundamental long term value of this cash flows and that it was purely due to a market dislocation. We pit as a percentage of the fund in non agency credit around 35% back in the spring of this year in 2009 and the performance obviously over the last year and even looking back further has benefited tremendously from that type of exposure.
We’ve taken the opportunity and the rally this fall to trim those holdings. Still a significant portion of the overall fund at about 20% to 25% but like any rally, I have to give dollar cost average away in as prices are dropping. We also think we should dollar cost average our way out as prices are rising.
Eric Jacobson: Let me take you back a little further than that. I want to say perhaps and you can correct me. Sometime not too long after you join Met West and started building out the platform. My recollection from that period of time is that the team was very aware right even then that there were a lot of differences in the way that underwriting standards are being applied, differences in the way refies were occurring lots of things in terms of the servicing and that was something you guys were focusing on the building and that platform. Talk to me and our readers a little bit about, our viewers if you will about when the signs started to appear and how that evolves in terms of the strains in the market and what the signals were that you were saying.
Bryan Whalen: Well, you know, the first signs were on the subprime market to us. We were seeing these transactions get issued by Wall Street in greater and greater volumes and the first big sign to me was the use of hybrid arms in that market place, 228 to 327 which mean the rates is fixed for two to three years and then start to adjust. Other sees the risk there that if rates rise, the index raises that your mortgage payments going to rise as well. Within three to six months, they start including interest only components to those mortgages.
Eric Jacobson: And this—
Bryan Whalen: This is 03 or 04 and then they started losing the documentation requirements so no longer did you have to approve your income, how you could effectively just stay it. And that was really the first signs to us that it looks like this is getting out of control and we definitely saw it predominantly in a small group of originators but as the party went on, more and more originators started to use that type of underwriting. And really if you wanted to stay afloat unless you were a large national or multi-national bank with other sources of revenue, if you were a US domicile and mortgage only company, you know your choices were to either go out of business or kind of match that kind of lax underwriting just as you can do allowance.
So that was the big sign and it expanded. It got even worst in subprime. It definitely expanded to the alternative A market and then even in the prime market as defined by vital scores underwriting there definitely started to deteriorate as well.
Eric Jacobson: And so what was it going on in terms of the way you guys were allocating mortgages back in that point. Were your friends investing in non agency mortgages at that time and if so how are you sort of having to play that?
Bryan Whalen: I mean the funds been investing and the firm that spot less have been investing in non agency mortgages through its inception back in 1996. The founding partners, Tad Rivelle, Laird Landmann, Steve Kane they were investing mortgages all the way back to PIMCO over 20 years ago. So the firms founders come with mortgage expertise, the firm is always had a heavy focus in mortgages, obviously increasing, reducing that percentages base upon market opportunities.
Even throughout the course of when we saw that lending, the underwriting terms really start to get to loosen up, we still thought there was value at the senior part of the capital structure and typically in the shorter duration cash flows such that one day if things did get bad, you would be first in line to get paid out. And of course those securities, they did drop in value when we really hit the credit crisis in the fall of 08 but our conviction was that this are solid fundamental sound cash flows where you will get paid back at par and now looking back with over 12 months of up high insight, now we are absolutely right. And so it’s just a short term dislocation in pricing. Not an actual fundamental hit to the value of those box.
Eric Jacobson: That kind of brings us all the way back to sort of today now. We’ve have this huge rally sort of a retracement or rebound and a lot of cases where things were just beaten down horribly last year for all kinds of reason. What can you tell us about you and the team in terms of the thinking about where we are today in terms of the securities market for a lot of the non- agency stuff. Is there a lot of value left out there, what can people expect?
Bryan Whalen: Sure. You know I think I’ve describe it as basically rounding second right now. There's a baseball analogy in terms of where we are in this rally approximately half way through or I think eventually will end up and the prices will stabilize. I think a big part of the first half of this rally has a lot more to do with basically the removal of panic from the system, no more fear that we’re entering the next depression and secondly leverage coming back into the system. There is leverage through the government programs like PPIP. There's leverage just from the broker community. You can now take a non-agency bond and get reverse reform on putting up a haircut, paying a financing rate but you still can get leverage.
So that is when we price it. It’s lifted the whole sector up but we’re not at the point yet really where the market is running a particular bond and expecting fewer defaults on the borrower pull then it did just 6 months ago. That hasn’t happened yet. I think the market is going to need to see the economy stabilize, housing truly stabilized at it’s on own two feet not from government programs.
Once that happens and people start getting more comfortable that the faults are actually not going to be as bad as we thought right now and the severities on every loan that defaults isn’t going to be as high as the markets fearing right now. That will really be the second leg of this rally when prices rise even further. It will be rising base upon fundamentals not just upon leverage.
Eric Jacobson: Well that’s a good place to stop. Thank you very much for your time Bryan, we appreciate it.
Bryan Whalen: You’re welcome.
Eric Jacobson: Thank you for joining us. I’m Eric Jacobson with Morningstar.