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'Deleveraging' Likely To Spur Buying Activity

As banks and other mortgage investors struggle to "deleverage" their balance sheets, it's little wonder why private equity and hedge funds smell blood in the water.

Many expect a fire sale of subprime mortgage assets. And while sellers still far outnumber buyers, the growing presence of potential buyers lining up funds for "distressed assets" could actually help the financial sector de-leverage.

In a recent report, analyst Paul Miller and his colleagues at Friedman Billings Ramsey estimated last summer that the financial system would have to attract $150 billion to $250 billion of new, permanent capital to avoid a fire sale of mortgage assets. More recently, FBR upped its estimate of how much new capital would be required to $1 trillion.

The failure to attract that new capital would force banks to sell assets, depressing prices in an already weak market.

FBR estimates that prices for mortgage securities will fall to a level where buyers can expect a 15% rate of return for non-agency AAA rated securities. Today, those securities are trading "down to the mid-70s," FBR says. And spreads between rates on agency-backed mortgage securities and Treasury securities have widened to their highest level in more than two decades.

FBR estimates it will take another six to 12 months for "pricing pressure to alleviate" on these mortgage assets.

FBR's math shows that the mortgage investment sector is substantially leveraged at a time when market participants are increasingly wary about mortgage collateral. FBR says mortgage debt outstanding totals about $11 trillion, with roughly $587 billion of equity support. That results in a 19 to 1 leverage ratio, according to FBR's analysis.

The pressure to deleverage is falling hardest on non-banking companies (witness Thornburg Mortgage's recent margin calls in the repurchase market). FBR estimates that leverage for non-agency paper is moving from a 10-to-1 ratio to something on the order of a 2-to-1 ratio, which would require those non-banking companies to raise about $880 billion of new capital. In the agency-backed sector, FBR estimates that the leverage ratio is moving from 20-to-1 to 12-to-1, which would require another $100 billion of capital.

"These calculations are based on FBR's assumptions and may differ from other mortgage experts, but everyone will agree that there is an imbalance between housing debt and the capital base and the quick way to return to equilibrium is for asset prices to adjust down," FBR said in its report.

Small wonder that private equity honchos are beginning to circle around the market. Until the broad market regains confidence in the value of mortgage collateral, the bottom fishers may have a field day.

Snapshot: New Capital Requirements Pressure Mortgage Securities Investors

Non-Agency $880 Billion

Agency-Backed $100 Billion

Source: FBR. Projection of new capital needed to meet lower leverage expectations. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/