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Opinion

Equity investors can avoid future shock

If equity investors paid closer attention to what is going on in parts of the bond market they could avoid kneejerk reactions to what is essentially old news.

On July 12, UK non-conforming mortgage originator Kensington Mortgages announced its half-year results. The figures showed strong growth and a year-on-year increase in profits from £24 million to £30.3 million ($55.1 million) – up 25%.

But the results also showed a rise in 90-day arrears and the prediction that they could climb further still. There was also a 100% increase in bad debts in the first half of the year.

This news, although not exactly great, came as no surprise to those in the mortgage-backed securitization market. Kensington’s business model (like that of many of its sub-prime lending peers) is based on funding itself in the securitization market [see FIG Watch: Kensington proves the value in non-conformity, Euromoney May 2006]. But Kensington tapped the reserve accounts on two of its securitizations (RMS 15 and 16) more than a year ago. At the time the news was a shock – the lender is the blue-chip issuer in this asset class. Indeed, the news was sufficient to trigger a general unease about the sub-prime lending sector in the UK. The feeling was that if the more established and experienced players in the space were experiencing problems, then the many newcomers that have piled into this business must only spell trouble. And there has been no shortage of warnings about a rise in mortgage arrears: Libor has risen by 1.1 percentage points since 2003 and many UK borrowers faced payment shock when they came off their two-year fixed-rate periods on 2003 mortgages last year. Indeed, properties taken into possession had been falling steadily until 2004 (0.05% of all loans) but rose sharply in 2005 to 0.09%. But this was a full year ago and several other sub-prime lenders have also tapped reserve funds in the past 12 months – notably Southern Pacific Mortgages and Rooftop Mortgages (and Kensington tapped another deal (RMS 17) earlier this year).

So Kensington’s half-year results should not really have taken anyone by surprise. Indeed, the announcement had zero impact on credit spreads. But it precipitated a more than 10% collapse in the stock from more than £10 to 793p. Why didn’t this happen a year ago when the reserve funds were tapped? Some fixed-income investors did in fact short the stock when the news of the taps came out, but eventually gave up when the stock did not budge. It took the half-year results to generate sufficient concern in the equity market to trigger a sell-off. The episode is another example of the complete dislocation between the equity and ABS market, a dislocation that both sides should try to address.

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