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At the Helm of TCW Total Return

Met West's Bryan Whalen on the firm's mortgage expertise, the first signs of the mortgage crisis, and the value remaining in the mortgage market.

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 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 Whalen: Thanks for having me.

Jacobson: So Bryan, sort of trial by fire here now with the recent transaction and given the style that TCW ran money, especially in the TCW Total Return Fund, lots of questions about Metropolitan West's 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 the non-agency side of the businesses in particular.

Whalen: Sure. Well after first half of my career on Wall Street, I joined Metropolitan West in 2004, and I realized there was an opportunity to expand the platform into the credit side of the business. I was taking some of the experience I had on Wall Street and bringing it over to the buy side. That experience in the platform that we built out really lent 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 Rate of Return Fund, and really started to leg into that sector, just about post-Lehman Brothers downfall in September of '08. We slowly started to dollar-cost average our way into the sector throughout the end of '08 and in the beginning of 2009.


And around the turn of the year in the first quarter of '09, our performance was suffering versus the benchmark, but we definitely recognized just the fundamental long-term value of these cash flows, and it was purely due to a market dislocation. And we peaked as a percentage of the fund in non-agency credit around 35% back in the spring of this year, 2009, and the performance obviously over the last year and even looking back further has benefited tremendously from that type of exposure.

We have taken the opportunity in the rally, this fall, to trim those holdings. Still a significant portion of the overall fund of about 20% to 25%, but like in any rally, after you have dollar-cost averaged your way in as prices were dropping, we also think we should dollar-cost average our way out as prices are rising.

Jacobson: Let me take you a back a little farther than that to I want to say perhaps, and you can correct me, sometime not too long after you joined MetWest 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 were being applied, differences in the way refis were occurring, lots of things, in terms of the servicing and that was something you guys were focusing on in the building of the platform.

Talk to me and our viewers about when the signs started to appear and how that evolved in terms of the strains in the market and what the signals were that you were seeing?

Whalen: Well you know the first signs were in the subprime market to us. You know 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 marketplace, 2/28s and three 3/27s which means the rate is fixed for two to three years and then starts to adjust.

Obviously there is risk there that if rates rise, the index rises that your mortgage payment is going to rise as well. Within three to six months, they started including interest-only components to those mortgages.

Jacobson: And this is...

Whalen: This is '03-'04 and then they started loosening their documentation requirements. So no longer did you have to prove your income, you could effectively just state 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 are a large national or multinational bank with other sources of revenue, if you were a U.S.-domiciled mortgage-only company, your choices were to either go out of business or kind of match that kind of lax underwriting just to say you can do loans. So, that was the big sign, and it got even worse in sub-prime. It definitely expanded to the alternative "A" market and then even in the prime market as defined by FICO scores, underwriting there definitely started to deteriorate as well.

Jacobson: And so what was going on in terms of the way you guys were allocating mortgages back at that point, were your funds investing in non-agency mortgage at the time and if so how were you sort of having to play that?

Whalen: I mean the fund has been investing and the firm, Metropolitan West have been investing in non-agency mortgages through its inception back in 1996, the founding partners Tad Rivelle, Laird Landmann, Stephen Kane, they were investing in mortgages all the way back to PIMCO over 20 years ago. So the firm's founders come with mortgage expertise; the firm has always had a heavy focus in mortgages, obviously increasing, reducing that percentage based upon market opportunities.

Even throughout the course of when we saw the lending, the underwriting terms really start 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'd 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 these are solid, fundamentally sound cash flows where you will get paid back at par and now looking back with over 12 months of hindsight, we were absolutely right, and so it was just a short term dislocation in pricing, not an actual fundamental hit to the value of those bonds.

Jacobson: That kind of brings us a little all the way back to sort of today now. We have had this huge rally, sort of a retracement or rebound in a lot of cases where things were just beaten down horribly last year for all kinds of reasons--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?

Whalen: Sure. I think I have described it as basically rounding second right now, using a baseball analogy, in terms of where we are in this rally. We are approximately half way through where I think eventually we will end up and 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 is leverage just from the broker community.

You can now take a non-agency bond and get reverse repo on it, putting up a haircut, paying a financing rate, but you still can get leverage. So that ... has lifted the whole sector up, but we are not at the point yet really where the market is running a particular bond and expecting fewer defaults on the borrower pool than it did just six months ago. That hasn't happened yet.

I think the market is going to need to see the economy stabilize, housing truly stabilize that it's on its own two feet, not from government programs. Once that happens and people start getting more comfortable, that defaults 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 market is fearing right now. That will really be the second leg of this rally, when prices rise even further. It will be rising based upon fundamentals, not just upon leverage.

Jacobson: Well, that's a good place to stop. Thank you very much for your time Bryan, we appreciate it.

Whalen: You're welcome.

Jacobson: And thank you for joining us. I am Eric Jacobson with Morningstar.

Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.