Can An ETF Save The World?

January 30, 2009

Maybe, if it's one of the new mortgage-backed security ETFs coming from PowerShares.

These have to be the most exciting ETF filings to hit the Securities and Exchange Commission in years.

In case you missed the story, PowerShares filed to launch two new ETFs targeting the MBS market. Unlike other MBS ETFs, these products will not buy mortgages underwritten by federal agencies like Fannie Mae and Ginnie Mae. Those mortgages come with either an explicit or implicit federal guarantee, and are as boring as dirt.

Instead, the PowerShares ETFs will buy so-called "non-agency securities": MBSs that don't have the backing of the federal government. These are the securities that we read about in the papers; the ones that are illiquid and difficult to price, and that are causing banks so many problems.

The PowerShares ETFs will be available in two flavors: Prime, focused on mortgages backed by good credit; and Alt-A, which are backed by weaker credits.

PowerShares CEO Bruce Bond minced no words in the press release announcing the filing. 

"We believe that various economic factors have converged to push the prices of many Prime and Alt-A residential mortgage-backed securities well below their fundamental values," said Bruce Bond, president and CEO of Invesco PowerShares. "We are hopeful that these ETFs will provide access and transparency into these markets along with some of the much needed additional liquidity originally intended by the TARP."

The quote is a great one, and surprising.

In the first half, Bond comes straight out and says that he thinks this market is fundamentally undervalued. By proxy, he's saying these ETFs will be great buys when they come to market. I happen to agree with him, but it's rare to see such direct language coming from a product issuer.

The second half of the quote is even more interesting: Bond suggests that these ETFs, if successful, could actually help financial recovery efforts by providing liquidity and transparency into the frozen MBS market.

I happen to agree with him here, too. The biggest problem with these markets is that they haven't been functioning properly. Liquidity has disappeared, price discovery has halted and banks have had to guess at the value of these securities. There's been a buyer's strike, as all the people who could bid on these securities—institutions, hedge funds, etc.—have been locked out of the market because they faced massive deleveraging and have no capital to put at risk.

Now, people like me—people who have been watching this market from the sidelines—will have the means to jump in, add liquidity, provide price discovery and make a market. It's a beautiful thing.

There is a risk here: Many investors do not understand how the MBS market works, and may not understand where these ETFs fit in a portfolio. PowerShares has a duty to provide education and research into the MBS space so that investors and advisors can understand what they are buying. But assuming they do that, these ETFs strike me as a home run.



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