Investors who made some of the biggest profits from the 2007 bust in U.S. mortgages are once again in agreement. This time, they're going long.
Hedge fund manager Kyle Bass, who made $500 million betting against subprime debt in the crash, is raising a fund to buy home loan securities. He's joining Greg Lippmann, a former Deutsche Bank AG trader, and John Paulson, who made $15 billion in 2007, in betting on default prone mortgages. Goldman Sachs Group Inc. (GS) and American International Group Inc. (AIG) have also emerged as buyers this year as trading more than doubled for non-agency mortgage notes.
The $1.1 trillion market for U.S. mortgage bonds without government-backing is joining a global rally in everything from stocks and commodities to company loans, as confidence grows that Europe's sovereign debt crisis will be contained. Investors are speculating the riskiest mortgage securities are priced to withstand an economic slowdown and home price declines even as President Barack Obama and the Federal Reserve pursue policies to combat the six-year residential real-estate slump.
“You can end up, even using severe assumptions on things such as home prices and defaults, with a very high yield based on the prices that bonds are trading at,” Larry Penn, chief executive officer of Old Greenwich, Connecticut-based Ellington Financial LLC (EFC), said yesterday in a telephone interview. “Especially with interest rates this low, if you can buy something where you can end up with a double-digit yield under severe assumptions, that's great.”
Toxic Debt
Typical prices for the most-senior bonds tied to option adjustable-rate mortgages rose to 55 cents on the dollar last week from 49 cents in November, according to Barclays Capital.
Option ARMs, a type of loan that allowed borrowers to pay less than the monthly interest due with the shortfall added to the balance, were among the “toxic” debt that the Financial Crisis Inquiry Commission said was at the center of the “corrosion of mortgage-lending standards” that helped fuel the housing boom and subsequent bust. About 45 percent of the option ARM loans that are in bonds are delinquent, according to JPMorgan Chase & Co. data.
The rally may help bolster fixed-income trading revenue that fell at the five biggest U.S-based Wall Street banks by more than 20 percent last year, excluding accounting gains, according to data compiled by Bloomberg.
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The debt has previously gained since markets seized up in 2008. Prices rose to 65 cents in February 2011 from a low of 33 cents in 2009. That reversed when the Federal Reserve Bank of New York in April began auctioning off bonds it acquired in the 2008 government rescue of insurer AIG, sparking a rout in credit markets that intensified as investor concern grew that Europe's sovereign debt crisis would infect bank balance sheets globally.
The New York Fed has taken advantage of the recent rally to try again. This time, the Fed switched tactics. After inviting more than 40 broker-dealers to take part in a series of auctions, it asked only a handful of banks to bid on the debt.
Goldman Sachs last week bought $6.2 billion of mortgage bonds from the AIG rescue. It held onto much of that to distribute later to clients at higher prices, regulatory data on trading volumes show.
“That's a pretty strong message that Goldman is sending about not being in a hunkered down mode,” said Steven Delaney, an analyst at San Francisco-based JMP Securities LLC who covers real estate investment trusts that invest in mortgages.
Benmosche Increased Investments
The offering followed a Jan. 19 sale by the central bank to Credit Suisse Group AG (CSGN), which said it immediately resold a “significant” portion of $7 billion of bonds. AIG bought some of the securities from the Zurich-based bank, said people with knowledge of the transactions, who declined to be identified as the buying is private.
AIG's holdings of residential mortgage-backed securities surged 64 percent to $32.6 billion in the first nine months of 2011, according to regulatory filings. Chief Executive Officer Robert Benmosche has increased the holdings as he seeks to boost annual pre-tax investment income by as much as $700 million.
The insurer has participated in the Fed auctions and found other sources of the securities, such as banking institutions looking to reduce risk-weighted assets, Benmosche said today at a conference in New York sponsored by Bank of America Corp. The Fed last year rejected AIG's bid for the entire pool, called Maiden Lane II, before beginning to auction off the assets.
“We got some really good high quality mortgages, higher quality, I should say, than Maiden Lane II,” Benmosche said. “A lot of people think the lion's share of Maiden Lane II is still owned by AIG after the auctions. That is not the case.”
Mark Herr, a spokesman for New York-based AIG, declined to comment on this year's purchases.
Ellington Buys
Ellington Financial LLC, which is run by hedge-fund manager Michael Vranos' Ellington Financial Management LLC, said it bought bonds sold in each of the two Fed auctions.
Trading in non-agency mortgage bonds averaged $15.6 billion per week in the first six periods of this year, compared with $6.6 billion in the final 20 weeks of 2011, according to data reported to regulators and compiled by Empirasign Strategies LLC, a New York-based provider of information on securitization trading.
The securities are bouncing back “almost like a coiled spring,” Clayton DeGiacinto, chief investment officer of hedge fund Axonic Capital LLC said in a telephone interview.
“Risk appetite among the dealers” has increased, said DeGiacinto, a former Goldman Sachs trader whose New York-based firm oversees about $350 million. “A lot of people came in on Wall Street in January and realized they didn't have any inventory.”
Dealer Inventories
Dealers have trimmed their stockpiles of debt including corporate bonds and mortgage securities without government backing to the lowest level in almost a decade, Fed data show. The holdings fell to $43 billion as of the week ended Feb. 1, down from 2011's peak in May of $94.9 billion.
The Fed's portfolio from AIG includes bonds backed by the types of home loans with some of the highest default rates, such as subprime, Alt-A and option ARMs. Those securities, which can be difficult to value, offer a chance for a bigger profit to a savvy investor.
Renewed demand doesn't mean a property rebound is near. Appetite for the non-agency debt is growing because of the potentially high yields rather than any changes in bond buyers' views on housing, said DeGiacinto.
Almost 28.3 percent of home loans pooled in bonds without government backing are at least 60 days delinquent, in foreclosure or already turned into seized property, according to data compiled by Bloomberg. The share has fallen from a record 30.2 percent in March 2010 as new defaults eased while regulatory probes into foreclosure practices slowed liquidations of bad debt.
Bass Generally Bearish
Bass is seeking to raise money for a residential mortgage-backed securities fund, according to two people with knowledge of the plans, who asked not to be identified because the information is private.
“We believe that regulatory changes, rating downgrades and continued bank deleveraging have caused a dislocation between credit fundamentals and prices for many asset-backed securities,” his firm, Hayman Capital Management LP, said in marketing documents.
Bass has remained generally bearish amid mounting concern driven by government deficits. He told overseers of Texas's state university endowment on Feb. 2 that “as every day goes by, I see deflation in the things you own and inflation in the things you need.”
Chris Kirkpatrick, general counsel at Dallas-based Hayman, declined to comment.
‘The Big Short'
Paulson became a billionaire in 2007 by betting against subprime mortgages, a trade that was documented in Michael Lewis's “The Big Short.” He started buying residential and commercial mortgage securities in late 2008 and 2009. Paulson & Co.'s Credit Opportunities Ltd. fund gained 3.5 percent last month after losing 18 percent in 2011, according to an investor letter.
Lippmann, also featured in Lewis's 2010 book after betting against mortgages while at Deutsche Bank, says residential mortgage-backed securities are priced the best for a souring economy compared with other investments. He made $1.5 billion in 2007 and 2008 for the Frankfurt-based lender, according to a U.S. Senate report.
“The product is as cheap to broader markets as it has been in a long time,” Lippmann wrote in a Feb. 10 letter to clients of his hedge fund LibreMax Capital LLC. “Perhaps more importantly, we believe RMBS has potentially less downside to adverse economic scenarios.”
Global Risks
LibreMax, which he co-founded after leaving Deutsche Bank in 2010, has been reducing the hedges used to balance the risks of the residential debt that accounts for about two-thirds of his holdings, he said.
While Lippmann wrote he was “heartened by the recent string of largely positive U.S. economic data,” he's “wary of a second-half slowdown amid continuing global risks.” His New York-based firm, which oversees $1.1 billion, is forecasting a 6 percent decline in home prices from January through April 2013.
Bonds backed by so-called Alt-A mortgages, which fall between prime and subprime in terms of projected defaults, offer yields of more than 7 percent “to stressed scenarios,” according to JPMorgan analysts led by John Sim.
Losses on the underlying loans total 10.3 percent of the original balances so far, with 30 percent of remaining borrowers delinquent, the bank's data show. In a “severely negative” outcome, where home prices decline 10.7 percent, 55.3 percent of the existing borrowers will default, leaving investors with cumulative losses of 21.8 percent, the analysts forecast.
CQS, Cerberus Raising Funds
The S&P/Case-Shiller index of property values in 20 cities declined 3.7 percent in November from a year earlier, compared with the 3.3 percent drop projected by economists. Values are down almost 33 percent from a July 2006 peak.
Other firms that have started funds include CQS U.K. LLP, the $11.2 billion money-management firm run by Michael Hintze in London. Its CQS ABS Alpha Fund, run by Alistair Lumsden, started this month with $140 million, according to a Feb. 2 letter sent to clients. Cerberus Capital Management LP raised $800 million for an RMBS Opportunities Fund, according to a person familiar with the matter.
‘Lottery Ticket'
Recent gains mean residential debt no longer offers “double-digit” returns, Bill Roth, co-chief investment officer of Two Harbors Investment Corp. (TWO), said on a Feb. 8 conference call with analysts. Two Harbors is a publicly traded REIT run by hedge-fund firm Pine River Capital Management LP; both have said they've been buying subprime debt
“Still, if you compare it to almost anything else that's available -- in an interest rate environment where the 10-year Treasury is below 2 percent, and most other fixed income assets yield 6 percent or less -- yields of 7 percent, 8 percent, 9 percent are still appealing,” Roth said.
That's not even taking into account the “free lottery ticket” given by President Barack Obama's legislation that would enable refinancing of borrowers into government-backed loans, which has been given small odds of passing Congress, said Tom Siering, CEO at Two Harbors and a partner at Pine River.
The bounce in prices may not directly help lenders. While the five biggest U.S. banks held about $115 billion in mortgage securities without government-backing as of Sept. 30, the most- recent regulatory data available, changes in their values mostly don't turn up in the lenders' earnings because of their accounting policies.
Higher prices do mean it's more likely that U.S. banks can sell off bonds if they want to restructure their portfolios, said Marty Mosby, an analyst at Guggenheim Securities LLC in Memphis, Tennessee.
Strong Reception
Barclays Capital analysts led by Ajay Rajadhyaksha said in a Feb. 10 report the strong reception to the Fed's sales may also “entice” European banks into attempting to offload debt, a move that could set the market back.
U.S. banks hold $780 billion of delinquent first mortgages, with $124 billion of that amount representing borrowing above the value of the homes serving as collateral, according to data from the JPMorgan analysts.
Banks' mortgage losses are “going to improve relative to what they were last year and remain elevated compared to historic norms” at least through 2013 because of borrowers' negative equity and loan modifications, Mosby said. That means charge-offs of about 1 percent, about double the typical rate.
For all the gains in the market, issuance may not be any closer to reviving. Less than $1.5 billion of new U.S. mortgages have been packaged into securities without government backing since mid-2008, compared with the record of about $1.2 trillion in each of 2005 and 2006.
That's part of the downside of all the cheap bonds. Buying and securitizing new loans just doesn't look attractive yet in comparison, according to Siering.
--Bloomberg News--
