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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. and American International Group Inc. 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, CEO of Old Greenwich, Conn.-based Ellington Financial, said Tuesday 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.”
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 adjustable-rate mortgages, 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% of the option Adjustable-rate mortgage loans that are in bonds are delinquent, according to J.P. Morgan 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% last year, excluding accounting gains, according to data compiled by Bloomberg.
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 who covers real estate investment trusts that invest in mortgages.
The offering followed a Jan. 19 sale by the central bank to Credit Suisse Group AG, 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% to $32.6 billion in the first nine months of 2011, according to regulatory filings. CEO 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, Mr. Benmosche said Wednesday 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,” Mr. 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.”
A spokesman for New York-based AIG declined to comment on this year’s purchases.
Ellington Financial, which is run by hedge-fund manager Michael Vranos’ Ellington Financial Management, 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, 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 said in a telephone interview.
“Risk appetite among the dealers” has increased, said Mr. 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.”
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 adjustable-rate mortgages. 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 Mr. DeGiacinto.
Almost 28.3% 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% in March 2010 as new defaults eased while regulatory probes into foreclosure practices slowed liquidations of bad debt.
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