Monday, October 5, 2009

Mortgage-Bond Prices Double From March Lows in Rally

Oct. 5 (Bloomberg) -- U.S. home-loan bonds without government backing ended a third-quarter rally with a week of gains, leaving some securities at prices almost double their March lows.

Typical prices for the most-senior prime-jumbo securities rose 2 cents on the dollar last week to 84 cents, according to Barclays Capital data. Similar bonds backed by Alt-A loans with a few years of fixed rates increased 2 cents to 60 cents. The jumbo bonds are up from about 75 cents three months earlier, while the Alt-A bonds have climbed from 47 cents.

The debt has jumped from 63 cents for the jumbos and 35 cents for Alt-As in mid-March, as investors accept lower potential yields amid a rally across debt markets and traders anticipate demand from the U.S. Public-Private Investment Program. Investment funds, banks, insurers and Wall Street brokers have been among buyers, according to Scott Buchta, head of investment strategy at Guggenheim Capital Markets LLC in Chicago.

“There’s a ton of dollars sloshing around, and the people who are compensated to put those dollars to work have to do something,” David Castillo, a senior managing director at San Francisco-based broker Further Lane Securities, said in a telephone interview. “The great cushion which the market provided for errors in assumptions is almost entirely gone.”

Feeding the Rally

Home-loan securities in the almost $1.7 trillion non-agency market lack guarantees from government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae, and they have been among the largest sources of the $1.6 trillion of writedowns and credit losses reported by the world’s largest financial companies since the start of 2007.

The recent rally has reflected a combination of yield premiums over Treasury debt coming down across credit markets, anticipation of buying by PPIP funds and data suggesting housing is starting to stabilize, according to Tom Hamilton, the head of Barclays Capital’s securitized products trading in New York.

“All those things culminated at once and made for an unbelievable third quarter,” he said in a telephone interview last week.

Sectors benefiting from increased demand for debt also include high-yield, high-risk company loans. Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index has climbed to 85.5 cents on the dollar, from a low of 59.2 cents in December. Investors are seeking higher yields than available in the money markets, accounting for about $300 billion of inflows this year into funds targeting debt such as corporate and municipal notes.

Lull in Foreclosures

Albert Sohn, Credit Suisse Group’s co-head of global structured products, said many investors behind the rally in mortgage bonds are skeptical of signs of a recovery in housing and attribute them to a temporary lull in foreclosures as the government pushes servicers to assess which loans should be reworked.

“It hasn’t necessarily been because suddenly people are expecting performance to become materially better anytime soon,” he said. “In fact, a lot of people who are buying expect performance to continue to deteriorate.”

An S&P/Case-Shiller index for 20 U.S. metropolitan areas showed home values rising in May, June and July, the first increases since 2006. The recovery reduced the average drop from the peak to 30 percent from 33 percent in April. About 28.2 percent of mortgages backing non-agency securities were at least 30 days late in August, up from 19.3 percent a year earlier and 9.6 percent two years earlier, according to Bloomberg data.

Atypical Terms

Jumbo mortgages are larger than Fannie Mae or Freddie Mac can finance, currently $417,000 in most areas and as much as $729,750 in expensive regions. Alt-A mortgages have atypical terms such as proof-of-income waivers or delayed principal repayment, and are ranked between prime and subprime in terms of projected defaults.

The U.S. said in July that the PPIP would begin with nine managers raising as much as $10 billion and receiving as much as $30 billion in taxpayer capital and loans to buy mortgage bonds that were issued with top ratings. The Treasury last week began confirming managers including Invesco Ltd. and TCW Group Inc. have raised at least $500 million, the minimum to get started.

Advantus Capital Management Inc., which oversees about $14 billion, is telling investors as it seeks more cash to buy devalued mortgage bonds they’d be better off with managers like it that aren’t part of the PPIP and thus have more freedom in selecting assets. The marketing underscores PPIP managers’ difficulty immediately raising the maximum amounts allowed and the possibility they may hold back on buying until prices drop.

Performance Goals

PPIP managers Invesco, AllianceBernstein Holding LP and Marathon Asset Management LP have told potential investors they are targeting annual returns of at least 18 percent, according to a Sept. 2 memo by M. Timothy Corbett, chief investment officer of the Connecticut Retirement Plans and Trust Funds.

Amid the higher prices among eligible securities, “the likelihood of generating those types of returns are becoming remote, unless one were to take ever-riskier bets,” Dean Di Bias, high-yield mortgage portfolio manager at St. Paul, Minnesota-based Advantus, said in an interview last month.

While some traders and investors wonder whether PPIP managers will deploy money at current prices, “it would be a pretty bold move to not put any money to work and wait for prices to back up,” Barclays’ Hamilton said. “If they’re pitching investors on something like 20 percent returns, they’re not going to put the money into cash until prices go down.”

Even if they don’t buy much immediately, their need to make purchases will probably limit any declines, he said.

‘Potential Problem’

“Prices have gotten pretty full,” Hamilton said. “We think that market prices have increased to the point of being much closer to the intrinsic value of securities. Against a whole range of other fixed-income assets, though, they still look cheap.”

At the same time, Credit Suisse’s Sohn said, “a unique potential problem for structured products” is that financial companies worldwide are holding “hundreds of billions” of dollars worth of the securities, which still carry a taint from the market’s collapse in 2007 and 2008, and may eventually decide to sell the debt in the market.

Any reverse in the rally may be large, said Adam Schwartz, mortgage portfolio manager in Miami at hedge-fund firm Fir Tree Partners LP. One mistake investors may be making is over- estimating the number of borrowers who will be able to refinance out of loans or sell their houses, he said. Prepayments this year removed many homeowners with equity in their properties from the pool of existing mortgages.

“When people are groping for yield, whenever there’s a negative surprise they react as violently on the way down as they did on the way up,” Schwartz said in an interview last week.

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