Investors have regained their taste for “toxic” mortgage debt. Securities related to subprime and other risky home loans that were at the heart of the 2008-09 financial crisis have embarked on an unexpected bull run.
This stellar performance has divided analysts. Some argue that an improving US economy and the steep fall in the price of these securities last year leaves plenty of room for further gains.
Last week, Goldman Sachs beat four other banks in an auction for a slice of these securities owned by the Federal Reserve Bank of New York as part of the 2008 bail-out of insurer AIG. Real estate investment trusts have been raising funds to invest in this corner of the market.
Others warn, though, that the market for this type of debt is vulnerable to another bout of risk aversion, especially if the eurozone crisis intensifies or the US economy slows sharply.
There is also uncertainty over possible losses on individual bonds. Investors are trying to sort out the ramifications of a settlement, potentially amounting to $40bn, between state prosecutors and banks over allegations of abusive foreclosure practices, which provides for writedowns of principal amounts on underlying home loans.
But the bigger question is whether this bull run can reinvigorate the market for fresh securitisation of home loans, seen as crucial if the housing market is to turn and help sustain a US recovery.
For now, many investors are willing to buy into the asset class in the hope of high returns. “The yield advantage of non-agency market is very attractive for a lot of investors,” says Chris Flanagan, mortgage-backed securities strategist at Bank of America Merrill Lynch. “The value proposition is much better than it was a year ago, with so much policy support from central banks.”
Yields on these securities, some in the low double digits, look attractive when 10-year US Treasuries are yielding 2 per cent and junk bonds are paying just over 7 per cent. Indeed, a version of the ABX index for debt structured at the height of the credit boom in 2006 – considered a proxy for subprime debt – has risen 22 per cent this year, according to Markit, which owns the index.
Some investors say prices on subprime debt, which trades at a discount to par, are low enough to sop up potential losses from the underlying loans. “There are no bad bonds, just bad prices,” says one banker at a large Wall Street group. “It was stupid at 100 cents on the dollar, but it makes sense at 50.”
For all the bullish sentiment, there is scepticism too. Should the wider global rally in risky assets go into reverse, subprime is likely to be swept up in any selling, while the outlook on potential losses related to individual bonds may worsen. “Idiosyncratic risk affects subprime more than any other sector,” says Paul Norris, portfolio manager at Dwight Asset Management.
As well as the foreclosure settlement, the US government will implement other principal forgiveness programmes to try to help the estimate 11m homeowners who are “underwater” on their mortgages – owe more on their mortgages than their home is worth – following the one-third slide in property prices since 2006.
Some officials favour more widespread but limited initiatives on principal forgiveness, and that adds to uncertainty for bondholders. Investors are worried, too, that banks were holding back from seizing homes before the settlement. Now a settlement has been reached, a jump in foreclosures could follow.
Regardless of whether the rally continues, strategists are doubtful that it will translate into much fresh issuance of private label mortgage debt, the non-agency bundles of mortgages not backed by government agencies such as Fannie Mae and Freddie Mac. There have been only five deals in this market since the financial crisis.
“There are still tons of hurdles to be cleared for a robust securitisation market to come back,” says Chandrajit Bhattacharya, a strategist at Credit Suisse.
One of the biggest obstacles is that new regulations on the structure of future securitised debt deals still need to be ironed out. Investors will need to believe strongly in subprime for prices to gain another 20 per cent.
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