Narula's Metacapital Sees Risk in Mortgage Bonds After 28% Gain in Fund
July 29 (Bloomberg) -- Rick Sharga, senior vice president for marketing at RealtyTrac Inc., talks with Bloomberg's Mark Crumpton about U.S. foreclosure filings. Foreclosures climbed in three-quarters of U.S. metropolitan areas in the first half as high unemployment left many homeowners unable to pay their mortgages, according to the Irvine, California-based mortgage-data company. (Source: Bloomberg)
Metacapital Management LP, the hedge-fund firm run by former Lehman Brothers Holdings Inc. mortgage-bond trader Deepak Narula, returned 28 percent in the first half of this year, boosted by government-backed debt that benefits from limited homeowner refinancing.
Now the New York-based firm is seeking to protect against one of the “biggest” risks in the $5.2 trillion market for agency mortgage bonds, Narula wrote in a July 22 letter to investors. That’s the potential for the U.S. to boost refinancing amid record-low loan rates by changing the rules at taxpayer-supported Fannie Mae and Freddie Mac, he wrote.
Homeowners with $2 trillion of debt would save $40 billion to $50 billion annually with a “one-time amnesty,” Narula, 47, said in the letter. The “only losers,” if all Fannie Mae and Freddie Mac loans could be refinanced, “are the security holders of mortgages that are paying above market interest rates,” he wrote.
Certain mortgage bonds tumbled early today by the most relative to Treasuries since March on concern that refinancing trends may change. Fannie Mae-guaranteed 6.5 percent mortgage securities, containing loans with average rates of about 7 percent, were underperforming Treasuries by 0.09 cent on the dollar as of 3 p.m. in New York, paring an earlier relative drop of 0.24 cent, after climbing to a record 109.94 cents two days ago, according to data compiled by Bloomberg.
‘Slam Dunk’
Morgan Stanley economist David Greenlaw said this week that changing refinancing rules would be “slam dunk stimulus,” estimating the consumer savings at $46 billion in a July 27 report.
Other analysts called the move unlikely. Credit Suisse Group analysts led by Mahesh Swaminathan said in a report today that “forget a ‘slam dunk,’ a government induced refinancing spike is not even a ‘layup’” because of “logistical challenges” and because creating hundreds of billions of dollars of new bonds trading close to par would raise yields.
It “would result in more indigestion than the government can stand,” because the new debt would also boost Treasury yields and such refinancing would cost Fannie Mae and Freddie Mac about $30 billion on their own securities holdings, Citigroup analysts led by Brett Rose said today in a report.
‘Double Dip’
Yields on current-coupon mortgage bonds may end up being “a lot lower” than some investors expect if changes in refinancing rules came amid a “double dip” in the economy that created demand for debt with limited credit risk, though rates would still rise, Nomura Securities International strategists led by Ohmsatya Ravi wrote today in a note to clients. The current-coupon bonds most affect loan rates because they trade closest to par.
The strategists estimated the odds of refinancing changes being enacted at 10 percent if the U.S. doesn’t fall back into a recession and 30 percent if it does. Most of the losses at Fannie Mae and Freddie Mac in their portfolios “should be offset by the improved credit performance of the mortgages they guarantee,” they said.
Narula’s Mortgage Opportunities Master fund, begun after he decided to unwind his first fund during the start of the financial crisis that later bankrupted his former firm, gained 14 percent last quarter, Metacapital said. The firm added to its 2009 gain of 125 percent while hedge funds suffered their worst second quarter since 2000.
Narula confirmed his letter, which said the fund began in 2008, and declined to comment further. The fund’s assets rose more than $100 million during the period to $150 million, the letter said.
Missed Target
In February 2009, the U.S. announced an initiative called the Home Affordable Refinance Program, which created 291,600 loans through March, compared with a target of 4 million to 5 million, according to data from the Federal Housing Finance Agency.
The program is meant to aid consumers, and cut Fannie Mae and Freddie Mac’s losses, by allowing more refinancing among borrowers whose loans approach or exceed their properties’ values and who haven’t missed payments, if the companies already own or guarantee their debt.
Narula, who joined Lehman Brothers as a mortgage-bond analyst in 1989 and eventually headed its strategy group, moved into trading in 1995, according to information posted on a conference website. From 1997 to 2000, he ran two of the mortgage-bond trading desks at the company, which collapsed in 2008. He founded Metacapital in 2001.
Inverse IOs
In the first half of this year, hedge funds lost 1.2 percent, declining 2.8 percent in the three months through June, according to Hedge Fund Research’s HFRX Global Hedge Fund Index. Investments in so-called inverse interest-only slices of collateralized mortgage obligations, known as inverse IOs, and trading in other IOs helped drive Metacapital’s gains last quarter, according to its letter.
Inverse IOs are a type of CMO tranche offering payments that move in the opposite direction of short-term benchmark rates for as long as the underlying loan balances remain outstanding, meaning bond prepayments can hurt holders.
Investors this year lost an average 24 percent on Trust IOs, another type of interest-only note, amid Fannie Mae and Freddie Mac’s purchases of delinquent debt from their bonds and declines in rates that investors can hedge against, according to Bank of America Merrill Lynch index data. Metacapital’s letter said that it traded in and out of Trust IOs, buying during “volatility and risk aversion” in May and then paring positions.
HARP Targets
The Home Affordable Refinance Program was first geared toward borrowers who owed up to 5 percent more than their homes’ worth, and later 25 percent. While refinancing applications have climbed this year, they remain 45 percent below a January 2009 peak even as 30-year loan rates hover at the lowest on record, according to the Mortgage Bankers Association.
Lenders are wary of refinancing mortgages under HARP because they must make their usual representations to Fannie Mae and Freddie Mac about the new debt’s quality, JPMorgan Chase & Co. analysts led by Matt Jozoff wrote in a July 16 report. Those types of promises are forcing originators to repurchase a soaring amount of defaulted loans made during the boom as faulty appraisals, inflated borrower incomes or missing documentation are discovered.
Some borrowers also need home-equity lenders to agree to allow the loans to be replaced, and many homeowners may not qualify because their debt-to-income ratios are too high, the analysts said. Fannie Mae and Freddie Mac also continue to charge their typical extra fees for borrowers with worse credit.
Corinne Russell, a spokeswoman for the Federal Housing Finance Agency, their regulator, and Janis Smith, a spokeswoman for Washington-based Fannie Mae, declined to comment.
Refi Risk
Freddie Mac, based in McLean, Virginia, has refinanced $448 billion in loans since the start of 2009, creating $5.1 billion in annual cost savings for 2.1 million families, including $57 billion under HARP, Brad German, a spokesman, said in an e-mail.
The possibility of “a ‘heroic’ attempt to get refis going” is a risk that investors need to consider amid record- high prices for certain mortgage bonds, the JPMorgan analysts said. “At this point, with housing having bottomed locally, we believe the probability of an extreme policy move is low.”
Metacapital is girding for new Fannie Mae and Freddie Mac rules by adding lower-coupon mortgage bonds as hedges and focusing on IOs created out of Ginnie Mae securities, whose underlying Federal Housing Administration loans already allow for “streamlined” refinancing, as well as IOs that are part of non-agency securitizations, according to its letter.
Faster-than-anticipated prepayments on mortgage bonds trading for more than face value punish investors by returning their cash more quickly at par, rather than offering higher coupon payments for a greater period.
To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net
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