Billionaire Paulson Persists With Property
Paulson, who made $15 billion in 2007 betting against U.S. subprime mortgages, is sticking with bullish investments in residential and commercial mortgage securities, helping his Credit Opportunities Ltd. fund gain about 1 percent last quarter to narrow its 2011 decline to 18 percent.
Renewed demand is helping to fuel a rebound that’s allowing the Federal Reserve Bank of New York to attract buyers for bonds it took over during the rescue of American International Group Inc. (AIG) in 2008. It dropped efforts in June to sell that debt after sending prices tumbling in credit markets. Neuberger Berman Group LLC, Pine River Capital Management LP and Metacapital Management LP also see value in the $1.1 trillion market for non-agency debt, or home-loan bonds without government backing.
“Investors can make attractive returns without any improvement in the economic landscape,” said Troy Gayeski, who helps invest $3 billion of client money in hedge funds at SkyBridge Capital LLC in New York. “It’s the second-most compelling opportunity for hedge funds by far,” trailing only speculation on the pace of repayments in mortgage securities backed by the U.S. government.
One benchmark gauge of commercial-mortgage debt has jumped 6.6 cents to 63.2 cents on the dollar this year, up from 46.6 in October, and subprime residential bonds are poised for a third month of gains, according to Markit Group Ltd. and Barclays Capital data.
Buyer Approached Fed
Some mortgage securities slumped more than 30 percent from first-quarter highs after the Fed sold about $10 billion in face value of debt once owned by New York-based insurer AIG, Wall Street dealers curbed risk-taking and Europe’s fiscal crisis roiled markets.
Goldman Sachs Group Inc. approached the Fed to buy a block of the AIG-related debt, prompting the central bank to weigh an auction for about $7 billion of the securities, three people familiar with the matter said. Goldman Sachs may have sought the bonds for itself or clients, the people said, who declined to be identified because the deliberations are private. The assets, held by a vehicle called Maiden Lane II, had dwindled to about $21 billion when the auctions were halted.
Michael DuVally, a spokesman for New York-based Goldman Sachs, declined to comment, as did the New York Fed’s Jack Gutt and Mark Herr of AIG. The Wall Street Journal reported yesterday Goldman Sachs’s bid.
While non-agency securities may fall further if Europe’s banks need to sell assets, in “a doomsday scenario” of home prices declining as much as 30 percent and unemployment reaching 20 percent, the bonds are priced so low an investor could probably avoid losses by holding to maturity, Gayeski said.
Home prices will drop 1 percent in 2012, according to a forecast by Freddie Mac, which along with Fannie Mae and Ginnie Mae guarantee so-called agency mortgage bonds with government backing. An S&P/Case-Shiller index of values in 20 cities slid 3.4 percent in the year through October to 32 percent below its 2006 peak. Unemployment fell to 8.5 percent in December, the least since February 2009, from 10 percent that year.
Paulson, 56, started buying top-rated residential debt in late 2008 and similar commercial-mortgage bonds around April 2009. His credit fund, which also invests in high-yield, high- risk corporate bonds and loans, gained 591 percent in 2007 on bets against subprime mortgages. It returned 20 percent in 2010 and hadn’t posted a losing year since inception in 2006.
“While the housing market continues to face some weakness, the recent correction in MBS prices has been more severe than justified by underlying real estate market fundamentals,” Paulson said in an October investor letter, a copy of which was obtained by Bloomberg News. “This creates an opportunity to benefit from very attractive yields on both” residential and commercial mortgage securities.
Paulson & Co.’s credit funds owned at least $2.4 billion of mortgage-backed securities on a “notional” basis in the third quarter, or at least 20 percent of its holdings, according to data in the letter. Notional typically refers to the face value of bonds or bets in derivative markets.
Paulson is persisting with the wager, according to a person with knowledge of the fund, who asked not to be named because the information is private. A spokesman for the $28 billion hedge fund in New York declined to comment.
Paulson’s Advantage Plus fund, one of his largest, slumped 51 percent last year as bets on a U.S. economic recovery backfired and banks declined. The fund had lost 46 percent through the end of September.
Tom Sontag, a money manager in Chicago at Neuberger Berman, which oversees about $183 billion in assets, added non-agency securities to some of his portfolios in late November and December, focusing on subprime bonds.
“The sector is one of the most attractive out there,” he said. The market fell more than other securities for “specific technical factors” such as the Fed’s auctions and regulatory changes that will boost how much capital dealers will need to hold against low-rated debt, which spurred sales, he said.
Top-ranked subprime-mortgage bonds from 2005 through 2007, the years with the worst loans, declined 8.8 percent on average from March through October, according to a Barclays Capital index. Some lost 21 percent in 2011, JPMorgan Chase & Co. estimates.
Subprime bonds, which gained 25.6 percent in 2010, returned 1 percent since the end of October, Barclays data show. Typical prices of top-ranked securities tied to so-called Alt-A (BBMDA60P) adjustable-rate loans were unchanged in the month ended Jan. 4, after falling to 48 cents on the dollar from 68 cents in February.
Paulson referred to prices on Alt-A debt, which falls between prime and subprime, in his October letter.
More than 28 percent of home loans underlying non-agency securities are at least 60 days delinquent, near the record 30.2 percent reached in March 2010, according to data compiled by Bloomberg, after loan servicers slowed liquidations in response to foreclosure-document errors and new defaults eased. First- time defaults fell last month to an annual pace of 9.8 percent, from 12 percent a year earlier, Amherst Securities Group LP data show. Improvement since early 2009, when the rate exceeded 25 percent, is slowing as unemployment remains elevated.
The CMBX.NA.AJ.4, tied to classes of originally AAA rated commercial debt most exposed to losses, has jumped 16.6 cents to 63.2 cents on the dollar since Oct. 18, after dropping from 84.8 in February, according to Markit, the index administrator.
Investment Grade Ratings
Commercial-mortgage debt is beating residential because more securities tied to offices, shopping malls and skyscrapers retain investment-grade ratings, said Steven Delaney, an equity analyst at JMP Securities LLC who covers real estate investment trusts. That widens the pool of potential investors, he said.
Non-agency securities are more attractive to investors able to hold them to maturity than high-yield corporate debt because they’re better priced to withstand an economic slowdown, said Pacific Investment Management Co.’s Dan Ivascyn, who manages the $6.5 billion Pimco Income Fund (PIMIX) in Newport Beach, California.
“Most market participants think this sector is cheap versus other credit that’s rallied a bit,” said Ivascyn, who also helps run Pimco’s private funds that target mortgage debt. “The key is, we’re talking about on hold-to-maturity basis, because if you have a major macro shock in the meantime, they can trade down a lot.”
The securities generally offer “high-single digit” yields even in a scenario where homes prices decline 10 percent, he said.
Subprime debt offers yields of 12 percent to 13 percent assuming 80 percent of the underlying borrowers default with recoveries of 25 percent, saidSteve Kuhn, head of fixed-income trading at Minnetonka, Minnesota-based Pine River Capital, on Bloomberg Television on Dec. 13. The firm oversees $5.4 billion.
High-yield company bonds, ranked below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s, are yielding 8.3 percent after declining from 10.2 percent in October, according to Bank of America Merrill Lynch index data.
Metacapital, whose almost $900 million mortgage-focused hedge fund returned about 23 percent in 2011, is looking for opportunities in non-agency securities after last year remaining “very light in the sector,” said Deepak Narula, the New York- based firm’s head. The bonds “have cheapened to more reasonable levels” and offer diversification to bets on refinancing, he said.
Mortgage bonds have a higher risk of price declines when there are sellers than corporate securities because fewer investors have the tools to evaluate them, Ivascyn said.
European banks that may need to sell assets to bolster capital hold as much as 249 billion euros ($319 billion) of dollar-denominated securitized debt, including more than 60 billion euros of non-agency securities and as much as 21.7 billion euro of commercial mortgage bonds, Morgan Stanley estimated in a November report.
Wall Street’s reluctance to carry inventories also means that investors who want to sell may need to accept discounts, said Jason Callan, head of structured products at Minneapolis- based Columbia Management Investment Advisers LLC.
Columbia, which oversees $170 billion in fixed-income, has generally eschewed riskier types of housing debt in favor of bonds backed by large prime mortgages issued before 2006, in part because of concerns that liquidity is limited, Callan said.
Limited trading may prove a boon, Neuberger’s Sontag said.
“If there’s demand for this stuff, if people get hungry for yield in this world of near-zero rates, we could see prices gap upward,” he said. “Because there aren’t a lot of guys who want to part with bonds carrying yields in the mid-to-low teens.”
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