Subprime mortgages that helped fuel the U.K. housing boom are making a comeback in the bond market even with Prime Minister David Cameron cutting spending by the most since World War II and the jobless rate at a 16-year high.
Credit Suisse Group AG (CSGN) sold bonds backed by more than 340 million pounds ($540 million) of non-conforming home loans last week in the first deal of its type since May, according to data compiled by Bloomberg. Apollo Global Management LLC, which acquired the mortgages in 2010, is using its servicing business Lapithus Group to help collect on the loans and will keep the riskiest part of the transaction, meaning it’s in line for the highest possible returns, according to an investor presentation.
Apollo and the bondholders are betting homeowners will make debt payments as the Bank of England holds rates at a record-low 0.5 percent, while economic growth slows and property prices fall in most of the country. Investors are seeking riskier, higher-yielding securities in Europe and the U.S. after the European Central bank extended more than 1 trillion euros ($1.3 trillion) of loans to banks to avert a credit crunch.
“Even second-row asset-backed bonds like non-conforming are starting to become interesting for investors with huge amounts of cash available in the market,” said Alexander Fagenzer, a fund manager at Union Investment GmbH in Frankfurt which oversees 120 billion euros. “Losses on non-conforming mortgages have been mild so far” and “even though it may get worse, a senior portion is a safe place to bet on that market.”
Banks create residential mortgage-backed bonds by packaging home loans into securities of varying risk and return that are sold to investors.
Senior bonds backed by non-conforming loans are paying 315 basis points, or 3.15 percentage points, more than lending benchmarks, the smallest premium since June, according to data compiled by JPMorgan Chase & Co. The spread has narrowed from 440 basis points in December as investor concern eased that Europe’s debt crisis will destabilize the banking system and from a peak of 1200 in June 2009.
British homebuyers who didn’t qualify for standard mortgages because of a poor credit record or an unreliable income such as the self-employed took out the mortgages, according to the Council of Mortgage Lenders. The market ballooned to about 25 billion pounds in 2006 from 1 billion pounds a decade earlier as home prices rose. The CML estimates that in 2007, mortgages to credit adverse people accounted for as much as six percent of gross mortgage advances.
‘Led to the Crash’
That helped prolong an expansion of home ownership that should have ended in 2005, according to Savills Plc (SVS) residential research director Lucian Cook.
“The free availability of mortgage finance drove the housing cycle for two more years,” Cook said. The growth in non-conforming mortgage lending was “one of the factors that led to the crash,” he said.
Apollo (APO) jumped into the U.K. housing market in 2007 when it paid 1 billion pounds for Countrywide Plc, at the time the U.K.’s largest residential real-estate broker. Prices were rising at the fastest pace in almost four years, according to researcher Hometrack Ltd. That followed its $6.6 billion purchase of Realogy Corp. (3362726Q), which also held the top position in the U.S.
Non-conforming lending, which includes stated income loans in which homeowners weren’t required to document their earnings, has largely dried up. Home prices have retreated 11.6 percent since the U.K. market peaked in November 2007, with the biggest declines, of 20 percent, in the northwest of England, Savills estimated. Prices nationally are forecast to decline 2 percent in 2012, Savills said in a February report.
That’s not dissuading investors from buying mortgage bonds as they grow more confident that the debt is priced to withstand potential declines.
Fitch Ratings forecasts EUR29.1 billion of non-conforming mortgage bonds will have losses of 6.5 percent of their original balance compared with cumulative losses of 25 percent on U.S. subprime bonds issued in 2007.
Delinquencies of more than 90 days on loans packaged inside the bonds declined to 16.7 percent in November 2011 from a peak of 21 percent in June 2009, according to Moody’s Investors Service. Repossessions have declined to 0.9 percent from 3.6 percent in February 2009.
Apollo Buys from GMAC
About 75 percent of Credit Suisse’s Alba 2012-1 transaction is linked to borrowers with interest-only mortgages, 25.9 percent are self-employed and 22.4 percent have self-certified income. More than 11 percent have properties in the northwest of England.
The mortgages were originated by GMAC-RFC, the former financing unit of General Motors Co. that exited the business in 2007 after losses on U.S. subprime mortgage debt infected the global financial system and froze credit markets.
Apollo, led by Chief Executive Officer Leon Black, bought them in 2010 as it scooped up nonperforming loans and mortgages from across Europe as banks collapsed or exited lending.
The New York-based private equity firm now owns 20,000 residential mortgage loans in the U.K., said Marc Rowan, a senior managing director at the Citibank Financial Services Conference in New York on March 8.
It’s a “great market: island, restricted land policy, generally not overbuilt, overpriced,” said Rowan, who cofounded Apollo with Joshua Harris and Black in 1990.
The investment firm can earn percentage returns in the “high teens’ to low 20s without using borrowed money “by buying defaulted mortgages, going through a collection process and selling on the back end,” he said.
Brother of Centaurus
The Alba transaction provides Apollo’s investors with financing linked to the mortgages to potentially increase returns.
Apollo set up Lapithus, the name of a character in Greek mythology who was a son of Apollo and brother of Centaurus, to oversee and collect on loans after raising 1.3 billion euros for its European Principal Finance Fund. Lapithus is directly servicing 54,000 loans secured by more than 19,000 commercial and residential properties, according to an Apollo regulatory filing.
The investment firm, which went public last year, fell 10 cents to $14.32 as of 9:42 a.m. in New York. The shares have declined 25 percent since its initial public offering last year. Black said last month his firm had “miserable” timing for its offering as Europe’s sovereign-debt crisis fueled market volatility.
Raising Second Fund
Charles Zehren, a spokesman for Apollo in New York, declined to comment on Alba or the firm’s investments. Apollo is collecting commitments for a second European non-performing loan fund and raised $200 million by the end of December, the filing shows.
Fitch assigned a ranking of AAA to the safest 180 million pound portion of the Alba transaction, a week before it said Britain risks losing its top investment grade because of its limited ability to deal with shocks.
The U.K. economy will grow 0.45 percent this year, according to the median of 14 forecasts in a Bloomberg survey of economists, down from 0.9 percent last year, as the U.K. government cuts spending to erase by 2017 the bulk of a budget deficit that equals 9 percent of gross domestic product.
U.K. jobless claims rose more than economists forecast in February, and a broader measure of unemployment remained at the highest level in 16 years, according to data released March 14 by the Office for National Statistics in London.
Chancellor of the Exchequer George Osborne will say in the budget this week that Britain will escape recession this year after a strong-than-expected first quarter. While the growth outlook may improve, the Office for Budget Responsibility, the non-partisan body that prepares Osborne’s forecasts, is likely to report little improvement in the labor market.
‘Less Loved Assets’
The top-ranked Alba notes were sold at 95.78 pence on the pound and have a coupon of 225 basis points more than the London interbank offered rate, according to a person with knowledge of the transaction. A 53.6 million pound portion pays 1.5 percent fixed, according to data compiled by Bloomberg.
Renewed interest in non-conforming mortgage bonds is part of increased demand for residential mortgage securities globally after Greece negotiated a debt restructuring and the U.S. economic recovery strengthens.
Investors are “switching to risk on mode” after the sovereign outlook improved, according to Flavio Rusconi, a JPMorgan bond analyst in London. “This is benefiting less loved asset classes, including U.K. non conforming mortgage-backed securities.”