Subprime Bulls Trim Bets as Rally Raises 2011 Specter: Mortgages

A rally in the mortgage securities that blew up in the crash of 2008 is leading firms to trim bets in the $1.1 trillion market for home-loan bonds without government backing after similar gains a year ago evaporated.

Some of the securities are up 12 percent this year, and have been outperforming the Standard & Poor’s 500 stock index, corporate bonds and gold. Western Asset Management Co. and Pine River Capital Management LP have sold after starting 2012 among the most bullish on the debt. In last year’s rally, the notes gained the same amount to peak in February before crashing as Europe’s fiscal crisis curbed risk-taking across markets.

“The memory of what happened after the first quarter of 2011 is still fresh, so the natural instinct is to take some chips off the table after such a strong rally,” said Alex Cha, a partner at hedge fund 400 Capital Management LLC in New York. “Compared to the beginning of the year, all risky assets are more susceptible to re-pricing lower should we start getting macro noise again.”

Investing in non-agency mortgage securities has proven profitable this year after concern eased that Europe’s sovereign debt crisis would spiral out of control, the Federal Reserve sold $19.2 billion of debt underscoring demand and Wall Street banks started adding to inventories after dumping notes in 2011. Bondholders are wary of a repeat of last year’s rout with German Chancellor Angela Merkel this week citing “fragility” in Spain and Portugal and Fed Chairman Ben S. Bernanke saying improvement in the job market may not be sustained.

‘Intense Rally’

Western Asset, which oversees about $443 billion, is paring investments in non-agency securities after “an intense rally,” said Paul Jablansky, co-head of the Pasadena, California-based firm’s mortgage group. The Legg Mason Inc. (LM) unit is replacing the debt with notes such as high-yield corporate bonds, he said.

The firm probably sold more than $1 billion in face value of the securities last week, according to Empirasign Strategies LLC in New York. The provider of information on securitized-debt trading based that assessment on auction lists from dealers and public reports on the firm’s holdings.

Jablansky, who declined to comment on any sales, said the firm continues to hold more non-agency securities than other managers amid signs that housing is nearing a bottom.

“While we think the market is long-term attractive, we’ve taken this opportunity to rebalance a little bit and realize some gains,” Jablansky said in a March 19 telephone interview.

Pine River Reduces

Pine River told investors in its $2.2 billion fixed-income hedge fund in a letter this month that “we have gradually reduced our exposure to lock in gains.”

The Minnetonka, Minnesota-based firm continues to see potential upside, “especially relative to corporate credit,” it said in the letter. Asset-Backed Alert reported the contents on March 23.

Steve Kuhn, the firm’s head of fixed-income trading, declined to comment. It gained 8.5 percent in the first two months of the year with non-agency securities representing its largest investments, according to the letter.

Typical prices for the most-senior bonds tied to option adjustable-rate mortgage rose to 57 cents on the dollar last week from 51 cents in December, according to Barclays Plc data. That compares with 65 cents in February 2011 and the record low of 33 cents in 2009.

Bonds backed by Alt-A ARMs rose to 52 cents on the dollar, from 48 cents in December. That debt had fallen from 68 cents, after rising from 35 cents in 2009. Fixed-rate prime-jumbo bonds climbed to 91 cents from 89 cents, matching last year’s high reached after an advance from 63 cents in 2009.

Flip Properties

Option ARMs allow borrowers to pay less than the interest they owe by increasing their balances. Alt-A loans often went to borrowers who didn’t document pay or planned to flip properties, while jumbo mortgages are larger than allowed in government-backed programs, currently $417,000 in most places.

The S&P 500 gained 11.6 percent this year through last week, assuming reinvested dividends, while U.S. corporate bonds returned 2.9 percent and gold advanced 6.3 percent.

Mortgage debt has climbed even as home prices set new lows since beginning to collapse in 2006. An S&P/Case-Shiller index of property values in 20 cities dropped in January to the lowest since December 2002, down 34.4 percent from July 2006, a report yesterday showed. Recent declines are slowing, pointing to stabilization.

Potential Challenges

Potential challenges loom from several million homes in the “shadow inventory” tied to defaulted or delinquent loans that may be sold, said Youriy Koudinov, a director in structured-finance research at New York-based TIAA-CREF, the $441 billion manager of retirement accounts for employees of non-profits. Mortgage servicers are also increasing their use of principal reductions when reworking loans, which may either damage or benefit bondholders, he said.

While Europe’s debt crisis has been contained after the European Central Bank extended 1 trillion euros ($1.3 trillion) of loans to banks, stresses in the market remain. The three-month London interbank offered rate has held at about 0.47 percent every day in March, after sliding from this year’s high of 0.58 percent on Jan. 3.

“Investors need to be cautious when the market begins to base return expectations on scenarios that may not price in a material probability of adverse-performance outcomes,” Koudinov said. ‘We cannot be focused only on the positives.”

AIG Rescue

This year, those included the Federal Reserve Bank of New York selling assets assumed in its rescue of insurer American International Group Inc. The transactions fetched about $10 billion, according to disclosures by the central bank.

In contrast, the New York Fed last year helped spark a rout in credit markets when it began auctioning off the bonds. The selloff intensified as investor concern grew that Europe’s debt crisis would infect bank balance sheets globally.

Buying and selling in the debt, which seized up last year when investment banks cut inventories amid the sovereign default concern and pending regulatory changes to increase capital, has also revived.

Total trading averaged $3.3 billion per day this year through last week, compared with $1.7 billion in the second half of 2011, according to data reported to regulators and compiled by Empirasign.

Improved liquidity is helping an Apollo Global Management LLC real estate investment trust adjust its holdings.

“We’ve taken advantage of the strong bid provided by the market to upgrade certain of our non-agency positions as we swapped into some bonds with an even more stable profile than what we had owned,” Apollo Residential Mortgage Inc. (AMTG) Chief Executive Officer Michael Commaroto said on a March 7 conference call with analysts.

Adding to Bets

While Neuberger Berman Group LLC’s Tom Sontag has also sold a few individual notes that “had run up in price perhaps a bit too much,” he’s adding to bets on the bonds in most accounts he oversees. The Chicago-based bond manager prefers them to high-yield alternatives such as speculative-grade corporate debt, he said.

“Would you rather buy bonds with an 8 percent yield that takes into account the fact that you are going to have losses, or a 7 percent yield that assumes perfection,” Sontag said. “To me it doesn’t say screaming sell,” he said.

Loss-adjusted yields in “base scenarios” among senior non-agency bonds range from 12 percent for some option ARM debt to 4.5 percent for certain prime-jumbo bonds, according to Bank of America Corp. analysts, who wrote in a March 25 report that “despite our improved expectations for the housing market, we feel that most of the sectors are at or near fair value.”

Yields on government-backed agency mortgage securities average 2.79 percent, with U.S. speculative-grade company debt at 7.2 percent, according to Barclays index data.

MFA Persists

MFA Financial Inc. (MFA), the New York-based REIT that invests in both agency and non-agency mortgage debt, hasn’t changed the mix as a result of the gains in the latter securities, President William Gorin said.

“Even with the change in prices we prefer the non-agency because of the absolute yield differential,” Gorin said in a telephone interview.

Most of the recent selling in the non-agency market has come from mortgage specialists, while much of the interest in purchasing the debt has come from private-equity funds and “yield buyers” such as insurers, 400 Capital’s Cha said.

While Cha declined to comment on his firm’s investments, he said that “on an absolute basis, and certainly on a relative basis, this sector continues to look attractive.”

There’s a “disparity” of approaches being taken by hedge funds that target the debt after the rally, said Troy Gayeski, who helps invest approximately $3 billion of client money in the vehicles as senior portfolio manager at SkyBridge Capital LLC in New York. Many are reducing positions or adding to hedges, such as bets that stocks or corporate bonds will suffer, and are doing so in a “marginal” way, he said.

Others “that are not quite as long are making an argument that the market got demolished last year, and it still has a lot of room to run,” he said.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net; Rob Urban at robprag@bloomberg.net

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