Derivatives Breaking With Bonds as PrimeX Falls: Credit Markets

Subprime Redux Sought in PrimeX Bond Divergence
PrimeX indexes, used to wager on higher-quality mortgages from before the housing crash that were too large for government backing, reached record lows this month as trading quadrupled. Photographer: Ed Lallo/Bloomberg News

Mortgage derivatives tied to the biggest U.S. home loans are plummeting in a divergence from the underlying bonds as firms from TCW Group Inc. to Wells Fargo & Co. say the credit-default swaps are sending false signals.

PrimeX indexes, used to wager on higher-quality mortgages from before the housing crash that were too large for government backing, reached record lows this month as trading quadrupled. One index tied to fixed-rate debt fell 10.6 percent through yesterday, while the underlying bonds declined less than 1 percent, Markit Group Ltd. and JPMorgan Chase & Co. data show.

Hedge funds that don’t usually trade mortgage debt are piling into PrimeX swaps, seeking the kinds of fortunes that investors earned in 2007 betting against subprime loans, JPMorgan and Barclays Capital analysts said. While the positions are proving profitable because few firms want to take the opposite bets in a volatile market with dealers retrenching, the funds will eventually be proven wrong, TCW’s Bryan Whalen said.

“They’re being either naive or misled,” said Whalen, co-head of mortgage bonds at the Los Angeles-based firm, which oversees $120 billion. “Or, they’re momentum investors thinking they can get on this, push it down and make a quick buck.”

Trading in PrimeX contracts, whose prices move lower as the cost of protection against defaults on so-called jumbo mortgages rises, soared to $1.2 billion in the first week of October, about the same as in all of September, according to Depository Trust & Clearing Corp. data. Volumes for benchmark U.S. investment-grade corporate swaps totaled more than $200 billion.

Not ‘Prescient’

“I don’t view PrimeX as being particularly prescient in terms of what collateral performance will do because I don’t think there’s enough people involved to look at it that way,” said Glenn Schultz, the head of residential-mortgage bond research at Wells Fargo’s securities unit.

Mark Hanson, a consultant to money managers who worked in the mortgage industry as housing boomed, disagreed, saying the drops have come because “you had managers kicking their feet up on the desk and wrongly thinking they’ve got prime mortgages.”

About 12 percent of jumbo mortgages in securities are now at least 60 days delinquent, according to Amherst Securities Group data.

Elsewhere in credit markets, the extra yield investors demand to own company bonds worldwide instead of similar-maturity government debt fell 1 basis point yesterday to 253 basis points, or 2.53 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Spreads have narrowed from 277 on Oct. 4, the widest since July 2009. Yields averaged 4.06 percent.

Default Swaps Fall

A benchmark gauge of U.S. corporate credit risk fell for a second day. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 1 basis point to a mid-price of 131.6 basis points as of 12:13 p.m. in New York, according to Markit Group Ltd.

The index typically declines as investor confidence improves and rises as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

JPMorgan, the largest U.S. bank by assets, plans to sell 10-year notes in a benchmark offering after issuing similar debt in August, according to a person familiar with the transaction.

The offering follows a $1.25 billion sale of the 4.35 percent notes on Aug. 15, said the person, who declined to be identified because terms aren’t set. Benchmark issues are typically at least $500 million.

Bigger Mortgages

PrimeX indexes track U.S. mortgages generally bigger than $417,000 and issued from 2005 through 2007. Net outstanding contracts fell to $3.8 billion on Oct. 7, from $4.1 billion a week earlier, even as trading jumped, DTCC data show. More than $170 billion of prime-jumbo mortgage securities from the same years are outstanding, with bonds from other years totaling more than $81 billion, according to Amherst data.

At least 50 hedge funds placed bets in 2006 and 2007 through so-called ABX and other default swaps against debt tied to subprime borrowers with poor credit or high levels of debt, according to a report from the Financial Crisis Inquiry Commission. John Paulson’s Paulson & Co. made $15 billion wagering on subprime defaults in 2007.

Better Underwriting

“PrimeX isn’t ABX and it isn’t what ABX represented,” said Paul Norris, a senior money manager at Dwight Asset Management Co. in Burlington, Vermont, which manages and advises on more than $50 billion of assets.

Investors shouldn’t view the indexes as indicative of sentiment on prime mortgages smaller than limits for government-backed Fannie Mae and Freddie Mac, which were better underwritten and less concentrated in the states with the biggest home-price booms, Norris said.

“That’s even worse, that’s like apples and bananas,” he said.

The PrimeX market was vulnerable because bond buyers were underestimating the extent of weakness in the underlying mortgages, said Hanson, the San Francisco-based consultant who said he recommended in February that clients pair bearish bets through the swaps and Treasury purchases.

Incomes for about half of PrimeX borrowers weren’t fully documented, between 40 percent and 64 percent of homeowners now owe more than their properties’ values, and much of the debt is interest-only loans with potentially rising payments, he said.

‘Best Case’

Prices for the fixed-rate jumbo-prime securities from 2006 and 2007 tracked by one of the four PrimeX indexes have fallen less than 1 cent on the dollar this month to about 85 cents on average, according to JPMorgan data. The debt, which was originally AAA rated, climbed from a record low of less than 66 cents in May 2009 to start this year at almost 91 cents.

The 87.5 level for that PrimeX index, called FRM.2, means that an investor would need to put up $12.5 million upfront as well as pay an additional $4.5 million a year to wager against $100 million of debt. The index ended 2010 at 102.5.

JPMorgan analysts led by John Sim said in an Oct. 14 report a price that day of 88.5 meant the contracts offered annual leveraged returns to bullish investors of 35.5 percent in their “base case.” That scenario assumes almost 31 percent of the underlying loans default. With 50 percent more defaults, the returns would be 26 percent, they said.

‘Poor Liquidity’

Barclays Capital said in an Oct. 14 report that even at the higher prices earlier this month, PrimeX indexes tied to 2005 loans offered estimated leveraged yields of 8 percent assuming 17 percent declines in national home prices and 14 percent unemployment.

Analysts at both banks said the investors should be prepared for further declines in the indexes.

“Given the poor liquidity, we tend to have a pretty high threshold to get involved,” said Dan Ivascyn, a managing director at Pacific Investment Management Co. in Newport Beach, California, which runs the world’s largest bond fund. “Very few people think on a hold-to-maturity basis, you’re going to lose money.”

The slump is weakening the market for actual jumbo bonds by creating larger disagreements on prices between potential buyers and sellers, Ivascyn said.

Investment banks have scaled back risk-taking and investors such as banks and real estate investment trusts active in the jumbo-bond market are less willing to trade in derivatives for reasons including tax and accounting rules, according to Norris and TCW’s Whalen.

‘Dirty’ Securities

The decline may give investors an excuse to retreat from similar debt or negotiate harder as they seek to buy securities, said Jesse Litvak, a mortgage-bond trader at Jefferies & Co. Right now, “anything that’s clean you can trade, anything that’s dirty it’s very difficult to trade.”

PrimeX swaps could at some point draw TCW from other mortgage bonds, Whalen said, though the firm would rather target investments with steadier values because “there is a price where you’re getting compensating for the volatility and we would move in.”

Hanson, the consultant who said his 20 hedge and mutual fund clients each oversee more than $1 billion, said he isn’t sure whether PrimeX swaps still offer long-term value.

“It all depends going forward on what you believe is going to happen to mid-to-high-end housing and the mid-to-high-end borrower,” he said. “We tend to believe you’re going to see a compression in which the low-end is much more stable and the high end has a long way to go on the way down. If that thesis plays out, PrimeX is a great short.”

Refinancing Concerns

Investors with that view may be surprised because unlike with subprime swaps, the cash required for their trades may climb as some of the underlying homeowners refinance, said Clayton DeGiacinto, chief investment officer of New York-based hedge fund Axonic Capital LLC. That’s a bigger risk “with mortgage rates where they are,” he said, referring to loan costs for the best borrowers hovering near record lows.

It should also provide comfort to default-protection sellers that more than 80 percent of the borrowers have never missed a payment, he said. PrimeX investments offer annual returns of almost 30 percent even in scenarios where home prices drop 20 percent more, according to his calculations.

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