Mortgage Bonds Miss Rally as Europe Sales Loom: Credit Markets

Mortgage Bonds Miss Rally as Europe Sales Loom
While construction is improving, home prices around 20 U.S. cities are down 31.3 percent from a 2006 peak, according to an S&P/Case-Shiller index. Photographer: Andrew Harrer/Bloomberg

U.S. mortgage bonds that lack government backing are trading at about the lowest prices in more than a year, even as riskier assets from high-yield company bonds to stocks rally, with investors bracing for sales of home-loan debt by European banks.

A group of prime jumbo-mortgage securities tracked by JPMorgan Chase & Co. as a benchmark fell to 93.3 cents on the dollar this month, the lowest level since August 2010. A set of subprime bonds tumbled to a two-year low of 28.1 cents.

Banks across Europe have pledged to cut more than 950 billion euros ($1.2 trillion) of assets during the next two years, after regulators made them increase core capital to 9 percent by June instead of in 2019, according to data compiled by Bloomberg. Combined with the greater difficulty of trading in the $1.1 trillion market of non-agency mortgage bonds and concern that the U.S. housing market has yet to bottom, the threat of the region’s banks unloading their holdings is helping to depress values.

“The European banks are scrambling for capital and the traditional route” of selling shares isn’t available as investors shun their equity securities, said Reza Ali, who heads Prosiris Capital Management LLC, a New York-based hedge fund that’s gained 10.7 percent since starting in July. “There are big question marks that don’t exist to the same degree for corporate bonds” and structured debt in the U.S. including collateralized loan obligations, aircraft-backed notes and commercial-mortgage securities.

Default Swaps Tumble

Even as European leaders wrestle with resolving their sovereign-debt crisis, economists surveyed by Bloomberg have raised their forecasts for U.S. growth in the current quarter to 2.8 percent from 2.3 percent in November.

That’s bolstered average prices of U.S. speculative-grade company bonds, which climbed 3.5 percent since September, while those for commercial-mortgage securities gained 1.8 percent, Bank of America Merrill Lynch index data show. The Standard & Poor’s 500 stock index advanced 9.7 percent through yesterday.

Elsewhere in credit markets, the extra yield investors demand to hold company bonds worldwide rather than government debentures was unchanged yesterday at 271 basis points, or 2.71 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Average yields were 4.054 percent.

A benchmark gauge of U.S. credit risk held at about the lowest level in a week. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, rose 0.2 basis point to a mid-price of 126.7 basis points as of 11:51 a.m. in New York, according to Markit Group Ltd.

Bondholder Protection

The index typically rises as investor confidence deteriorates and falls as it improves. Credit-default 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.

Endurance International Group Inc.’s $350 million term loan, which backs the acquisition of the company from Accel-KKR Co. by Warburg Pincus LLC and GS Capital Partners, rose in initial trading.

The six-year debt began trading at 99.5 cents on the dollar, according to data provider Markit Ltd. The financing was sold to investors at 98 cents, Bloomberg data show.

Boost Core Capital

Credit Suisse Group AG arranged the deal for Burlington, Massachusetts-based Endurance, Bloomberg data show. The loan pays interest at 6.25 percentage points more than the London interbank offered rate, with a 1.5 percent floor.

The $1.1 trillion market for non-agency residential mortgage bonds is being roiled as European regulators, seeking to stem the region’s sovereign-debt crisis, ordered banks in October to increase core capital to 9 percent of risk-weighted assets by the end of June.

Bond prices had tumbled from April through June as the Federal Reserve attempted to sell $31 billion of the securities acquired in its 2008 rescue of American International Group Inc. The central bank then halted the auctions, citing “prevailing market conditions.”

European banks that may need to sell assets to bolster their capital ratios hold about 169 billion to 249 billion euros of dollar-denominated securitized debt, including more than 60 billion euros of non-agency residential-mortgage securities, Morgan Stanley analysts estimated last month.

Buyers Await

“The linkages between the sovereign crisis in Europe and securitized product markets on both sides of the Atlantic are not as tenuous as they might seem at a first glance, and go well beyond generic risk aversion that the crisis has engendered,” the analysts including Vishwanath Tirupattur in New York wrote in a Nov. 14 report.

Hedge funds Och-Ziff Capital Management Group and Marathon Asset Management LP have said they’re awaiting the opportunity to be buyers.

“The vast majority of assets that have to be sold have not been sold,” Och-Ziff Chief Executive Officer Daniel Och said Dec. 6 at an investor conference in New York.

In the U.S., data is signaling the economy is strengthening. Housing starts increased 9.3 percent to a 685,000 annual rate in November, exceeding the highest estimate of economists surveyed by Bloomberg and the most since April 2010, Commerce Department figures yesterday showed. While construction is improving, home prices around 20 U.S. cities are down 31.3 percent from a 2006 peak, according to an S&P/Case-Shiller index.

‘Products to Off-Load’

The set of fixed-rate prime-jumbo mortgage securities tracked by JPMorgan reached 94.3 cents on the dollar as of Dec. 19, after falling as low as 64.2 cents in November 2008 and compared with this year’s high of 97.2 cents in February. The subprime debt fell to 15.9 cents in April 2009 before soaring to 37.3 cents in April and dropping to 28.4 this week.

Jumbo mortgages are larger than the limits for government supported Fannie Mae and Freddie Mac, currently $417,000 in most places. Subprime home loans went to borrowers with poor or limited credit records.

Marathon CEO Bruce Richards favors non-agency mortgage bonds at the cheaper prices, he told Bloomberg Television on Dec. 1. Later that day, Richards said at the Bloomberg Link Hedge Funds Summit that there will be “tremendous amounts of assets sold” by European banks “in the next one year, two years and many years to come.”

‘Sensitive’ Disposal

In their 2012 outlook reports, analysts at JPMorgan, Barclays Capital and Nomura Securities International Inc. cited the potential supply from European banks’ sales of home-loan bonds as a possible challenge for the market.

European bank sales of non-agency bonds won’t prove problematic, said Bryan Whalen, co-head of mortgage bonds at Los Angeles-based TCW Group Inc. He estimates they will total $10 billion to $15 billion in 2012.

“While that’s not a small number, to date they have been sensitive to the manner in which they dispose of their legacy assets and we don’t expect that to change,” Whalen said. “If that is the case, we believe the market can accommodate the supply without significant weighing on prices.”

He pointed out that Dexia SA, which is now being broken up after running out of short-term funding, said in August it had sold $8.8 billion of mortgage bonds. The market has been lagging behind other risky assets because it has been “abandoned” by traditional investors after credit-rating downgrades, said Whalen, whose firm oversees $120 billion in assets.

‘Large Chasm’

Europe’s banks may delay asset sales as they pursue lawsuits against issuers and underwriters, and because they are sitting on “unrealized losses” on the securities that would undercut the capital relief, the Nomura analysts said in a Dec. 7 report.

“European accounts” exploring potential sales with Further Lane Securities LLC are often finding a “large chasm” between what the bonds can be sold for and the values at which firms hold them on their books, said David Castillo, the San Francisco-based head of sales and trading at the broker.

“Let’s just say their marks are not necessarily on target right now,” he said.

Potential sales may also be depressed because many of the holdings are in “some way guaranteed by the government,” such as with Germany’s Landesbanks or support provided to ING Groep NV by the Netherlands, according to the Barclays Capital analysts.

“Although we estimate that the bulk of non-agency holdings in Europe are in run-down portfolios, even a few distressed sales could push the market lower in this environment,” they wrote in a Nov. 21 report.

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