Subprime Rally Building as Dealers Sop Up Supply: Credit Markets

Subprime Rally Building as Dealers Sop Up Supply
While U.S. property values have gained before for short periods during their six-year slump, prices in 20 large U.S. metropolitan areas rose 1.3 percent in April from the previous month, according to the most recent S&P/Case-Shiller index data. Photographer: Daniel Acker/Bloomberg

The rally in U.S. home-loan securities without government backing is accelerating as investors wager the housing bust is over and supply is sopped up by bond dealers emboldened by new capital rules.

Gains on subprime-mortgage bonds from 2005 through 2007, the years that produced the most defaults leading to the worst financial crisis since the Great Depression, have soared to 5.4 percent in July, bringing returns for the year through last week to 21.6 percent, according to Barclays Plc data. Securities backed by option adjustable-rate mortgages jumped over the past month by 7 percent to the highest level since May 2011.

Investors faced with benchmark interest rates at record lows are seeking mortgage securities after a 35 percent decline in home prices from the peak in 2006. Wall Street banks are also adding to inventories after regulatory changes in June. As Citigroup Inc. warns prices may drop if dealers can’t place the holdings, daily trading volumes surged almost 40 percent last week, reaching the highest this year by one measure.

“There’s been a lot of investors waiting on the sidelines until home prices stabilize and now that they have, they’re moving in,” said Adam Yarnold, managing director of securitized products trading in New York at Barclays’s investment-banking arm. In addition, “the absolute low level of rates out there is driving institutional investors like pension funds to put money into anything with” returns that can top 7.5 percent and so-called non-agency securities offer that potential, he said.

Less Capital

The Federal Reserve and other regulators last month ended the use of credit ratings in calculations of how much capital Wall Street traders must hold against securitized debt. That’s allowing them to hold less for speculative-grade debt, helping the $1 trillion market manage greater sales.

Dealers added $3.5 billion of non-agency securities to their inventories last week, based on regulatory data. That compares with $4.5 billion for the rest of 2012 and sales of $18.1 billion in the final seven months of last year.

“While the market has shown resilience in the face of large supply, we would be cautious,” Citigroup analysts including Tanuj Garg wrote in a July 20 report. “Yields are at the tightest levels in the past two years, and the prices could pull back if dealers are unable to place their increased inventory.”

FedEx Bonds

Elsewhere in credit markets, FedEx Corp. plans to raise $1 billion in a two-part offering, including its first 30-year bond in more than two decades. The world’s largest cargo airline will sell 10-year notes and obligations due in 2042 to fund working capital and general corporate purposes, the Memphis, Tennessee-based company said today in a regulatory filing. FedEx last sold 30-year bonds in 1989, issuing $100 million of 9.625 percent debt that was called in 2000, according to data compiled by Bloomberg.

The cost of protecting corporate bonds in the U.S. from default rose for a third day, with the Markit CDX North America Investment-Grade index, which investors use to hedge against losses or to speculate on creditworthiness, increasing 1.9 basis points to a mid-price of 115.3 basis points as of 11:08 a.m. in New York, according to prices compiled by Bloomberg.

The index, trading at the highest on an intra-day basis since June 29, 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.

General Electric

Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 61 trades of $1 million or more as of 11:09 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Investors in mortgage bonds are gaining confidence the housing market has reached a bottom, in part because of a surge in money devoted to buying and renting out foreclosed homes, Barclays’s Yarnold said.

While U.S. property values have gained before for short periods during their six-year slump, prices in 20 large U.S. metropolitan areas rose 1.3 percent in April from the previous month, after a 35 percent plunge from July 2006, according to the most recent S&P/Case-Shiller index data.

Option ARMs

Values nationwide rose 1.8 percent in May, the third straight monthly gain, according to real-estate data firm CoreLogic Inc. in Santa Ana, California. Still, sales of previously owned U.S. homes unexpectedly declined in June to an eight-month low, slumping 5.4 percent to a 4.37 million annual rate, the National Association of Realtors said July 19.

Typical prices for the most-senior bonds tied to option ARMs rose to 60 cents on the dollar, gaining 2 cents from the previous week and 4 cents from a month earlier, Barclays data show. Option ARMs can allow borrowers to pay less than the interest they owed by increasing their balances.

Prices have been volatile. After reaching a record low 33 cents in 2009, the bonds soared to 65 cents in February 2011 before slumping to 49 cents last October, roiled by a sovereign-debt crisis in Europe, prior Fed sales and dealer retreats.

Subprime-mortgage securities lost an average 5.5 percent last year, Barclays index data show. Some of the debt fell as much as 30 percent from early 2011 peaks. Record defaults on subprime loans, which went to borrowers with poor credit or high levels of debt, sent bond prices tumbling and helped spark the financial crisis that led to $1.6 trillion in writedowns and losses at the world’s biggest banks.

‘Top End’

Asset managers including D.E. Shaw & Co., Cerberus Capital Management LP, Canyon Partners LLC and Goldman Sachs Group Inc. started funds during the past year targeting non-agency debt, spurred by its 2011 collapse, bullishness on housing or predictions of forced selling by European banks.

Sellers of the debt have less optimistic views on housing or have “held these securities for a while and think they’re at the top end of their range,” Yarnold said.

Daily trading of non-agency mortgage bonds of $3.4 billion last week compares with an average of $2.5 billion for 2012, according to data reported to the Trace system and compiled by Empirasign Strategies LLC. The debt lacks guarantees from government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae.

Trading volumes were bolstered in January and February as the Fed sold $19.2 billion of securities assumed in its 2008 rescue of American International Group Inc. Subsequent auctions of debt once held by the New York-based insurer have focused on so-called collateralized debt obligations that repackaged mortgage bonds.

‘Strong’ Recovery

Dealers circulated 278 lists of non-agency securities last week in auctions for investors known as “bids wanted in competition,” totaling $21.3 billion in face value, the largest amount of debt and fourth-most lists this year, according to New York-based Empirasign, a provider of trading information.

Non-agency bonds’ recent performance “has been strong, but we think there are solid fundamental and technical trends underlying the market so we don’t see it weakening substantially in the near term,” said Jim Shallcross, a money manager at Metacapital Management LLC. The New York-based firm returned 19.3 percent in its main, mortgage-focused hedge fund in the first half, newsletter Asset-Backed Alert reported.

U.S. homebuilders are an attractive investment as housing starts a “strong” recovery that may drive a surge in new-home sales, Goldman Sachs said yesterday in a report.

Subprime bonds with projected average lives of seven years or more are yielding 7.5 percent including anticipated losses, according to JPMorgan data. That compares with 7.1 percent for high-yield company bonds before accounting for defaults, Bank of America Merrill Lynch index data show.

‘Little Frothy’

The share of securitized non-agency loans defaulting for the first time fell to a 7.7 percent annual pace in June, from 9.8 percent a year earlier and a record of more than 25 percent in 2009, according to Amherst Securities Group data.

The size of the recent bond gains “makes little sense” because “a bottoming in housing this year has already been baked in,” John Sim, an analyst at JPMorgan, said in a July 20 report. Based on current assumptions, much of the non-agency market is offering loss-adjusted yields of about 5 percent.

“Valuations are looking a little frothy,” Sim wrote. Still, “with continued talk of entering into a negative rate environment and the scarcity of anything with yield and current income,” the rally may continue, he added.

Wall Street dealers increased bets on the securities after changes by regulators including the Fed and Treasury Department to capital rules for debt in trading accounts that Amherst, Barclays and JPMorgan analysts say make holding certain bonds in inventory less onerous.

’Ongoing Doubts’

Instead of relying on credit grades and requiring a dollar of capital for every dollar of junk-rated debt, the calculations now involve formulas utilizing defaults rates on the underlying loans and an individual bond’s protection against losses, usually producing a smaller number.

The threat of sales by U.S. banks of debt owned in their long-term portfolios also “have abated” after the regulators last month proposed creating similar rules for those holdings, Barclays analysts including Sandeep Bordia and Jasraj Vaidya wrote in a July 20 report.

While the analysts are “constructive” on non-agency securities, the probability of markets in general being roiled “remains high due to issues in Europe and ongoing doubts over the U.S. economic recovery,” they wrote, suggesting investors should favor more “stable” types of the debt.

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