U.S. home-loan securities without government backing, the debt that sparked the worst financial crisis since the Great Depression, shrank last quarter to less than $1 trillion for the first time in eight years, leaving fewer bonds to meet soaring demand as housing recovers.
The non-agency mortgage bond market has contracted from $2.3 trillion in mid-2007 when a property bubble fueled by shoddy loans burst, according to Federal Reserve data. It’s fallen to about $970 billion after record homeowner defaults, borrower refinancing and limited sales of new debt.
Growing interest in a diminishing asset has bolstered a rally that’s pushed returns on subprime-backed securities to almost 30 percent this year. Cerberus Capital Management LP and Goldman Sachs Group Inc. are among firms that have raised money for new funds targeting the bonds, as investors speculate on the real-estate recovery or seek to earn higher returns as the Fed pushes yields on safer debt to record lows.
“The contraction is a huge part of the story of why non-agencies have outperformed almost every other asset class,” said Bryan Whalen, co-head of mortgage bonds at TCW Group Inc., a Los Angeles-based firm that oversees about $130 billion.
The subprime gains are double the 15 percent rise this year through yesterday for the Standard & Poor’s 500 Index, and more than eight times greater than S&P’s GSCI Total Return Index of 24 commodities. It’s also more than double that for high-yield, high-risk company bonds, which have returned 12.2 percent, according to a Bank of America Merrill Lynch index. The so-called junk-bond market has grown to more than $1 trillion from $680 billion in 2007, as corporations have sold record amounts of the debt.
Canyon Partners LLC, Brevan Howard Asset Management LLP and D.E. Shaw & Co. have also said this year that they planned to bet on home-loan bonds as buyers wagered prices were low enough to compensate for a lack of a housing rebound or would be available cheaply as European banks sold assets.
At the same time, money has flowed to mortgage specialists including Greg Lippmann’s LibreMax Capital LLC hedge fund and Two Harbors Investment Corp., a real-estate investment trust.
Daniel Loeb’s $9.3 billion hedge fund Third Point LLC has also been betting on the bonds, according to an investor letter.
The biggest risk is that hype around mortgages has brought in too many investors and that a “herd mentality applies in both directions,” Loeb said in the letter yesterday.
Demand was underscored earlier this year when the New York Federal Reserve sold $13 billion of home-loan bonds assumed in the U.S. rescue of American International Group Inc., as well as about $40 billion of collateralized debt obligations used to repackage such securities from the insurer’s bailout.
The central bank may further fuel demand with its pledge last month to buy an additional $40 billion of government-backed mortgage securities a month and hold short-term rates near zero until after the economy strengthens, driving down bond yields.
After a “wave of opportunity seekers” targeting non-agency securities, the move should further increase interest among a broader range of more-staid investors, such as mutual-fund managers and insurers, said Brad Friedlander, head portfolio manager at Atlanta-based Angel Oak Capital Partners.
“I don’t see the momentum ending, with yield being just that much more difficult to obtain,” Friedlander said.
His firm’s Angel Oak Multi-Strategy Income mutual fund, which focuses on the debt, has returned 20.1 percent this year, according to data compiled by Bloomberg. That’s the best performance among intermediate-term bond funds this year, and has helped it grow to $325 million in assets since opening in June 2011, according to Morningstar Inc.
Wall Street dealers have recently bought the securities, “perhaps in anticipation of the QE3 supply squeeze,” JPMorgan Chase & Co. analysts led by John Sim said in a report, referring to the Fed’s third-round of so-called quantitative easing that was unveiled Sept. 13.
Dealers, whose inventories had been little changed this year after tumbling in 2011, may have added about $5 billion of non-agency bonds since the announcement, according to regulatory data compiled by Empirasign Strategies LLC.
Existing holders are also receiving about $75 billion annually in principal repayments, such as from foreclosure sales, some of which may be plowed back into the bonds, according to estimates by Barclays Plc analysts.
Issuance of non-agency bonds peaked at $1.2 trillion in both 2005 and 2006 before collapsing as their prices tumbled amid soaring foreclosures and plunging home values, according to newsletter Inside Mortgage Finance.
About $3.5 billion of new loans have been packaged into the securities since 2008, according to data compiled by Bloomberg. In contrast, sales of agency mortgage bonds, which carry guarantees from government-supported Fannie Mae or Freddie Mac or U.S.-owned Ginnie Mae, exceed $1.2 trillion this year.
The dominance of taxpayer-supported mortgage programs that account for about 90 percent of lending is limiting a revival in non-agency markets. Banks are also holding private mortgages on their balance sheet instead of securitizing the debt, as borrowing from other customers remains subdued as the economy fails to accelerate.
Another constraint is that ratings firms are being too cautious, potential issuers including Lewis Ranieri’s Shellpoint Partners LLC have said. BlackRock Inc., the world’s largest money manager, says bondholder confidence has been damaged by the government interfering in the market and favoring the interests of banks that lied about the quality of loans and then failed to oversee the debt correctly.
While the shrinkage is “very favorable for prices” in the near-term, the decline may eventually push dealers to exit the business, said Jonathan Lieberman, head of residential-mortgage securities at New York-based Angelo Gordon & Co., which oversees about $24 billion. That would reduce liquidity, potentially damaging future valuations, he said.
Returns on senior-ranked subprime securities from 2005 through 2007, the years that produced the most defaults, averaged 1.4 percent last month to lift 2012 gains to 29.6 percent, according to Barclays Plc index data. After gaining 25.6 percent in 2010, the debt lost 5.5 percent last year.
The contraction in supply, which is “just one part of the puzzle,” didn’t prevent a sell-off in 2011 as “fast money” such as hedge funds and dealers dumped bonds, said Glenn Boyd, chief investment strategist at Zais Group LLC, a Red Bank, New Jersey-based asset manager that oversees $5.8 billion. “This year, as opposed to last year, the rally is more about improving economic views, more confidence that housing is actually bottoming, and most importantly, the search for yield.”
The S&P/Case-Shiller index, which gauges property values in 20 cities, rose 1.2 percent in July from a year earlier, the biggest 12-month jump since August 2010. The measure fell 35 percent from the peak in July 2006 to February 2012.
Subprime-mortgage bonds now typically yield 6 percent after anticipated losses for debt with projected average lives of at least five years, JPMorgan estimates. That compares with absolute yields of 1.9 percent on government-backed mortgage securities and 2.7 percent on investment-grade corporate bonds, Barclays data show.
Non-agency yields are quoted on a loss-adjusted basis because homeowner defaults and refinancing mean the securities usually aren’t outstanding until maturity. Yields will be greater if forecasts for foreclosures, recoveries or refinancings among the underlying loans prove too pessimistic.
With a drop in potential returns on the most-senior slices of non-agency securities, Meg McClellan, U.S. head of fixed income at JPMorgan’s private bank, sees more value in riskier so-called mezzanine tranches, though buyers need to be “extraordinarily selective.”
“Hopefully, we’re all a little smarter for what just happened,” she said Sept. 19 during a Bloomberg Television interview, referring to the financial crisis that wiped out the value of many of those securities.
Lippmann, the former Deutsche Bank AG trader who bet against the bonds before their collapse, has doubled assets this year at LibreMax to $2 billion and has returned about 16 percent, according to a person familiar with the fund, who declined to be identified because the performance isn’t public.
Two Harbors, the REIT managed by Pine River Capital Management LP that added subprime debt as prices weakened last year, raised $1.1 billion in three share sales.
Terry Wakefield, a mortgage consultant, says he expects the market to start expanding again as the regulator for Fannie Mae and Freddie Mac, Edward J. DeMarco, pushes the companies to increase how much they charge to guarantee mortgage debt.
As potential non-agency issuers learn how to appease investors, the private sector will be acquiring more than 40 percent of all new mortgages by early 2014, predicted Wakefield, an executive in 1980s at Salomon Brothers Inc. when that firm was a pioneer in the non-agency market under Ranieri.
“That assumes DeMarco is still at the helm and he continues on with his campaign,” he said. Local governments meddling in the market by using their power to seize loans and help homeowners would stunt issuance, he said, referring to efforts in San Bernardino County, California and elsewhere to so-called study eminent domain programs.
Mortgage investors’ shattered confidence in their contracts and worry that issuers’ interest conflict with their own make any quick revival unlikely, according to Bill Frey, head of Greenwich Financial Services LLC in Greenwich, Connecticut and author of “Way Too Big to Fail,” a book about those concerns.
“I’m not holding my breath,” he said.