Goldman Sachs Group Inc., which survived the U.S. real estate collapse five years ago with the help of derivative bets against subprime mortgages, is promoting the opposite trade to clients as housing recovers.
The firm, which teamed with four other dealers to create the ABX indexes, benchmark contracts that offered investors a way to protect against the risks of a crash, said in a Nov. 28 report on its top 10 market themes for 2013 that clients should buy some of the derivatives.
Home prices are recovering from a six-year slump, helped by Federal Reserve efforts to push mortgage rates to record lows and buyers competing for a shrinking supply of properties. The bank’s analysts said after “the positive surprise” from housing this year, versions of the ABX that have already rallied are still attractive compared with real estate investments such as homebuilder shares, which have almost doubled over the past 12 months.
“You’re going to get a further lift because of the steady improvement in the indexes’ underlying assets and the housing market,” said Adrian Miller, a fixed-income strategist at GMP Securities LLC in New York. “Yes, there’s room to go, but how much juice is left in the trade is another question.”
Michael DuVally, a Goldman Sachs spokesman in New York, declined to comment on the recommendation beyond the report.
New ABX indexes were created every six months by securities firms from early 2006 through early 2008. The contracts offer protection if the securities aren’t repaid as expected, in return for upfront and regular insurance-like premiums.
The credit-default swaps enabled speculators to bet against housing, and helped meet demand from investors for the high yields of loans to homeowners with poor credit. As the credit crisis grew, investors followed the price of the contracts as a gauge of losses at banks and hedge funds.
Goldman Sachs has taken a more bullish view on housing since at least March, when it was raising money for a new fund to buy home-loan bonds to benefit from an improving real-estate market.
Investments such as homebuilders have already priced in the recovery, the bank said in the report. PulteGroup Inc. leads the 11-member homebuilding index with a gain of 166 percent this year followed by M/I Homes Inc., which rose 129 percent, and KB Home with a 114 percent increase. The index, which had gained 83 percent for the first 10 months of the year, fell 0.8 percent today in New York, extending the decline in November to 3.1 percent.
Investors need to look beyond these stocks for the “ripple effects of housing stabilization,” the analysts said in the report. Potential beneficiaries include certain versions of the ABX and U.S. domestic banks, which may be helped by more homeowner refinancing as credit conditions improve, they wrote.
An ABX index tied to bonds created in the second half of 2006 that were issued with AAA ratings rose 39 percent to 47.05 cents on the dollar this year, according to London-based administrator Markit Group Ltd.
“The higher-rated tranches have already repriced significantly, but still price in severe future mortgage default assumptions that are more likely than not to surprise on the low side,” the Goldman Sachs analysts wrote. “They are clearly sensitive to further home price strength.”
The index has tumbled from about 100 when it was created in early 2007, just after the bank’s mortgage holdings started dropping in value.
In December 2006, David Viniar, Goldman Sachs’s chief financial officer at the time, told the firm’s traders to shift to a neutral risk position and get “closer to home,” according to a report from the Senate Permanent Subcommittee on Investigations led by Michigan Democrat Carl Levin.
The group sold their stockpile of subprime bonds and collateralized debt obligations, and bought credit-default swaps protecting against losses, according to the panel.
They “quickly shot past ‘home,’” leading to their first large net short position in February 2007, the report said. By June, the net short position reached a peak of about $13.9 billion, including $9 billion in ABX bets against top-rated bonds that Goldman Sachs had earlier acquired as “disaster protection,” in case the subprime market as a whole lost value, the subcommittee calculated.
The resulting position was referred to by Viniar as the “big short,” a term later used as the title of a Michael Lewis book about the financial crisis.
As the worst housing slump since the 1930s deepened and millions of Americans failed to meet mortgage payments, the ABX index linked to the 2006 mortgages fell to as low as 23.3. While banks, including Bear Stearns Cos., struggled, Goldman Sachs posted record earnings in 2007.
In April 2010, Levin questioned Goldman Sachs executives including former trader Josh Birnbaum and Chief Executive Officer Lloyd C. Blankfein about whether the bank had bet against clients even as it sold mortgage-linked securities to customers. The firm has denied wrongdoing.
Goldman Sachs paid a record $550 million fine that year to settle a fraud lawsuit filed by the Securities and Exchange Commission, which accused it of misleading investors who bought debt tied to mortgages.
Investors that reaped some of the biggest profits from the 2007 bust such as hedge fund manager John Paulson, who made $15 billion, have since reversed their bets. Birnbaum and Greg Lippmann, who helped pioneer the ABX contracts at Deutsche Bank AG, are profiting this year from a rally in subprime and other bonds not backed by the U.S. government.
Lippmann’s $2.3 billion LibreMax Capital LLC was up 19 percent this year through October. Birnbaum, who now manages $1.2 billion at Tilden Park Capital Management LP, has gained 34 percent in the firm’s main hedge fund through October this year.
Returns on senior-ranked subprime securities from 2005 through 2007, the years that produced the most defaults, average almost 33 percent this year, according to Barclays Plc index data. The debt lost 5.5 percent last year.
Kyle Bass, who made $500 million shorting subprime, said this month that the securities offer a “very safe place” to make double-digit returns and that he’s betting more than half the money from his firm -- Hayman Capital Management LP -- on the bonds.
The debt is virtually “bulletproof,” because even if the housing market declines by 10 percent, investors won’t take a principal hit on their bonds, Bass said in an interview with Bloomberg Television.
Home prices rose 3 percent in the 12 months through September, according to an S&P/Case-Shiller index, paring the decline to 29 percent from the 2006 peak. The median existing-home price may rise 5 percent in 2013, with comparable gains in 2014, according to the National Association of Realtors.
While Axonic Capital LLC sees value in some subprime debt, there’s “significant risks” in the market. These include loan servicers forgiving principal for delinquent homeowners, said Clayton DeGiacinto, a former Goldman Sachs mortgage trader and its chief investment officer. The servicers--which collect payments from borrowers on behalf of bond investors--can also decide to disrupt cash flowing to investors by invoking their right to stop advancing missed payments until foreclosure proceeds are collected, he said.
“It’s a heavy analytical process to weigh the benefits of home appreciation versus the cons,” said DeGiacinto of New York-based Axonic. The firm, which manages $1.4 billion, has gained more than 22 percent in its credit-opportunities hedge fund this year. “The decision to buy or sell isn’t completely predicated on home price views.”
ABX investments also carry different risks than owning the actual bonds. Trading in the market has fallen since before the housing crash, making the swaps less liquid than others used to bet on debt. Reduced liquidity can make it more expensive to enter and exit positions at quoted prices.
The most active ABX index, tied to securities created in the second half of 2005, had $2.5 billion of net outstanding contacts as of Nov. 23, according to the Depository Trust & Clearing Corp. data. That compares with almost $110 billion for the largest swaps index tied to corporate bonds and $8.1 billion for commercial-mortgage securities.
Outstanding ABX contracts total a net $16.7 billion, compared with more than $310 billion of subprime securities, according to DTCC and Amherst Securities Group LP data. As much as $200 billion of ABX contracts tied to bonds with just the lowest investment grades were outstanding in mid-2007, according to an estimate from a Paulson & Co. presentation that year.
ABX values also often don’t track the returns on actual securities.
The indexes can reflect individual funds making “macro” economic wagers or dealers and investors adjusting their hedges, said Marina Tukhin, a managing director of subprime and home equity bond trading at Brean Capital LLC in New York.
“They don’t really reflect much of anything at this point,” she said. Their illiquidity means you can “end up driving up the market all by yourself,” she said.
During the 10 three-month periods over the past two years in which subprime values gained more than 10 percent, the correlation between the debt and an ABX index tied to the same 20 securities was negative 0.08, according to a Nov. 21 report from JPMorgan Chase & Co.
“We see better value in subprime cash bonds,” New York-based analysts at the bank led by John Sim wrote.
The housing recovery may also be “hitting speed bumps,” according to a Nov. 29 report from Raymond James & Associates, which cited new-home sales falling in October. Headwinds include new financial regulation that is likely to emerge next year, said analysts including Buck Horne.
“It’s hard to see where the sustained demand for residential real estate lending is going to occur absent a sustained tick up in the employment situation in this country,” Bonnie Baha, head of global developed credit at Los Angeles based DoubleLine Capital LP, which oversees more than $50 billion, said in a telephone interview. “There’s still a lot of inventory and while the headline unemployment number has declined,” a broader labor market metric, the U-6 jobless rate is still elevated, she said.
Investors looking to bet on a “housing recovery” should make sure they’re clear about what they mean and be careful about their approach, said John Dolan, an independent market maker for futures on the S&P/Case-Shiller indexes that trade on the CME Group Inc. New-home construction and property values may not move at the same pace or in the same direction, and mortgage-bond prices can be linked to unrelated issues such as benchmark rates and how individual loan servicers deal with bad debt, he said.
Still, “ABX contracts are probably a good viable way of expressing a view on home prices,” said Dolan, who traded mortgage bonds as chief investment officer at Hyperion Brookfield Asset Management and Bankers Trust. “Not the purest theoretical way, but a good pragmatic way.”