’Underwater’ Loans Make Jumbo Bonds Risky, Seer SaysJody Shenn
The rally in securities tied to the biggest U.S. home loans probably has gone too far because defaults are set to rise for properties worth less than the mortgages on them, according to hedge-fund firm Seer Capital Management LP.
“People wrongly feel more comfortable merely because it’s higher-quality borrowers,” Seer Capital Chief Executive Officer Philip Weingord, the former head of global markets in the Americas for Deutsche Bank AG, said in an interview at his firm’s New York offices.
Jumbo-mortgage securities are one exception to the attractiveness of securitized debt, said Weingord, whose firm manages about $300 million. The bonds, including $1.4 trillion containing loans without government backing that recorded unprecedented gains as they recovered from all-time lows, remain generally attractive because a limited number of investors are dedicated to scouring the sector for opportunities compared to corporate bonds, he said.
Senior-ranked bonds tied to fixed-rate jumbo mortgages issued from 2005 through 2007, when the home-loan securities with the highest default rates were created, have generally soared to more than 92 cents on the dollar from record lows near 60 cents in March 2009, according to data from Bank of America Merrill Lynch and Barclays Capital.
Will Borrowers Pay?
Investors are banking on low defaults by borrowers who can afford their mortgages even if the value of their properties has fallen below the mortgage amount, called being underwater, according to Seer Capital.
“If you’re wrong about the propensity to default, you’re screwed,” Richard D’Albert, Seer’s co-chief investment officer and the former head of securitized products at Deutsche Bank, said in the Sept. 30 interview.
Of $291 billion in prime-jumbo mortgages whose borrowers have never been delinquent and whose loans are contained in bonds, about 27 percent are underwater, according to data from Austin, Texas-based Amherst Securities Group. An additional $47 billion of such loans are delinquent or have been, with 60 percent of non-performing debt owed by borrowers in negative equity on the properties.
Jumbo mortgages are loans exceed limits for government-supported Fannie Mae and Freddie Mac to buy. The companies are currently restricted to purchasing loans of less than $417,000 in most of the U.S., or those of as much as $729,750 in high- cost areas.
Seer’s Other Picks
Seer Capital is buying senior securities backed by subprime home loans and so-called option adjustable-rate mortgages, D’Albert and Weingord said.
Option ARMs allow borrowers to pay less than the interest they owe each month, adding the unpaid amount to the overall mortgage balance. The choice may raise the homeowner’s payments later. Subprime mortgages went to borrowers with the worst credit records.
Seer assumes almost all the home loans underlying the bonds it buys will eventually default, so the company focuses on analyzing house prices and assessing how long it will take for soured loans to be liquidated through action such as a property sale after foreclosure, D’Albert said.
Prices for subprime-mortgage securities created in 2005 through 2007 and which aren’t paying principal right now range from about 28.5 cents on the dollar to about 90.5 cents, according to Bank of America data. Some of the debt rallied 20 percent this year.
Jumbo-mortgage securities are trickier to invest in because of their higher prices and because senior-ranked, originally AAA rated notes in the sector were often structured to lose principal after losses of about 5 percent on the pools of underlying loans, D’Albert said. The figures for subprime loans and option ARMs were about 20 percent.
That means defaults need to stay low to create acceptable returns and data shows borrowers often decide to stop paying when they go underwater, D’Albert said. Across the U.S., owners of about 11 million homes, or 23 percent of households with a mortgage, owed more than their property was worth as of June 30, according to Santa Ana, California-based CoreLogic Inc.|
TCW Group Inc., which oversees about $115 billion, also is concerned jumbo-mortgage securities may be too expensive, partly because values of those homes have further to drop, said Tad Rivelle, head of fixed-income investment for the Los Angeles- based firm.
“It suggests the prime markets may be more exposed to the issue of strategic defaults,” Rivelle said in an interview at Bloomberg News headquarters in New York. “We feel good about subprime and less so about prime.”
Strategic defaults occur when a homeowner with enough money to pay the mortgage chooses not to because investing in the home no longer makes financial sense.
Homeowners become very likely to walk away from underwater properties once they owe 40 percent more than the house is worth, TCW’s data show.
On the positive side, jumbo mortgage bonds that investors are buying for less than face value contain more loans that homeowners are likely to refinance, said Scott Eichel, the global co-head of the mortgage- and asset-backed securities business at Stamford, Connecticut-based RBS Securities Inc.
When those refinancings occur, bondholders receive their purchase price back, plus additional principal that boosts their returns.
“You’re still seeing higher-than-expected prepayment rates,” Eichel said. “That helps justifies the prices.”
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