Why Toxic Debt Looks a Lot Less Toxic

Goldman Sachs and hedge funds are buying risky mortgages again

Some of the same investors who made big profits betting against mortgage bonds before the 2007 housing bust have started snapping up the toxic assets. Hedge fund manager Kyle Bass, who made $500 million when subprime debt cratered, is raising a fund to buy them. He’s joining John Paulson, who made $15 billion in 2007 thanks to the housing bust. Goldman Sachs Group has bought the bonds this year. Remarkably, so has American International Group —the insurer that had to be rescued by the U.S. government in 2008 after its wagers on risky mortgages went bad.

These investors are jumping in as the $1.1 trillion market for mortgage bonds without government backing joins a global rally in everything from stocks and commodities to corporate loans. They are attracted to the riskiest mortgage bonds by their high potential yields. And they are speculating that the bonds’ prices have fallen so far that even continued weakness in the housing market won’t drive them down much further. “You can end up, even using severe assumptions on things such as home prices and defaults, with a very high yield based on the prices that bonds are trading at,” says Larry Penn, chief executive officer of Old Greenwich (Conn.)-based investment company Ellington Financial. “Especially with interest rates this low, if you can buy something where you can end up with a double-digit yield under severe assumptions, that’s great.”

Typical prices for a type of mortgage bond tied to option adjustable-rate mortgages (ARMs) rose to 55¢ on the dollar in the second week of February from 49¢ in November, according to Barclays Capital. The securities are bouncing back “almost like a coiled spring,” says Clayton DeGiacinto, chief investment officer of hedge fund Axonic Capital. Option ARMs allowed borrowers to pay less than the monthly interest due with the shortfall added to the balance and were among the toxic debt that the Financial Crisis Inquiry Commission said helped fuel the housing boom and subsequent bust. About 45 percent of the option ARM loans that are in bonds are delinquent, according to JPMorgan Chase data.

The debt has rallied before, with prices rising to 65¢ on the dollar in February 2011 from a low of 33¢ in 2009. That reversed when the Federal Reserve Bank of New York in April began auctioning off bonds it acquired in the rescue of AIG, setting off a rout in credit markets. The New York Fed has taken advantage of the recent rally to try again, with different tactics this time. Unlike last year, when it invited more than 40 broker-dealers to take part in a series of auctions, it asked only a handful of banks to bid on the debt. On Feb. 8, Goldman Sachs bought $6.2 billion of mortgage bonds from the AIG rescue. It held on to much of that to distribute later to clients at higher prices, regulatory data on trading volumes show. “That’s a pretty strong message that Goldman is sending about not being in a hunkered-down mode,” says Steven DeLaney, an analyst at San Francisco-based JMP Securities.

The offering followed a Jan. 19 sale by the New York Fed to Credit Suisse Group, which said it immediately resold a “significant” portion of the $7 billion in bonds. AIG bought some of the securities from the bank, say people with knowledge of the transactions who declined to be identified, as the sale was private. AIG’s holdings of residential mortgage-backed securities surged 64 percent to $32.6 billion in the first nine months of 2011, according to regulatory filings. AIG CEO Robert Benmosche has increased the holdings as he seeks to boost annual pretax investment income by as much as $700 million. Mark Herr, a spokesman for AIG, declined to comment.

Bets against subprime mortgages by Paulson and former Deutsche Bank trader Greg Lippmann were documented in Michael Lewis’s The Big Short. Paulson started buying residential and commercial mortgage securities in late 2008 and 2009. Lippmann has been investing through LibreMax Capital, the hedge fund he started in 2010. Recent gains in bonds tied to residential debt mean they no longer offer “double-digit” returns, Bill Roth, co-chief investment officer of Two Harbors Investment, said in a Feb. 8 conference call with analysts. Two Harbors is a publicly traded real estate investment trust run by hedge fund firm Pine River Capital Management; both have said they’ve been buying subprime debt. “In an interest-rate environment where the 10-year Treasury is below 2 percent and most other fixed-income assets yield 6 percent or less,” said Roth, “yields of 7 percent, 8 percent, 9 percent are still appealing.”

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