Subprime Mispriced After Legal Ruling Boosts Banks, Narula Says

U.S. subprime-mortgage securities are overpriced as investors misjudge a court ruling last month that will limit bondholders’ ability to force banks to buy back soured loans, according to hedge-fund manager Deepak Narula.

In the case, a four-judge appellate panel in New York on Dec. 19 dismissed a suit against Deutsche Bank AG by mortgage-bond investors, saying the case over a requirement for the issuer to repurchase loans that failed to match their promised quality needed to be filed within six years of the sale.

Subprime mortgage bonds issued before sales froze in 2007 are up about 2 percent this month after returning 66 percent over the previous two years, according to Barclays Plc data, even as attorneys said the mid-level state court’s ruling may limit litigation that would boost the debt. Agreements between potential plaintiffs and defendants can extend deadlines for the statute of limitations, the attorneys said.

“We view the ruling as a significant negative driver for valuations and believe that the market has not focused correctly on the potential pricing implications of this issue,” Metacapital Management LP founder Narula said in a letter to investors dated Jan. 24.

Subprime debt has gained as housing recovered, the Federal Reserve provided unprecedented stimulus to markets and investors wagered on loan repurchases. The Deutsche Bank ruling represents a risk to values because it may prevent new suits seeking mortgage buybacks and “gives issuers leverage in more general settlements” by reducing the odds that some investors will object to the deals, Narula wrote.

Subprime Litigation

He cited a proposal announced in November in which JPMorgan Chase & Co. agreed to pay $4.5 billion to bondholders. While the accord was reached with a group including BlackRock Inc. and Pacific Investment Management Co., trustees for the debt representing all holders still must approve the deal. Hedge fund Fir Tree Partners said last week that it was offering to buy some of the securities and would seek to continue existing litigation over them.

The plaintiffs in the Deutsche Bank case asked the appeals court in Manhattan on Jan. 21 for permission to reargue the issue or leave to appeal the matter to the state’s highest court, the Court of Appeals in Albany, a clerk for the First Department said.

The ruling could be “very important” in “clearing the backlog” of potential mortgage suits stemming from the financial crisis, Elaine Golin, a partner at Wachtell Lipton Rosen & Katz, said last week at an industry conference.

Preserve Claims

“Optimistically, from my position representing defendants, I expect we’ll have a lot less of these cases going forward,” she said, speaking on a panel.

Kathy Patrick, a partner at Gibbs & Bruns LLP who represented the investor group that reached the potential deal with JPMorgan, said at the conference that so-called tolling agreements used to extend statute of limitations would “preserve some claims” even if the ruling isn’t overturned.

Metacapital’s largest hedge fund, which focuses mainly on government-backed mortgage bonds, gained 41 percent in 2012, when it topped Bloomberg Markets magazine’s list of the best-performing managers overseeing more than $1 billion. After losses in the first half of last year, the $1.3 billion fund was up almost 10 percent over the next six months to eke out returns of 0.5 percent for all of 2013, according to the Jan. 24 letter.

The New York-based firm’s $133 million fund that focuses on mortgage securities without government backing gained 13.2 percent last year, the letter showed. A fund meant to profit from rising interest rates started in May gained 20.1 percent, and ended the year with $322 million in assets.

Narula declined to comment on the letter.

The case is Ace Securities Corp. v. DB Structured Products Inc., 650980/2012, New York State Supreme Court, New York County (Manhattan).

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