New Way to Short Home Loans May Give a Boost to Mortgage-Bond Market

  • Investors divided on whether timing is right for new product
  • Derivatives could reference an index similar to pre-crisis ABX

A new product that would allow investors to short U.S. home loans may kickstart the growth of an infant mortgage-bond market if some money managers have their way.

Derivatives on a pricing index that tracks mortgage risk sold by Fannie Mae and Freddie Mac would help banks support the underlying notes, Roman Shimonov, a director at Annaly Capital Management -- one of the largest mortgage-focused real estate investment trusts -- said at an industry conference in New York on Monday.

Talk of derivatives on credit-risk transfer notes sold by Fannie and Freddie -- the biggest guarantors of U.S. home loans -- emerged earlier this year when New York-based Vista Capital Advisors rolled out a pilot version of its mortgage-securities index. For some, that evoked memories of the pre-crisis era when the ABX -- the last large tradeable index tracking mortgage bonds -- imploded under the weight of the collapsing subprime securities it referenced.

In the case of derivatives on credit-risk transfer notes, a dedicated index “could be good for the dealer community,” Shimonov said. It would help them provide more liquidity to the underlying securities and better hedge their inventory using derivatives, he said.

Better Hedge

Fannie Mae and Freddie Mac began transferring mortgage-default risk to bond funds and other investors in 2013 as part of a plan to reduce risks to taxpayers. The program has since gained steam, and is considered a linchpin in reforming the housing companies and removing them from government oversight.

Credit-risk transfers will be “core” to U.S. housing policy, Craig Phillips, a former BlackRock Inc. executive who recently joined the Treasury Department, said at the conference. Around $50 billion of the notes have been sold, data from Wells Fargo & Co. show.

A derivatives market could help boost sales of these notes -- and ultimately lower taxpayer risks -- by increasing the trading activity in the securities and making it easier for dealers to hedge their exposure, Barclays Plc said in a letter to housing regulators last year. Movements in the securities often correlate with high-yield bonds, creating swings that some investors complain are inappropriate.

“The market would benefit from a mechanism to support long and short views,” said John Vibert, a managing director at PGIM Fixed Income, which manages $637 billion including mortgage-backed debt. The industry would, however, want to make sure capital charges for dealers of the instruments aren’t punitive, he said.

But while these instruments could give the market for credit-risk transfer notes a lift, they threaten to overshadow reform plans for the two government-sponsored enterprises, known as GSEs, according to Michael Canter, head of securitized assets at AllianceBernstein Holding LP.

Derivatives are “inevitable” but the timing isn’t right, said AllianceBernstein’s Canter. “We are at a moment in time when GSE reform is on the table and we are concerned a derivative will harken people back to the ABX days,” he said. “GSE reform is more important than getting more liquidity.”

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