The rally among home-loan bonds without government backing is being fueled by errors made by “most market participants” in translating current prices to potential returns, Amherst Securities Group LP analysts said.
Investors are overestimating potential yields in part because they are failing to consider how many loans are becoming delinquent for the first time and partly because they are arriving at incorrect conclusions on how long it will take to liquidate seized homes, the New York-based analysts led by Laurie Goodman wrote in a report yesterday. Those issues can influence both the size of foreclosure losses and how quickly bonds get paid down.
“Do your homework, and sell securities which are being evaluated incorrectly by the marketplace,” the analysts wrote.
Non-agency home-loan bonds have soared from record lows or near-nadirs in March amid speculation that Treasury Secretary Timothy Geithner’s Public-Private Investment Program, or PPIP, will add as much as $40 billion of demand to the market, and that the longest U.S. recession and worst housing slump since the Great Depression are easing.
For example, the most-senior classes of 2006 and 2007 securities backed by prime-jumbo mortgages have rallied to more than 80 cents on the dollar, from as low as 55 cents, according to Amherst. So-called super-senior bonds backed by “option” adjustable-rate mortgages have jumped to about 48 cents, from the “low 30s,” the analysts wrote.
Insufficient Analysis
Investors also have been doing too little analysis of the differences, such as the level of home equity, among borrowers with currently non-delinquent mortgages backing non-agency bonds, which lack guarantees from government-supported Fannie Mae and Freddie Mac or U.S. agency Ginnie Mae, they said.
After correcting two of the three common mistakes by investors, the potential yield on a Countrywide Financial Corp.- issued option ARM bond now trading at 48 cents on the dollar would fall to 6.49 percent, from 12.67 percent, assuming the London interbank offered rate remains unchanged, Amherst said. Adjusting for all three reduces the yield on a Wells Fargo & Co. jumbo-mortgage note bought at 85 cents to 7.15 percent from 11.52 percent, the analysts wrote.
That is “much lower than most market participants believe they are receiving on the security,” they said. “Moreover, the yield must be evaluated in conjunction with the level of uncertainty about our assumptions” around whether borrowers will continue to refinance at the “fast” pace of recent months and how many borrowers with “negative equity” will default.
Third Point Profits
Scott Simon, mortgage-bond chief at Newport Beach, California-based Pacific Investment Management Co., the world’s largest fixed-income manager, told Bloomberg Television on Aug. 4 that “from a long-term point of view, a lot of this paper still will yield a lot after losses.”
A buyer last quarter of at least some kinds of home-loan bonds was Third Point LLC, the hedge fund run by Daniel Loeb, which entered the market amid lower prices after profiting from bets against subprime-mortgage bonds in 2007, according to a July 31 investor letter from the New York-based firm.
Third Point bought $160 million in mortgage bonds and made more than $20 million in profits from April through July, Loeb wrote. He estimated that under “severe economic distress” where all of the underlying loans default and home prices drop another 20 percent, the debt the fund held as of June 30 would return 10 percent based on the prices it paid. The debt would return 17 percent to 20 percent under “our base case economic assumptions,” he said.
Pleased Investor
Loeb may “eventually” increase his fund’s mortgage-bond investments to 10 percent to 15 percent of invested capital, up from a previous target of 5 percent to 10 percent, depending on other opportunities, he said.
“Although four months is certainly too brief of a period to ‘declare victory’ in the mortgage markets, I am pleased with our timing, security selection, and ability to obtain choice offerings from the Street,” Loeb said.
Goodman is the former head of fixed-income research at UBS Securities LLC whose team there was top-ranked for non-agency mortgage debt in a 2008 poll of investors by Institutional Investor magazine. Amherst is a securities firm specializing in trading and advising investors on home-loan debt.
The U.S. government announced July 8 that the PPIP would begin with nine managers raising as much as $10 billion, and receiving as much as $30 billion in taxpayer capital and loans to buy mortgage bonds originally rated AAA.
Option ARMs
Jumbo mortgages are larger than Fannie Mae or Freddie Mac can finance, currently $417,000 in most areas to as much as $729,500. Option ARMs allow borrowers to pay less than the interest they owe, tacking on the difference to their debt and creating the potential for bills to spike.
A Markit ABX index of credit-default swaps tied to a type of subprime-mortgage bond rated AAA when issued in the first half of 2007 climbed to 29 yesterday, up 18 percent from a June low, according to Markit Group Ltd.’s Web site. The swaps offer protection if the securities aren’t repaid as expected, in return for regular insurance-like premiums. Subprime mortgages went to borrowers with poor or limited credit or high debt.
Posted by Sandy Hutchens