Even firm believers in the doctrine that what goes around comes around might feel squeamish about pepping up their portfolio with an investment in subprime mortgage-backed securities. Yet astute, risk-friendly investors have been making a killing on these toxic assets for years. At least they were until the Federal Reserve decided to cash in a few months ago.
While all residential mortgage-backed securities (RMBS to the trade) enjoy a scary reputation, the market divides into two principal groups. The much larger portion, with up to $5 trillion in circulation, is made up of “agency-backed” securities, whose underlying mortgages are guaranteed by Fannie Mae or Freddie Mac. These have had their downs-ups-downs since the 2007-08 crisis, but within a reasonably sedate range .
The sexier paper for aggressive money managers has been “non-agency” bonds that have no government backstop, partly because they tend to have a higher proportion of subprime loans mixed in. The volume of these securities peaked at about $2.3 trillion in 2007 and today has shrunk to $1.3 trillion, according to Walter Schmidt, an analyst at FTN Capital markets in Chicago. About half of this total is in default. The other half, about $600 billion, is available to buy and sell through FTN and other broker-dealers.
These non-agency bonds jumped 50 to 100 percent in value in the two years following March 2009, as the housing market seemed to bottom out and analysts developed better tools for assessing the 2,000-3,000 loans bundled into each security. “The bright side of the crisis is that we know more about mortgage credit than we ever have before,“ says Steven Abrahams, head of mortgage-backed securities research for Deutsche Bank in New York.
Washington nurtured this recovery. The U.S. Treasury bought $225 billion in agency-backed bonds and seeded private investors with more than $5 billion to buy riskier paper. The Fed bought $31 billion worth of non-agency RMBS from floundering insurance giant AIG, heading off a new flood of supply to the market.
Then in March of this year, events took a bizarre turn. A convalescent AIG offered to buy its own bonds, now packaged in a fund known as Maiden Lane II, back from the Fed for roughly half price, $15.7 billion. The central bank spurned the offer, announcing it would instead sell the paper on the open market through a series of auctions as often as once a week.
This the Fed commenced to do in April. Its timing was awful, selling off relatively high volumes just as the national housing market slipped convincingly into a fresh decline and a broader two-year investment rally ran out of gas. Citibank started privately trying to unwind an $11 billion non-agency RMBS portfolio around the sound time, aggravating the perception of oversupply. To make matters worse, the Maiden Lane bonds are of exceptionally low quality. They contain about 70 percent subprime mortgages compared to a market average of 40 percent, according to Deutsche Bank.
The result has been calamitous for the thin non-agency market. Investors lapped up nearly all of the Fed’s first lot of $1.5 billion in Maiden Lane paper, auctioned on April 6. By June 6, buyers took up only half of $3.8 billion in offered securities, and secondary market prices had slid by 20-30 percent.
RMBS dealers are quietly begging Ben Bernanke’s team for some respite, or a new AIG-style deal where the rest of Maiden Lane II would be offloaded to a single buyer with financing that enabled that institution to hold it for a while. The sphinx-like Fed shows some sign of listening, annoucing that it will take a month’s break between auctions this time at any rate. The next Maiden Lane sale is scheduled for around July 4.
A cutback in supply could spark another rally in the volatile RMBS market. But mainstream investors may want to admit that they missed the party for now, and watch for new lows.
