Fueled largely by demand from investors in Europe and Asia, bonds backed by subprime loans are riding high, even as the stocks of companies that make these loans are getting crushed amid reports that more borrowers are falling behind on their payments.
This is in sharp contrast to late last year, when hedge funds seized on negative reports from lenders and home builders as an opportunity to place big bets on a deterioration in the credit performance of subprime mortgage bonds, pushing spreads dramatically wider. But dealers say that just about everyone inclined to be short, or bet against, the market has already done so.
The demand for bonds backed by subprime mortgages appears to be bottomless: despite a rebound in issuance to $41.1 billion in August from $24.1 billion in July, risk premiums, or spreads, on all floating-rate classes of these securities are trading within 3.0 basis points of their 52-week narrows, according to Michael Youngblood, managing director, asset-backed securities research at Friedman, Billings Ramsey.
Youngblood said the pricings of some of the riskiest classes of recent subprime deals have been particularly notable. Spreads on the triple-B-minus tranches of these deals have been as narrow as 180 basis points over the one-month London interbank offered rate - well inside their 52-week widest levels of 375 basis points, reached in mid-December.
"Given the performance of the triple-B-minus floaters, we cannot infer any grave concerns" about the credit performance of these deals, he said. s
Strategists say investors may feel comfortable with the safeguards embedded in these deals, which are generally backed by loans worth more than the face value of the securities. Or they may feel that they are still being adequately compensated for the risks of holding the bonds by the yield pick-up they offer compared to other assets.
"From a yield and liquidity perspective, investors continue to find this market appealing," said Peter DiMartino, ABS strategist at RBS Greenwich Capital. But he said it's arguable whether the risks and rewards of bonds backed by subprime mortgages are fairly balanced at the moment.
Data Becomes Less Friendly
The data on subprime mortgages taken out in the first half of this year are still incomplete, but DiMartino said that the initial indications are that delinquencies are rising. He recently published research showing that late payments on interest-only loans that reset after two years are 1.75 times higher than those taken out in 2005, according to data from LoanPerformance.
Late payments are also rising on subprime loans that require borrowers to start paying off principal right away. Those taken out in the first half of the year are experiencing delinquencies at 1.5 times the rate of those taken out in 2005.
DiMartino compared delinquencies on loans taken out this year with those of the 2005 crop when it was just a few months old, to control for changes in the character of loans as they age.
Youngblood, the FBR strategist, thinks it's too early to pass judgment on the credit quality of this year's crop of subprime mortgages. But he said late payments could be even more prevalent than the early data would indicate. That's because borrowers are sometimes given a temporary free ride when their loans are sold to investors.
When mortgages change hands, the servicing of these loans may also be transferred to a third party. Youngblood said the new servicers may be reluctant to take action when a payment is missed during the first few months following the transfer. That's because they're mindful that borrowers may initially be confused about where to send their payments.
But servicers may also be giving a pass to borrowers who simply can't afford their payments. Some of these bad loans may eventually be sold back to the lender, and some could end up as collateral in securitizations.
In the meantime, Youngblood said, this "suspension of disbelief" about the credit quality of subprime mortgages could be contributing to the tight spreads on bonds backed by these securities.
There's some justification for investors to keep buying subprime mortgages even as they sell the stocks of companies that originate them. Part of the reason that mortgage lenders have been hit hard is they are being forced to buy back more loans when borrowers default on their initial payments. For example H&R Block (HRB) said last week it was setting aside $102.1 million as a result of loan delinquencies at its Option One Mortgage Corp. unit.
But this isn't necessarily bad news for bonds backed by mortgage bonds, since the troubled loans that are being sold back to lenders are excluded from the pools of mortgages being securitized.
Derivative Footprint
Mortgage bonds haven't always been this resilient, however. In late November and December of last year, early signs of a housing market slowdown spilled over into the mortgage bond market as hedge funds used insurance-like derivatives called credit default swaps to make bearish bets. They bought protection, essentially going short, on the triple-B and triple-B-minus rated classes of subprime mortgage-backed securities, pushing spreads on these securities dramatically wider.
But dealers say hedge funds are reluctant to add to their positions at this point.
Instead, the market for credit derivatives on mortgage bonds is dominated by investment vehicles called collateralized debt obligations, and they're bullish on the market.
CDOs, which are created by investment banks and money managers and sold primarily to foreign investors, see credit default swaps as an efficient way to supplement their holdings of cash mortgage bonds. They do this by going long, or sell protection, on triple-B and triple-B-minus classes of subprime deals.
"Given the current environment and the data regarding the housing market, I would have expected more buyers of protection than there are in the market right now," said Scott Eichel, senior managing director for derivatives of asset-backed securities at Bear Stearns. "The problem is that everyone is short already. The sellers of protection to fund CDOs seem to outnumber the buyers by seven to one."
Eichel said the large number of outstanding short positions may paradoxically be supporting the market, because when spreads do widen, they rush to cover their positions, pushing spreads back in again. And this is also helping keep the cash bonds backed by subprime home loans on firm ground.
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