By Neil O’Hara
The credit crisis whacked the mortgage-backed securities market worse than any other asset class, but hedge funds that specialize in these assets, such as Pine River Capital, FrontPoint Partners and Sorin Capital, have made spectacular returns this year amid the wreckage. A drastic narrowing of spreads since the March lows has helped, but the dislocation was so severe that smart players found ways to make money on both sides of a hedged position. Overall, the AR Mortgage-Backed Securities Index was up 14.29% through November, one of the top performing strategies of the year. The game is harder now that MBS prices have rallied, but managers who have the skills to analyze how the cash flows work and understand the nature of the underlying collateral still see attractive opportunities.
For Pine River, a $1.5 billion hedge fund manager in Minnetonka, Minn.—whose $441 million Nisswa Fixed Income Fund was up 87.05% through November—the biggest play of 2009 exploited a pricing disparity between government agency and private-label residential mortgage-backed securities. Bill Roth, a senior fixed-income portfolio manager at Pine River, explains that at the end of 2008, prices in the agency MBS market implied that prepayments would occur at the same rate they had in 2003—as much as 60% of some pools, among the greatest ever recorded.
That didn’t jibe with a weak housing market that had decimated borrowers’ equity in their homes. Nor did it make sense when tight credit had turned refinancing into an arduous process rather than a quick phone call. Meanwhile, prime private-label RMBS prices had fallen so far that the market expected prepayments to be just 5%.
“We took the view that one of these markets was likely to be wrong,” says Roth. “They might both be wrong, but if agency pools prepaid at 60%, we didn’t think non- agency prime pools would prepay at 5%.” Pine River bought agency interest-only bonds (IOs), a security that increases in value if prepayments slow because the bonds will remain outstanding longer and the holder will receive more coupons. It also bought senior and mezzanine triple-A tranches of prime private-label RMBS, whose value rises if prepayments speed up because investors receive principal payments sooner than they were expecting.
The double play paid off in spades: Roth says actual prepayment rates in agency pools have been “in the 20s"—less than half the rate the market anticipated—while prime private-label pools prepaid “north of 10% and in many cases in the mid-teens.”
The different implied prepayment speeds were a symptom of the market dislocation rather than its cause, however. Laurie Goodman, senior managing director in the New York office of MBS specialist broker-dealer Amherst Securities, explains that in early 2009, spreads in the agency market tightened in anticipation of purchases by the Federal Reserve—a program initially set at $500 billion and later expanded to $1.25 trillion.
Meanwhile, credit fundamentals in the nonagency market hit the skids as the economy slowed and unemployment soared. “You saw a wave of selling by banks and insurance companies, because these securities were being downgraded like crazy,” says Goodman. “At that point they faced higher capital charges, and they would sell.” The pressure eased when the FASB relaxed mark-to-market accounting rules in March, which set the stage for the subsequent rally in nonagency MBS.
Whatever the reason, Pine River wasn’t the only one to spot the disparity between agency and nonagency prices. FrontPoint Partners, a $6.8 billion hedge fund firm in Greenwich, Conn., participated in the same play, which Marc Rosenthal, co-manager of the FrontPoint Strategic Credit team, points out not only made sense as a standalone trade but also from the perspective of managing a portfolio.
“If you go long super-senior nonagency Alt-A fixed-rate paper, slow speeds hurt you and fast speeds help,” he says. “The agency IO was a natural hedge. You could win on both sides on prepayments, and if credit problems turned out worse than expected on the pass-through bonds, prepay speeds would slow and the IO would be worth more.”
Although the strategy did benefit from prepayment arbitrage, Rosenthal says the positions got an even bigger lift as credit spreads tightened across the board. The rally in MBS prices propelled triple-A super senior bonds backed by prime fixed-rate 30-year mortgages from 55 in March to 87 in October.
The huge move squeezed much of the juice out of the prepayment trade, so Pine River is now looking elsewhere in the capital structure for relative value plays. Roth sees opportunities arising from loan modification programs, which affect the cash flows, and hence the value, of some MBS bonds.
If a pool has so many loans heading to foreclosure that a bond is expected to default, the price will reflect the number of coupons that holders will receive before default occurs. Yet if the servicer manages to modify enough mortgages, borrowers may stay current with their payments for longer, and the time to default will stretch out.
The bonds are known as credit IOs; they have no hope of principal repayment, so investors have to judge how long before escalating defaults in the pool cut off coupon payments. It’s not an asset-class play like the agency vs. private label MBS trade, either.
Much depends on how the loans are modified—a break on the rate, a principal haircut, or both—as well as the vintage, location and quality of the underlying collateral. “There are many interesting possibilities,” says Roth, “but in most cases it takes a lot of analysis, and it can be difficult to get scalable size.”
The numbers speak for themselves. In a $500 million prime RMBS deal, the A-rated tranche is typically 1% of the capital, or $5 million. If it has a 6% coupon and is expected to default in one year, that slice will trade at perhaps five cents on the dollar (two coupons less a haircut), and the entire tranche is valued at only $250,000.
The play may work for some bonds higher up the capital structure that were originally larger tranches and that trade at higher prices today. But capacity is clearly limited.
Others aren’t so keen on the play. Noelle Savarese, co-manager of the FrontPoint Strategic Credit team, notes that servicers have different modification practices, which complicates the analysis. “If the redefault rate is low, bonds you thought were dead may survive,” she says. “It’s pretty risky to bet on modification saving your bond from a credit perspective.” Savarese isn’t optimistic that modified loans will avoid redefault, either.
Early data on government mortgage modification programs indicates that even with an average 34% cut in payments, about 65% of loans redefault. Amherst’s Goodman says an accounting trick ensures that the redefault rate will be much lower under the new Home Affordable Modification Program: Borrowers who skip payments during a three-month trial period won’t count as failures, only those who redefault later.
“You will see a higher rate of successful modifications—but it’s fake,” says Goodman, who doesn’t expect better numbers on an apples-to-apples basis.
Although FrontPoint passed on modification trades, it did uncover a nifty play in floating-rate Alt-A RMBS. The coupons on these bonds depend on Libor, so they were falling throughout 2009. Rosenthal bought a natural hedge against this risk: inverse IOs, which pay a coupon derived from the capital structure of the particular deal expressed as a (relatively high) fixed rate minus a multiple of Libor.
Inverse IO prices reflect the forward market in Libor. In January 2009, the forward market implied that at the end of the year Libor would be greater than 1% instead of the current 25 basis points. As Libor drifted down, investors bid up inverse IOs in anticipation of the higher coupons they would receive. Meanwhile, tighter credit spreads pushed up prices of the floaters, offsetting the effect of falling coupons.
“The IOs were not just a hedge,” says Rosenthal. “We got an incremental benefit. Yields tightened across asset classes, and we benefited on both sides.” For the 10 months through October 2009, the FrontPoint Strategic Credit strategy was up 31%.
Attractive returns are available in the commercial mortgage-backed securities world, too. Jim Higgins, founder and CEO of Sorin Capital Management, which manages a $530 million hedge fund that specializes in CMBS and REIT securities, took advantage of trading opportunities when investors misinterpreted the implications of news that affected the sector. In September, for example, the IRS published revised rules governing real estate mortgage investment conduits, which meant the conduits no longer had to be either in default or on the verge before they could modify loans in the pool. Prices jumped at first; the triple-B-minus CMBX Index doubled, from 16 to 32. “We thought the market vastly overestimated the benefits,” says Higgins, who went short the triple-B-minus CMBX index—and watched the price slip back to 21 by mid-November. Sorin closed its original fund earlier this year and launched a replacement in June. The new vehicle was up 2.56% through November.
In another instance, shortly after the TALF program was extended to legacy CMBS in the spring, Standard & Poor’s announced a revised rating methodology that threatened to downgrade the majority of triple-A CMBS bonds that were previously eligible for TALF. The bonds placed on negative credit watch traded at a yield 200 basis points higher than CMBS bonds that were definitely eligible for TALF, but Sorin was able to identify bonds in the cheaper pool that were likely to be affirmed as triple-A under the new rating scheme. “That played out extremely well for us,” says Higgins. “We’re in a world where the specialists in a sector have an edge. Many investors currently in the CMBS arena are not specialists and don’t really understand commercial real estate.”
FrontPoint has also unearthed rich pickings in the CMBS world, which lags behind the residential sector in the economic cycle. In a reprise of a trade that paid off in RMBS in 2008, Rosenthal and Savarese are long mezzanine CMBS bonds in seasoned 2004 and 2005 vintages they expect will avoid default. At the same time, they are short (using credit default swaps) subordinated triple-B-minus bonds that were issued in 2006 and are backed by buildings they believe won’t be able to meet their obligations.
“The mezzanine provides attractive risk-adjusted yields compared to the senior bonds,” says Rosenthal, “and we have a vintage play as well.”
For savvy investors who have the resources needed to sniff out anomalies, the MBS market still has plenty to offer. AR
