04/24/2009

Market Makers Buoy Mortgage-Bond Mood

A recent jump in the values of private-label mortgage bonds is looking more like a sustained rally.

The prices of such instruments rose on the secondary market this week, as Wall Street institutions including Bank of America, Citigroup and J.P. Morgan snatched up billions of dollars of bid lists. Those purchases signaled a willingness by the banks to make markets and hold inventory for buy-side clients, in turn creating optimism about a continuing improvement in trading conditions.

Since the credit crunch began in mid-2007, dealers had become less willing to help out clients who wanted to unload mortgage-bond investments - as the institutions became weighed down by their own inventories. "We are just getting back to the way we do business with our clients, which includes providing liquidity when they need it," said James DeMare, who heads securitized-product trading at BofA. "Most people you talk to say [non-agency mortgage bonds] are attractive."

The banks' renewed market-making interest is largely a result of improving financial health on their own part. They also believe investor interest in mortgage bonds has grown, which cancels out some of the risk that they'll get stuck with investments.

Bid lists containing mortgage securities with a face value of at least $2.7 billion found buyers in recent days, with big banks accounting for much of the demand. BofA, for instance, took on a $200 million portfolio of bonds backed by option adjustable-rate mortgages last week. An unidentified seller in Asia also sold a $1.5 billion package of bonds backed by floating-rate loans to Wall Street institutions on Monday.

The activity continued on Tuesday and Wednesday, as two money-market funds separately sold as much as $500 million of similar product.

With large financial institutions increasingly moving into the market, prices on such bonds have risen to their highest points in 2009. Senior securities backed by option ARMs gained 1-2 cents in the past week or two, adding to a jump of about 7-8 cents that occurred as other buyers came forth in the preceding weeks. Those issues are now trading around 40 cents on the dollar.

Bonds backed by alternative-A and prime-quality jumbo mortgages have also posted gains.

Most industry players believe further improvement is in store, or that values will at least hold steady - that is, unless a new catalyst drives prices lower. Some of the stronger sentiment results from plans for the U.S. Treasury Department's Public-Private Investment Program and a possible expansion of the Federal Reserve's Term Asset-Backed Securities Loan Facility to encompass mortgage deals. New accounting rules also give more favorable treatment to illiquid bank assets. Others cite signs of an impending economic rebound, recently buttressed by strong earnings reports by major banks.

Some market participants are more bearish. They note that this week's bid lists caused a shift in the balance between supply and demand, causing prices to rise more slowly than they had been.

They also point out that previous improvements vanished quickly. "We've seen this movie before," said Jesse Litvak, who heads trading of non-agency adjustable-rate mortgage products at Jefferies & Co. He noted that past gains have been erased when further details about government proposals emerged.

Nonetheless, the improvements mark a sharp turnaround from the dismal mood that prevailed earlier this year. And it's encouraging that the selling didn't kill the rally, as has happened before.

Big banks had already been buying some mortgage bond portfolios opportunistically in the past few months. One investment banker said their willingness to make markets will have a compounding effect, by alleviating pressure on fund managers to cut their losses by selling. That safety net largely vanished following Lehman Brothers' collapse in September, causing already-depressed mortgage-bond prices to enter a freefall. "For a lot of firms, liquidity became an issue," the banker said.

"Clients need to know that they can sell, that they have the liquidity from dealers, not that they can't sell if they can't find a buyer that day," he added.

The results of government stress tests of financial institutions could play a strong role in the market's direction. That effort is set to produce some initial reports today. "You haven't really seen the possible consequences of banks possibly having to dispose of assets as a result of the government stress tests," an investor said.

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