07/24/2009

Coming Sales Threaten Mortgage-Bond Gains

An anticipated gush of selling could cause the values of mortgage-related bonds to whipsaw in the coming months.

Industry players are looking ahead to a logjam of secondary-market offerings, as troubled collateralized debt obligations and structured investment vehicles are forced to liquidate portfolios of home-loan bonds. Healthier players are likely to unload inventory as well.

The upshot is that supply has a strong chance of exceeding demand, which could wipe out recent gains in the prices of mortgage securities.

Troubled CDOs with an estimated face value of $50 billion are expected to enter liquidation in the coming months, with a large portion of their holdings consisting of home-loan product. Defunct SIVs formerly run by Axon Financial and Ceres Capital are also poised to be heavy sellers, as they move to auction off $13 billion of assets by yearend.

On top of that, banks, insurers, asset managers and other investors are planning opportunistic sales to lock in price increases that occurred following a July 8 announcement by the U.S. Treasury Department that it was moving forward with its Public-Private Investment Partnership. On top of that are early indications of a spurt of new mortgage-backed issues in the pipeline (see article on Page 3).

A hint of the coming secondary-market supply was seen this week, when bondholders voted to liquidate Kent Funding 1, a CDO that Declaration Management issued in 2005 at a face value of $1 billion. The investors gained that power after the transaction hit an event of default on June 4.

MJX Asset Management is handling the sale of the underlying assets, which consist mostly of mortgage-related bonds. The firm has already moved many of the positions, but is finding others harder to place as buyers look at $2 billion to $4 billion of additional bid lists - some 90% of which entails similar investments. "There are enough buyers for this, but the market is softening and not all these positions are trading," one trader said.

Aside from the Kent portfolio, some of the added supply was coming from other forced sellers. Some also came from investors seeking to test the market ahead of the PPIP's launch.

Of course, troubled CDOs have been unwinding all throughout the financial crisis. But a growing number of investors in those vehicles are expected to push for liquidations in the next 6-12 months, as the debt market's struggles continue. In many cases, they could be swayed toward such maneuvers by one of the same factors influencing the market's healthier sellers - a desire to take advantage of the recent pricing rally.

According to Wells Fargo researchers David Preston and Justin Pauley, CDOs with face values of $352 billion have hit events of defaults since October 2007. Of those deals, $117 billion have already liquidated, and $7 billion are in the process of unwinding. Another $123 billion are on accelerated payment schedules that don't yet call for large-scale asset sales, and $105 million have yet to determine their courses of action.

If past patterns hold true, that means another $50 billion or so of the defaulted transactions will eventually seek to sell their underlying portfolios.

As for SIVs, the former Axon and Ceres vehicles - now controlled by Stone Tower Capital - aren't the only sellers. Banks that took SIV assets onto their balance sheets as that corner of the market collapsed are seen shedding those holdings as well. Citigroup, for example, ran six such entities whose investments wound up on its books.

For now, however, mortgage-bond prices are holding more or less steady at levels that are up roughly 50% from lows seen in February. Some traders said this week that they saw no movement in values, while others cited an uptick of 2-10 cents on the dollar - even as supply grew.

"Everything's ripping," one trader said, pointing to heavy trading of senior bonds with 5-6 year lives that are backed by adjustable-rate mortgages to prime-quality borrowers. Those issues gained 10 cents this week, settling at 75 cents on the dollar.

Another trader said he hadn't seen any price increase, but no decrease either. He said senior 7-9 year bonds backed by option adjustable-rate mortgages are going for 40-50 cents on the dollar.

Along with optimism brought on by the PPIP program, prices have been in part buoyed by recent stock-market gains, which have given investors more confidence in the values of their home-loan bonds.

Still, buyers are skittish about a weak housing market and high unemployment. They also want to see the government actually follow through with PPIP's mission of removing so-called legacy bonds from financial institutions' balance sheets. Plus, they're aware that supply and demand could soon be thrown off balance. "People know there's selling coming, and that's where the nervousness comes in," said Hiram Matthews, head of structured-product trading at New York investment-banking firm CastleOak Securities. The question is to what degree the coming supply can be offset by optimism gleaned from the PPIP and general economic improvements. One buysider said indications point toward an overload of offerings. "That's why prices are not going to stay where they are," he said.

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