Fresh Leverage Lifts Mortgage-Bond Trading

Leverage is trickling back into the mortgage-securitization market.

In a move that is already buoying bond prices, and could hurt smaller competitors, large Wall Street institutions including Bank of America, Citigroup and J.P. Morgan have begun financing client purchases of home-loan securities on the secondary-market. Some mid-size institutions have been in on the act too, including Jefferies & Co.

To be sure, leverage still isn't widely available to mortgage-bond buyers. Indeed, the banks have just begun to creep back into the business in recent weeks.

But any willingness to help investors buy on margin signifies a drastic change in sentiment. As credit-market conditions began deteriorating in mid-2007, banks trimmed the amounts they were willing to lend to hedge funds and other leveraged buyers of mortgage bonds. And when the financial crisis hit new depths a year ago, the institutions all but cut off the flow of leverage.

The result was that already-slow mortgage-bond trading became paralyzed. Now, the opposite is happening.

Secondary-market prices for non-agency mortgage bonds had already rallied sharply in recent months as buysiders prepared for the launch of the U.S. Treasury Department's Public-Private Investment Program. PPIP has presumably contributed to the banks' more-bullish view as well, and the resulting availability of leverage from those players has pumped a gust of wind into the market's sails.

The effect has been greatest for the cleanest mortgage-backed paper. Over the past two weeks, for example, prices for 5-7 year bonds backed by 15-year private-label mortgages to prime-quality borrowers have risen 2-5 cents on the dollar - in some cases to par.

Other sectors have also rallied. Strong performers among bonds with 5-7 year lives backed by alternative-A loans were up 1-3 cents this week, to 65-73 cents. Similar paper backed by adjustable-rate credits rose 2-3 cents to the low 90-cent range. Comparable issues underpinned by option-ARM loans rose 3 cents, in some cases to as much as 65 cents.

PPIP's contribution to those gains stems from a feeling that the program will help boost values even higher once it is in full swing. The initiative centers around nine Treasury-backed funds that aim to relieve banks of devalued home-loan investments. Of them, five have met minimum capital-raising thresholds set by the Treasury, with a combined $12.3 billion of private-sector and government money. They were set to begin buying as soon as Oct. 12, but it's unclear if any have done so yet.

As for the banks now offering leverage to their buy-side clients, they're charging steep interest rates. Typical financing fees are about 10% of the amount borrowed, and the credits roll over frequently - in some cases on a monthly basis.

As part of the process, the banks are said to be increasing the amount of mortgage bonds they hold in inventory.

Meanwhile, the moves could pose a threat to another group of market players: smaller broker-dealers. A bevy of those shops formed or boosted their securitization-trading businesses while big banks headed to the sidelines, often by absorbing castoffs from larger competitors. They include CRT Capital, Hoare Capital, MF Global, Raymond James Financial and 12th Street Capital, among many others.

Most of those shops simply don't have the cash on hand to offer buyer financing. That puts them at a disadvantage in winning business, as some deeper-pocketed players are willing to offer leverage only to clients that also use their trading desks. "We can't compete with the leverage and the financing," one brokerage professional said.

However, smaller broker-dealers aren't ready to throw in the towel. They argue that their business models are different from those of larger banks, and offer benefits such as lower fees and more personalized attention from senior staffers. The head trader at one shop that doesn't offer leverage also pointed to a number of recent senior-level hires as evidence of a brainpower advantage when it comes to analyzing specific deals for clients.

Another broker that doesn't lend to clients criticized the re-emergence of leverage as a gimmick to drive up business.

Said yet another: "Leverage is what got us into this mess in the first place," referring to the easy credit that led to the debt market's collapse.

Big dealers respond that they're simply reacting to demand from clients who want to drive up their buying power while yields are still attractive.

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