Legacy Subprime Mortgages Seen as Gift That Keeps Giving

(Bloomberg) -- In the aftermath of the financial crisis, a $60 million slice of subprime mortgage bonds from 2007 traded hands for as little as two cents on the dollar.

Now, they’re higher than 90 cents.

Fund managers that took a chance on beaten-down mortgage bonds sometime after Lehman Brothers collapsed have seen their money swell as the housing market has recovered. Home loans for even troubled consumers have turned out to be more solid than many investors had feared: borrowers that weathered the downturn are diligently paying their obligations and defaults at this stage are infrequent.

“While mortgage bonds were among the most hated assets eight or nine years ago, now they’re among the most loved, partly because the fundamentals of U.S. housing are so strong," said LibreMax Capital’s Greg Lippmann.

Bonds like these have helped Lippmann generate average annual returns of 8.5 percent at his hedge fund since inception in late 2010, according to a person with knowledge of the matter. That clobbered returns for bonds in general over the period, which have gained around 3 percent annually, according to Bloomberg Barclays index data.

When Lippmann co-founded the fund, it was more than three-quarters invested in mortgage bonds, a figure that is now closer to one-fifth. He helped Deutsche Bank AG and a series of hedge funds bet against subprime mortgages just as the housing bubble started deflating, and appears in Michael Lewis’s book “The Big Short.”

The easy money in these bonds was made years ago, and almost all the securities have disappeared as borrowers have defaulted, refinanced, paid down their debt, or moved. A market that once topped $2 trillion in 2007 is now closer to $350 billion outstanding. But for investors that have stuck with the asset class, the big short morphed into the big long.

Many of the bonds pay floating rates, making them attractive in a market where the Federal Reserve is still tightening monetary policy. The risk has diminished, too. Home prices nationally fell about 35 percent during the crisis, but since early 2012 they’ve risen around 60 percent, according to S&P CoreLogic Case-Shiller data. Prices are now above their prior peaks, meaning bonds backed by mortgages have stronger collateral behind them than they did seven years ago.

Consider the $60 million of bonds trading around 2 cents on the dollar soon after the crisis. Known as JPMAC 2007-CH5 M1, the securities were sold by JPMorgan Chase & Co. and backed by subprime mortgages. They weren’t the safest securities in the bond offering, but they also weren’t the first to suffer losses when mortgages stopped getting paid.

Many investors left the bonds for dead. But as the U.S. housing market recovered, the securities began climbing higher. And lawyers for bondholders began to fight back, arguing that many of the mortgages that had been bundled into the bond should never have been put into the securities in the first place. They forced JPMorgan to buy back bad loans at 100 cents on the dollar, further buoying the notes.

Trading opportunities still remain for bonds like these, said Neil Aggarwal, a senior portfolio manager at asset management firm Semper Capital, which owns some of the JPMorgan bonds. Banks are still sorting through lawsuits and probes tied to how they marketed and sold the debt.

Finding bargains requires searching carefully, said Chris Hentemann, founder and chief investment officer of hedge fund 400 Capital. He’s buying the riskier parts of old subprime mortgage bonds, some of which trade between 30 and 50 cents on the dollar.

“There’s a significant double-digit return in the legacy market that will exist for the foreseeable future," Hentemann said.

Subprime mortgage bonds still carry a taint for many investors. That may be why so few new securities are being sold now: just $5.6 billion have been issued this year, compared with closer to a trillion of annual issuance before the crisis, according to data from the Securities Industry and Financial Markets Association. The mortgage bond market for more creditworthy borrowers has been muted too. More than $17 billion of securities backed by "jumbo" mortgages to prime customers have been sold in 2018.

Some money managers are focusing on more obscure pre-crisis securities. Trust-preferred collateralized debt obligations, which are bundles of debt-equity hybrid instruments issued by banks, have helped Stamford, Connecticut-based Hildene Capital’s main fund return 11 percent this year through July, according to a person familiar with the matter. Brett Jefferson, the firm’s president and co-chief investment officer, said the fund recently bought a CDO of trust preferreds for 85 cents on the dollar that it had owned years earlier at around 3 cents. The risk of banks not being able to make good on their obligations now are lower, he said.

“Banks are much stronger," Jefferson said. “Most of them are far better capitalized than they were pre-crisis.”

Mortgage bond investors point to other factors that help bolster prices in the future. For example, home prices are rising faster than inflation, said Sam Dunlap, a portfolio manager at Angel Oak Capital, which manages assets including legacy bonds backed by pools of prime, "alt-A" and adjustable-rate mortgages.

“That’s an excellent story," Dunlap said. "There are a lot of people that did not expect the economy to be booming in 2018. We still have a high degree of conviction."

©2018 Bloomberg L.P.