Friday, August 8, 2014

The Next Structured Finance Collapse?

Joy Wilbermuth of Reuters reports, Hedge funds hit by RMBS margin calls:
Several hedge funds have received margin calls in recent days on their holdings of risk-sharing RMBS bonds from Freddie Mac and Fannie Mae, market sources told IFR.

The sources said the margin calls were met, but the event still unnerved the structured finance market, which has again become reliant on cheap leverage to sustain momentum.

One banker said brokers' margin calls required the hedge funds to pony up an extra four to five points of their equity against what they initially borrowed to purchase the bonds - understood to be more than 80% of the purchase price in some cases - to cover any losses.

"Dealers that lead these trades offer attractive financing of two to three times leverage," one mortgage strategist said. "But if the investor is forced to unwind, it can get ugly."

In the first quarter, some hedge funds were locking in 30-day repurchase agreements to buy risk-sharing bonds at a rate of 1.9% to lever 2.14 times, according to SEC filings.

Risk-sharing RMBS are barely a year old, having sprung up as a new asset class after US regulators issued guidelines urging the government to reduce its footprint in the massive US residential mortgage market.

Hedge funds piled aggressively into the riskier (and often unrated) tranches of the deals, looking for yield pick-up at a time when returns had shrunk dramatically just about everywhere else.

But those deals have recently tumbled dramatically. Between July 11 and July 29, the unrated bonds favoured by hedge funds gapped out as much as 50bp to roughly Libor plus 330bp in the secondary market, according to Wells Fargo data.

"Generally the sell-off has all the signs of a levered unwind," the mortgage strategist said.

And at a time when volatility is high - Lipper this week reported the largest one-week outflow from high-yield funds ever, at more than US$7bn - the risk-sharing bonds are continuing to struggle.

On Wednesday Freddie Mac had to price the unrated tranches of its latest Structured Agency Credit Risk (STACR) trade at Libor plus 400bp and 410bp - a whopping 100bp-120bp wide of Fannie Mae's last risk-sharing deal in July.

And while cheap money certainly enticed some players to buy into the risk-sharing sector in the first place, record volumes lately have led players to look for a way to trade out.

Approximately US$135m in risk-sharing bonds was out for bid in each of the past two weeks, the highest levels by far since the programme started in July 2013, according to Adam Murphy, president of market data company Empirasign.


Despite these stumbles, Freddie Mac is counting on being able to attract a broader base of buy-and-hold investors to the asset class - and remains optimistic.

For one thing, each of Freddie's four STACR deals prior to July had printed at successively tighter levels, as did the three prior Fannie trades.

"Maybe spreads tightened too much and are now back to a more sustainable level," Mike Reynolds, a director of portfolio management at Freddie Mac, told IFR.

"We definitely think the investor book should include hedge funds, and it's natural for them to use to get the yields they need," he said. "But we prefer to be a smaller percent of the total distribution."

And that seems to be happening already. For the 2014-DN3 portion of the new STACR trade, 20% went to hedge funds, down from a 30% participation in April for its DN2 deal, Reynolds said.

Meanwhile the 2014-HQ1 deal - the first from Freddie to include mortgages with loan-to-values above 80% - saw just 5% participation from hedge funds.
Last month, I discussed the return of subprime debt, focusing my attention on certain risky segments of the securitized debt market that can potentially blow up (like subprime car loans which have taken off but so far are not an imminent threat).

Now we're reading about hedge funds (ie. leveraged beta chasers) piling into "risk-sharing RMBS," which is a "new asset class" with an old twist. It's basically betting on unrated paper offered by the once bankrupt Freddie Mac (FMCC) and Fannie Mae (FNMA).

But times have changed. Both these government-controlled mortgage giants posted profits for the April-June period as the housing market continued to recover. Gains in recent years have enabled them to fully repay their government aid after being rescued during the financial crisis. And both entities are boosting their dividend to the U.S. Treasury in a clear sign of wanting to attract investors.

And as you can see below, their share price has soared over the last year (click on images):

And who has been buying shares of these once bankrupt mortgage giants? Who else? Some of the best known hedge funds. In particular, I noticed Bruce Berkowitz's Fairholme Capital Management is the top holder of both Freddie Mac and Fannie Mae shares. This is the same fund that made outsized gains buying AIG early on and they remain a top holder of that company too.

So maybe there is more to this housing/ mortgage recovery story than meets the eye but the structured finance side of it makes me nervous. I'd rather bet with Bruce Berkowitz on their shares recovering than taking leveraged bets on unrated paper in the RMBS market.

At 4.14%, the rate on a 30-year mortgage is down from 4.53% at the start of the year. Rates have fallen even though the Fed has been trimming its monthly bond purchases. The purchases are set to end in October.

As far as the overall market, geopolitical risks, fears of a global Ebola outbreak and low summer volume are making people nervous. Everyone is looking for a chance to cash out during this latest correction but I'm sticking firm with my thoughts which I expressed in my comment on preparing for another crash.

Importantly, there are always plenty of reasons to panic but the market has been steadily climbing the wall of worry each and every time. Do you remember when Greece teetered on the edge of default and everyone was worried that the eurozone was going to collapse? I do and told my readers to ignore the news media and keep buying them dips.

Of course, you can't buy the dips forever and in this market there are some stock specific dips which are worth buying and others that you have to steer clear from. When Twitter (TWTR) fell below $30 a share, I tweeted "top hedge funds are loading up and so should you!".  And what happened? Twitter killed their numbers and the stock is trading near $43 now. And wait, it ain't over, this stock will surge past $100 over the next 12 months because in a knowledge hungry world, Twitter will kill its social media competition, including Facebook (FB), which is all about vanity, not knowledge (rightly or wrongly, I still refuse to open up a Facebook account).

What else do I like? I already told you :
I still like biotechs (IBB and XBI), small caps (IWM), technology (QQQ) and internet shares (FDN). By the way, I particularly like Twitter (TWTR) and tweeted people to load up on it when it fell below $30 several weeks ago (stay long)...My personal portfolio remains in RISK ON mode, heavily invested in small cap biotechs like Idera Pharmaceutical (IDRA), my top holding at this moment (very volatile and extremely risky).
And there are plenty of other biotechs courtesy of the Baker Brothers and others which are on my radar. Companies like ACADIA Pharmaceuticals (ACAD), Pharmacyclics (PCYC), Seattle Genetics (SGEN), Synageva BioPharma Corp. (GEVA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), TG Therapeutics (TGTX),
XOMA Corp (XOMA) and other biotechs that can easily double from here (but they remain very risky so don't bet the farm on them if you're risk averse).

Then there is El Pollo Loco (LOCO) which shows me there is plenty of froth and craziness left in this market. Its shares have more than doubled in a little over a week after it IPOed as investors are betting it's the next Chipotle (CMG). Good luck with that bet and the momos and retail investors are going to get raped chasing this one (wait till their first earnings report before you do anything there).

Below, Nobel Laureate Robert Shiller, a professor at Yale University and co-creator of the S&P/Case-Shiller index of property values, talks about the U.S. residential-housing market. Residential real-estate prices rose in the 12 months ended May at the slowest pace in more than a year as a lull in the U.S. housing market limits appreciation. Shiller speaks with Alix Steel on Bloomberg Television's "Street Smart." David Kotok, chairman and chief investment officer at Cumberland Advisors, also speaks.

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