Mortgage-Backed Securities Make a Comeback, Despite Similar Risks

Some Wall Street investors made money as the mortgage market boomed; others profited when it fell apart.

Having reaped big gains during both of those turns, Greg Lippmann, a former star trader at Deutsche Bank, is now catching the next upswing: buying the same securities built from mortgages that he bet against before the financial crisis erupted.

Mr. Lippmann is joined by other big-money investors — mutual funds like Fidelity as well as hedge funds — in riding a wave of interest in the same complex loan pools that nearly washed away the financial system.

The attraction is the price. Some mortgage bonds are so cheap that even in the worst forecasts, with home prices falling as much as 10 percent and foreclosures rising, investors say they can still make money.

“Given its significant underperformance in 2011, we believe the product is as cheap to broader markets as it has been in a long time,” Mr. Lippmann, whose portfolio is heavy with subprime mortgage securities, wrote in a recent letter to investors.

More broadly, the nascent recovery in the mortgage bond market supports a view that the housing slump may have bottomed out. Sales of existing homes are picking up. State and federal authorities have reached a $26 billion settlement with the big banks that is expected to provide some mortgage relief. And the Federal Reserve Bank of New York has been able to auction off billions of dollars of mortgage securities that it acquired as part of the financial crisis bailouts.

“There is light at the end of the tunnel,” said Kenneth J. Taubes, the head of United States investment for Pioneer Investments, a global investment manager that owns these securities. “The mortgage crisis is getting behind us, and things are getting back to some semblance of normality.”

That optimism is an about-face from 2006 and 2007, when Mr. Lippmann and others told investors that housing was a bubble ready to burst. On Wall Street, Mr. Lippmann became known as “Bubble Boy,” and one of his traders wore a joking T-shirt that read, “I Shorted Your House.”

His exploits were chronicled in Michael Lewis’s best seller “The Big Short,” which described him as somewhat brash and crass. He was known for maintaining a sushi spreadsheet, where he ranked the top Japanese restaurants in Manhattan on ambiance, quality and cost. (He still maintains the spreadsheet.)

These days, industry competitors describe Mr. Lippmann, who runs LibreMax Capital, as a more mellow presence. And he is much more positive about the market, telling investors that his fund is reducing its hedge against a potential market crash. Through a spokesman, Mr. Lippmann declined to comment.

Others in the industry are also bullish, pouring money back into mortgage securities. Trading has surged in recent weeks. Prices have risen more than 15 percent in the first two months of 2012, after dropping by as much as 40 percent last year.

“There was a lot of money waiting on the sidelines because yields were starting to look very attractive,” said Jasraj Vaidya, a strategist at Barclays Capital. “Lots of it seems to have come out now.”

Yet the tide could turn again and wipe out investors. Chief among the risks is Europe: the Continent’s banks still hold a significant amount of United States mortgage securities, and if they are forced to sell assets, it could wreak havoc on the market.

Washington is a question mark, too. If banks have to pay for loans they issued under dubious circumstances, it would be a home run for investors, who could receive full payment for a mortgage in a security they bought at a discount. But if borrowers whose houses are worth less than their mortgages are able to reduce their principals on a large scale, bond investors could suffer because the securities would be worth even less than they paid.

“As a money manager, you can’t close your eyes to that potential outcome,” said Jeffrey Gundlach, a founder of DoubleLine Capital, who has been buying mortgage securities since 2008. “To believe that this time we are really out of the woods and the prices will not drop again is dangerous. People made that argument a year ago.”

The mortgage bond market is a very different creature than it was before the financial crisis. For one, it is much smaller: very few residential mortgage-backed securities have been issued since the crisis. The market, at $1.3 trillion, is half the size it was at its peak and shrinks by an estimated $10 billion every month.

Despite the limited supply, prices remain cheap, in part because the assets are difficult to value. Hedge funds and big investors use computer systems to analyze the underlying loans and estimate, among other things, how many borrowers will default and how much money can be recovered in a foreclosure.

Take one security, JPALT 2006-S1 1A11, which was built from Alt-A loans, or mortgages that required little documentation verifying a borrower’s income.

On the surface, the numbers are not encouraging: of the 799 mortgages underpinning the bond, many in foreclosure-heavy California and Florida, about 21 percent are more than 60 days late on payments.

The annual default rate is about 7 percent, and of the homes sold out of foreclosure, investors take a 54 percent hit, according to data from Bloomberg. On average, about 5 percent of the homeowners refinanced their mortgages before they were due over the last 12 months.

That bond recently traded at nearly 70 cents on the dollar.

At that price, even if defaults and the losses increase, an investor can still make more than 5.4 percent, an analysis shows. In a rosier prediction, where defaults drop slightly and the losses on the sale of foreclosed homes stay flat, the bond returns nearly 8.7 percent.

“Price is a wonderful thing,” said Chris Flanagan, an analyst with Bank of America Merrill Lynch. “Yields in this market range anywhere from 4 or 5 percent up to 12 percent.”

With long-term interest rates close to zero, such returns are hard to resist — even for investors who were punished in the housing bust. The American International Group, whose mortgage securities were acquired by the New York Fed in its more than $100 billion bailout in 2008, has been buying back some of those bonds. And a former mortgage team from Lehman Brothers, which went bankrupt in 2008, formed One William Street, a hedge fund that manages more than $3 billion in assets.

As for Mr. Lippmann, his reputation has made it both easier and more difficult to get commitments from investors. Some are impressed by his well-publicized bet against the mortgage market; others are turned off by his high profile in an industry known for secrecy and discretion.

LibreMax, made up of several members of Mr. Lippmann’s team from Deutsche Bank, has raised more than $1 billion in a little over a year. His performance has been relatively strong during a period of market turmoil — up 2 percent last year and a little more than 6 percent since launching.

Like his rivals, Mr. Lippmann cites his experience in the housing market — including its boom and bust — as a principal selling point for his fund.

“Because we have a trading history, I think we understand very well how the street works, better than perhaps people who didn’t work in trading before that haven’t had that experience,” he said at a Bloomberg hedge fund conference in 2010.