Troubled residential and commercial mortgage assets are posting their biggest rallies in months on expectations the US Treasury's plan to relieve financial institutions of beaten-down assets will help find the elusive floor for nearly $8 trillion in assets.
Soaring delinquencies have pummelled prices on the bonds backed by home loans since last year, pushing prices on even top-rated securities to less than half their initial value. The unfolding fallout from the housing slump and period of easy lending have fuelled expectations those prices will fall more, deterring potential buyers.
Residential mortgage-backed assets are at the heart of the crisis that has led to the downfall of Wall Street banks Bear Stearns Cos. and Lehman Brothers Holdings Inc, and the government rescue of American International Group, the world's biggest insurer.
Watching a vicious cycle threatening banks such as Washington Mutual Inc and Morgan Stanley, Treasury Secretary Henry Paulson called for the US government to spend up to $700 billion to free financial firms from mortgage assets choking their balance sheets. Extricating them from the assets could help reopen credit markets and arrest downward trends in housing and the economy.
"The government has stepped up to its role as 'capital provider of last resort'," J.P. Morgan Chase & Co strategist Christopher Flanagan said in a client note. "Asset price erosion due to inadequate capital availability, in the face of extraordinary fundamental value in many instances, is now largely off the table."
Credit indexes, including benchmarks of the subprime mortgage bonds that first stressed balance sheets more than a year ago, soared after Paulson on September 25 revealed plans to mop up bad assets and stabilise money markets.
The top "AAA" slice of the ABX 07-1 index rocketed higher by nearly 8 points, doubling the move and erasing at least three months of losses. Lower-rated subprime bond indexes bumping close to zero in recent months jumped by 1/2 point to more than 2 points. The yield spread premiums on commercial-mortgage bonds and related derivative indexes plummeted.
The downdraft in pricing for residential mortgage-backed securities had been so sharp and undiscriminating that bonds originated from the "best" issuer just four months ago recently took a 16 point loss when sold in the secondary market, Jeffrey Gundlach, chief investment officer at Los Angeles-based TCW, said at a conference in New York. He was able to buy the bond at a price of 74. Riskier bonds, such as those backed by pay option adjustable-rate mortgages, are trading below 50 cents on the dollar. Many subprime securities trade at much lower levels since they are unlikely to see any return of principal.
Wall Street analysts for months have been telling investors there is great value in the market, even with assumptions that home prices will continue to fall and defaults will top already lofty levels. However, buyers have been scarce as hedge funds and capital-constrained financial institutions must cut borrowings, and have no appetite for mortgage bonds at any price.
"Right now, you have a lot of good-to-average assets at low prices," said James Callahan, executive director of Pentalpha Capital Group in Greenwich, Connecticut. "If the federal government were to put all these assets into one entity, it would probably be a very good long-term investment for the government."
Further, the reduced supply of low-priced assets would stabilise the markets, Callahan said. Details of the plan are still being crafted. Congress aims to hammer out legislation this week, but issues such as how to best price the debt and reduce risks to taxpayers could cause delays.
The longer-term market response depends on what assets the entity would buy, and at what price, traders said. "It's positive in the sense that something is going to be done, but we're a little short on the details," said Mike Kagawa, portfolio manager at Payden & Rygel in Los Angeles.
"If you look at the reaction in the stock, Treasury and (interest-rate) swaps markets, they're all telling you that this is a good thing and that you're taking some of the fear and risks out of the system," he said. "But then again as they always say, the devil's in the details." Rating companies are also in the midst of a wave of downgrades, especially on subprime mortgage bonds, Gundlach said. More than 80 percent of the bonds are still rated "AAA", according to Gundlach, a rating that if lost would likely force waves of selling by many money managers.
"There should be no 'AAA' rated subprime securities," he said. "The vast majority may not return" principal, he said. The plan for "illiquid" assets to be hammered out by Treasury is seen similar in principle of the Resolution Trust Corp, the government institution set up in the early 1990s to liquidate nearly $400 billion in assets from more than 700 insolvent savings and loan institutions.
A plan for a government body to buy troubled real estate debt to relieve the credit crunch was advocated last week in a Wall Street Journal opinion piece by former Federal Reserve Chairman Paul Volcker, former Comptroller of the Currency Eugene Ludwig and former Treasury Secretary Nicholas Brady.
"One of the reasons why they are advocating an RTC-like entity, is the one thing that we achieved very quickly is we established a bottom," Tim Ryan, a former director of the RTC and Office of Thrift Supervision who now leads the Securities Industry and Financial Markets Association, said last week.
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