Mortgage-Bond Leverage Reaches 10-to-1, Markets Heal

(Update1) Share Business ExchangeTwitterFacebook| Email | Print | A A A By Jody Shenn Jan. 19 (Bloomberg) -- Wall Street firms are loosening terms of their lending to mortgage-bond investors as markets heal, an RBS Securities Inc. executive said. Repurchase agreement, or repo, lending against the debt has expanded so much since freezing in late 2008 that some banks now offer as much as 10-to-1 leverage and terms as long as one year on certain securities backed by prime jumbo-home loans, said Scott Eichel, the Royal Bank of Scotland unit’s global co-head of asset- and mortgage-backed securities. “It’s getting very competitive,” Eichel said in a Jan. 14 interview at Bloomberg headquarters in New York. “We’re at the point where I don’t think we would feel comfortable if things go too much further.” Increasing availability of leverage for mortgage-bond buyers was among the reasons that JPMorgan Chase & Co. and Barclays Plc each said in analyst reports this month that a record rally in U.S. home-loan securities without government- backed guarantees may continue even amid record foreclosures and further declines in home prices. Stamford, Connecticut-based RBS Securities was the second- largest underwriter of structured-finance securities worldwide last year, according to newsletter Asset-Backed Alert. In a repo, one party provides securities to another in exchange for cash, with an agreement to reverse the exchange at the end of a pre-set time period. The difference between the market value of the collateral and size of the loan is known as a haircut, and it determines the amount of leverage. Repo Data Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $32.7 billion of securities aside from Treasuries, agency debt and agency mortgage bonds as collateral for financings lasting more than one day as of Jan. 6, up from $15.8 billion on May 6. That’s down from $113.9 billion in 2007 and reflects so-called reverse repo, securities- lending agreements and other arrangements. Using borrowed money allows debt buyers such as hedge funds to potentially earn greater returns even as they buy at higher prices, though also increasing risk. As asset values dropped during 2007 and 2008, leverage boosted losses, wiping out hedge funds run by London-based Peloton Partners LLP and New York-based Bears Stearns Cos., and damaged markets by leading to forced sales by firms, including Santa Fe, New Mexico-based Thornburg Mortgage Inc., which filed for bankruptcy. ‘A Little Frightening’ “I’ve got to be honest, leverage coming back this quickly is a little frightening,” said Jim Shallcross, who oversees about $12 billion of bonds as director of portfolio management at Declaration Management & Research LLC in McLean, Virginia. “You can’t assume everybody is going to do stuff rationally.” While excessive leverage employed by borrowers ranging from consumers and commercial-property buyers to banks and funds led to markets collapsing, the economy needs some amount, Brian Lancaster, RBS Securities’ head of asset- and mortgage-backed securities strategy, said in a joint interview with Eichel. “It’s like the children’s story, there’s ‘too much,’ ‘too little’ and ‘just right,’” Lancaster said, referring to the tale of Goldilocks and the Three Bears. “Only, it’s really not easy to tell the difference.” RBS Securities, which traded $200 billion of mortgage bonds last year, has ramped up repo lending, though it “hasn’t gotten” to offering 10 percent haircuts on debt with long durations, exceeding four years, Eichel said. Competitors may be going further in a bid to win market share in businesses such as trading and underwriting, he said. Bear Stearns To lead the division’s repo business, RBS last year hired Matthew Chasin, who joined a group of other former Bear Stearns employees, including Eichel, who arrived after JPMorgan Chase & Co.’s purchase of the investment bank in 2008. Ten percent haircuts aren’t risky with certain securities, such as senior ones projected to be retired soon by foreclosure proceeds, refinancings and home sales, Declaration’s Shallcross said. Before markets for AAA rated home-loan bonds collapsed in 2007, repo haircuts on the debt were as low as 3 percent, UBS AG said in reports at the time. Banks are seeking to provide more financing for mortgage bonds in part because they are finding it difficult to add assets by making safe loans to consumers and companies with the economy still weak, Shallcross said. The best mortgage investments today may involve using leverage with safe securities, such as ones from 2003 and 2004 whose underlying homeowners owe less than their property’s current value, said Scott Buchta, head of investment strategy at Guggenheim Securities LLC in Chicago. His firm is “definitely hearing that haircuts for high quality assets have been offered as low as 10 to 15 percent,” he said. Return Profile “You’re going to have a better return profile buying a high- quality bond with leverage than a low quality one without it or less leverage,” Buchta said. “That’s something a lot of customers are thinking here.” Typical prices for the most-senior fixed-rate prime-jumbo securities soared to 86 cents on the dollar last week, up from a record low of 63 cents in March, Barclays data show. Projected yields have “firmly” fallen below 10 percent across all types of so-called non-agency home-loan securities, the London-based bank’s analysts wrote in a Jan. 8 report. They added to their recommended portfolio a trade using repos to buy prime-jumbo securities, a tactic that would offer yields in the “mid to high 20 percent” range. The terms they cited were a haircut of 15 percent, with funding costs of 1.5 percentage points more than the London interbank offered rate. Jumbo mortgages are ones larger than government-supported Fannie Mae or Freddie Mac are allowed to finance, currently $417,000 in most places to as much as $729,500 in high-cost areas. Non-agency mortgage securities lack guarantees from the mortgage-finance companies or federal agency Ginnie Mae. To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.