A curious thing happened in the RMBS and CMBS markets (ABX) this Spring: it crashed and ultimately recovered only somewhat (at least for the super senior tranches). DoctoRx, who follows things like spreads closely, brought this activity to my attention. Neither of us saw any underlying economic factors that would explain this phenomenon. So what happened?

Trepp, a provider of data on these markets, in a recent report on the CMBS market, and an article in the Wall Street Journal on RMBS, finally shed some light on this crash. The lesson learned was that only when everyone tries to get out at once does one realize how thin the market for these securities is. And guess who wanted to get out and couldn’t: The Fed.

Investors buy these mortgage backed securities, even ones backed by so called subprime mortgages, because they get pretty good returns, about 6% to 8%. Hedge funds report yields for MBS strategies of 15% or more. For information on how these securities work, see «Peeling Back The Onion.»

Here is an example of how the market looks, as shown on Markit’s ABX index:

Here is how these two bonds were affected:

You can see that the AAAs recovered somewhat but the BBBs haven’t recovered.

So when spreads (the difference between the 10 year Treasury and these MBS securities) started to widen, it caused some havoc in the marketplace. Here is the story of spreads, from Trepp:

What this chart shows is the gradual tightening of AAA CMBS spreads in the past year, reflecting the market’s relative comfort with these securities and the demand for high yield securities. But spreads increased from 167 in April to 275 bps in early June. As you can see, the market recovered somewhat. The BBBs took a beating. Here’s how Trepp describes the action:

The [second] quarter began strong, was followed by a hair-raising dive late in the quarter, and ended with a rally to keep the quarter from being an utter disaster.

In March, the instigators for the selloff were unrest in the Middle East and concerns about Japan after the earthquake and tsunami. In May, the prospect of a Greek debt restructuring and a weakening U.S. economy pushed CMBS spreads wider. The weakness in CMBS was only exacerbated in the second week of June when the Fed flooded the market with Maiden Lane paper. The combination of excess supply, new benchmark trading levels and greater risk aversion among investors sent spreads sharply higher.

Overall, spreads on legacy super seniors [AAA] actually tightened a few basis points in June despite a bump in the second week of the month that sent 2007 A4 bonds 30 to 50 basis points wider than early June levels. The benchmark GSMS 2007-GG10 A4 bond ended June at 210 basis points over swaps. [GG10s are a benchmark «super senior» preference-in-distribution bond.] This was a remarkable comeback for the GG10s. The GG10s began the month at 220 basis points over swaps but then gapped out to 275 basis points over in mid-day trading on June 9. The bellwether fought back to 210 over swaps to end the month: a 10 basis point tightening…

A similar pattern was apparent, although more magnified, for double A’s, single A’s and triple B’s. The 2005 through 2008 vintages were walloped during the second week of June, blowing out 500 to 1,000 basis points. The better names rallied toward the end of June making the carnage not as bad as it might have been. Bonds from dented deals were not nearly as lucky.

The Wall Street Journal article shed more light on this, discussing the residential MBS market. Here is a summary drawn from their article:

Point No. 1

Wall Street’s confidence grew in March when American International Group Inc. publicly offered to buy back a $30 billion portfolio of mostly subprime mortgage bonds from the Federal Reserve Bank of New York, which had held them since the crisis. [These are called the Maiden Lane II securities.] The bailed-out insurer offered to pay $15.7 billion cash, or an average of 53 cents on the dollar, for the bonds. [Ignore the irony here.]

Point No.2

The day after AIG’s offer, financial markets were jolted by the earthquake and tsunami that struck Japan. MKP Capital Management, a $4.5 billion hedge-fund manager that bought discounted mortgage bonds during the crisis, sold the bulk of its holdings of residential and commercial mortgage debt.

Point No. 3

By mid May, the Fed’s sales were hitting a wall. The market was satiated. The central bank put the sales on hold for a few weeks just as economic warning signals flashed. Home prices fell sharply in the first quarter, sinking to 2002 levels and dashing hopes of a near-term recovery. The U.S. unemployment rate increased amid weak job growth in May, and in Europe, fears increased that Greece wouldn’t be able to repay its debt sparked renewed concerns of a sovereign-debt crisis.

Point No. 4

Banks and investors that had just bought mortgage bonds from the Fed found themselves sitting on potential losses, forcing them to pivot.

Point No. 5

In late May, French-Belgian bank Dexia SA said it would sell off $8.5 billion in U.S. residential mortgage bonds to clean up its books, raising concerns of more supply hitting the market. The Fed held another mortgage bond auction in early June, but sold only half the securities it offered up. By then, the ABX had plunged to 47 cents on the dollar, down 20% from April, and even corporate high-yield “junk” bonds were losing value.

Point No. 6

[Sean Dobson], CEO of Amherst Holdings LLC, a broker-dealer that specializes in mortgage debt … says many mortgage bonds were “grossly overvalued” earlier in the year and prices are now more reflective of the bonds’ actual values given the absence of a housing recovery. [I.e., these investors expected the housing market to recover!]

Point No. 7

In light of the recent turmoil, Dexia intends to wait till market conditions are better before selling its mortgage bonds, according to a person familiar with the matter. Wall Street traders, meanwhile, are waiting to find out whether the Fed, which has so far sold a third of the Maiden Lane II portfolio [these are assets acquired during the AIG $182 billion bailout], will put its auctions on hold for the rest of the summer. At current prices, the Fed would fetch less than what AIG originally offered for the bonds.

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Historical note: The Fed paid these banks for the Maiden Lane II asset they acquired during the $182 billion AIG bailout: France’s Societe Generale at $11.9 billion, Germany’s Deutsche Bank at $11.8 billion, and Britain’s Barclays PLC at $8.5 billion. AIG, through this fund also funneled significant bailout money to U.S. banks that had already been bailed out themselves under the Troubled Asset Relief Program. As AIG counterparties, Goldman Sachs got $12.9 billion, Bank of America got $5.2 billion, and Citigroup got $2.3 billion all at 100% on the dollar. It pays to have friends in high places.

Copyright © 2011 · The Daily Capitalist

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Published by kind permission of Jeff Harding.
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