Where is Value in Sub-Prime Mortgage Market?
Some would argue that the sub-prime mortgage market in the United States is in melt down stage. Others, like the leading 2006 underwriter of sub-prime mortgage-backed securities debt (and Lars Toomre's former employer), Lehman Brothers, argue that the massive sell off in the sub-prime credit index known as ABX is way over done. Several people have turned to Lars Toomre recently to ask his thoughts on relative value. The answer is really unclear. The purpose of this posting is to welcome readership commentary: Where is Value in the Sub-Prime Mortgage Market?
As many investment professionals know, the major United States investment banks led by Lehman Brothers, Bear Stearns, and Morgan Stanley have moved heavily into the origination end of the mortgage business. By themselves originating the mortgage loans to specific standards, hedging the mortgage pipeline until sufficient principal volume was accumulated and then packaging them into a securities offering through a process known as securitization, the investment banks could guarantee that they would have a steady flow of lower cost collateral to feed their underwriting and trading businesses.
In the last two years, credit spreads and mortgage spreads have tightened to near all-time tights relative to U.S. Treasury securities and interest-rate swap curves. The near insatiable quest for yield has led many investors to purchase more riskier types of assets than they perhaps might normally do so. That has been true in both the corporate bond sectors and the mortgage-backed securities markets. Many more speculative investors searching for investment returns of 10% (after all fees) have turned to the subordinated tranches of mortgage-backed securities, including securitizations backed by sub-prime originations.
Other speculative investors have taken the strong view that the U.S. housing market is in the midst of bubble and housing prices will retreat in many markets sharply. As a result, they have deployed strategies that seek to profit from the decline in housing prices and associated credit quality. One often used strategy is writing credit-default swaps ("CDS") against one or more of the various mortgage indices. A very popular reference index is known as the ABX index. This index tracks the credit losses on representative subordinated tranches from twenty sub-prime MBS transactions originated in the second half of 2006.
The ABX index is down sharply since it was first introduced in at year-end 2006. Since mid-February it has moved even more sharply lower, as many more speculative accounts write CDS derivative contracts against this index. The number of OTC derivative contracts now outstanding against this index value far, far exceeds the total amount of principal in the twenty underlying bonds classes.
Some argue that the index selling pressure has driven the CDS swap value far below the amount of losses that ever will be experienced from the sub-prime collateral pools themselves. Others strongly disagree. What do you think? Reader comments and thoughts are welcome.