David Schawel's  Instablog

Reading Felix Salmon's follow up seekingalpha.com/article/166563-awful-investing-advice-of-the-day-distressed-mortgages-edition  to the NY Magazine article on Investing in Toxic Assets prompted me to issue a rebuttal.  If you are immediately afraid of investment opportunities based on media portrayal, this article is not for you.  If you are willing to search through facts and perform simple arithmetic in order to out-perform the market, you may want to keep reading.

So.... what is toxic?  Toxic to who?  How does that impact making money?  Let's pretend you are a bank who lends someone $100 at 6%.  What is the best outcome that can happen?  Well, you eventually receive your $100 back with the 6% interest.  Simple economics of a bond, I know.

So one day after the credit crises and during the recession, the Bank wakes up and realizes it will not receive their full $100 of principal back.  Let’s say that based on all available information they expect to receive $95 back.  If this hypothetical example were a mortgage-backed security, it would be rated CCC by the rating agencies.  If there is even one penny of principal not expected to be received, it is immediately a CCC.  The CCC rating does not tell you whether the rating agency projects 99% of principal back or 1% back.

 

Now, let’s take this a step further and assume an investor buys this $100 loan for $62 dollars.  What is the best scenario for this investor?  Clearly, she could receive $100 back in addition to the 6% coupon.  Now does it matter if she only receives $70 or $80 back?  No, in fact depending on the holding period, that would still be a fairly attractive return on investment – not even taking into consideration the 6% coupon.  Would this loan, that may only return 80% of the original principal back be toxic to a Bank who purchased originated it at $100?  Yes.  Is it toxic to the investor, who is indifferent to credit ratings, and receives more than her $62 purchase price?  Absolutely not.

 

What does this have to do with TSI?  They have spotted the very attractive opportunities available in non-agency MBS, and have made them a primary holding in their closed end TSI fund.  Based on portfolio manager Jeffrey Gundlach’s conference call last week(according to memory), their average purchase price is $62 cents on the dollar.  Let’s take a look at one of their top holdings:

 

This one is titled WFMBS   2007 - 8  2A10 – in other words a Wells Fargo mortgage backed security originated in 2007.  It is currently rated a CCC by both Fitch and S&P.  Remember, a CCC tells you that they expect it to receive less than 100% of principal – not how much.

 

If we look at the collateral statistics (i.e. – how each individual loan is performing, take from Bloomberg), we will see that out of the 3,658 loans, only 6.5% are delinquent greater than 60 days.  These loans have an average credit score of 744.  Let’s assume that 100% of the loans that are greater than 60 days delinquent will default.  Furthermore, the average 12 month severity is 40%.  This means that ONCE a loan defaults 40 cents on the dollar are lost – so only 60 cents will be returned to the bondholder.  Multiply 6.5% (the current delinquencies greater than 60 days) by 40%.  That gives you losses of 2.6%.  Would our bond take this 2.6% loss?  No – we have 4% of credit support – meaning 4% of the deal is below us to absorb losses.

 

You might say that my math does not account for future delinquencies.  You are correct.  Now, let’s use a cash flow engine to compute the amount of losses to maturity.  We will assume the economy does not recover and that defaults and losses will stay flat.  What are the results if you run this out to maturity?  It shows 0% of losses to this bond, with a Yield of 13.5% assuming a purchase price of $62.

Even if things get worse, look at the huge buffer the average investment has in this fund.  In this particular bond, 94% of borrowers are current.  After going through this recession, I believe it would be safe to assume that these 94% of borrowers are good credits.  Even if a draconian situation were to arise, a huge margin of safety is built in due to the credit support and purchase price at a discount.  Now this is the awful investing advice that the aforementioned blogger was ranting about?  Despite being a different asset class, aren't these same principles of "margin of safety" employed by famous investors such as Buffett, Berkowitz, etc...?  It's not that I think these skeptics are wrong, I just think they are wrong!

 

The average person does not have the time or expertise to understand this level of detail, but TSI has management that does, and they have produced alpha on a year in and year out basis.

 

Is this fund starting to sound attractive?  We are not done yet, consider the following facts:

 

-TSI is trading at an 11% discount to NAV as of last week.  Therefore, you are buying into to these assets at an even greater discount.

 

-They have a current borrowing facility in place to borrow at ~1%.    Gundlach stated on the call that the average yield on this portfolio is in the 19% range.  So on the borrowed portion; you are earning a significant arbitrage.

 

-They have targeted to pay-out a 7% dividend based on the NAV.  Given the monster income they are generating, it could be reasonably concluded that they will pay out a special dividend in the coming quarters.

 

-Like any bond fund, there is interest rate risk.  Should rates go up the bond prices will go down.  However, if rates go up it will likely indicate that the economy is recovering which will lower defaults and severity – thus helping the fund in other aspects.

 

-I strongly encourage you to read the transcript of the TSI call from last week.  He gives much more detail and granularity into the fund than this article.

 

In conclusion, this may or may not be a suitable investment opportunity for you.  That being said, amazing opportunities like these are created when fear and panic cause investors to disregard this asset class based on the “toxic” label.  The question remain, who is this toxic for?

Disclosure:  Long TSI

With stocks and bonds rallying the last few weeks, market observers have begun to question what is really taking place, and who is right (or wrong).

While equities continue to show strength, treasuries and mortgages have rallied as well.  Despite a large sell-off on Friday, the 10yr bond touched ~3.15% last week.  Could there really be a sustainable demand for 10 year paper at 3%?  Let's look at a few issues that should determine this going forward:

• Hanging on the Fed:  the market, more than ever, is hanging on every word of Bernanke to decipher when they will start to tighten policy.  I feel like I've heard that rates will stay low "for an extended period" has been repeated ad nauseum. 
• Quantitative Easing:  What affect will the ending of the Fed's purchases have on the bond market.  By the end of the $1.5T program, they will own over 75% of current coupon (4.5%) mortgages.  Despite the announcement of a soft landing, shouldn't bonds have sold off?  That hasn't been the case.  Who is it that the market's anticipating will soak up this demand?
• Inflation:  The inflation/deflation argument is above my pay grade, but I will say that I am not aware of a time when this country has seen inflation without wage inflation.  I recently read an article by John Mauldin stating that in order to get back to full employment in five years, and accounting for population growth, the US will need to produce an AVERAGE of over 250,000 jobs per month.  He went on to state that we have never produced this many jobs on average over any reasonable time period.

If the job situation is so dire right now, why does the equity market continue to rally?  After all, isn't Wall Street sophisticated enough to know that the "band-aids" of the new administration (8k home-buying credit, cash for clunkers) do not produce true sustainable job recovery?  

Until we see a reason to believe that the job situation is showing significant improvement, it seems hard to believe that the Fed will tighten policy.

As we are at a time of historically low interest rates, many Banks and Insurance companies are afraid to get burned by going out on the curve.  As they start to see that a true economic recovery is not within sight, I expect them to go further out on the curve.  This should help bolster bonds in the short run.

Disclosure:  Long FAIRX and TGLMX

 Over the past few weeks the much acclaimed PPIP program has started to find its way into the news again.  Billed as a savior to the much maligned non-agency MBS space, this idea by the Treasury was a relatively solid-game plan to bring back liquidity.

During early 2009, very clean 15yr private MBS (think 2003-2004, highly seasoned, less than 1% total delinquencies) was trading in the high eighties to low nineties.  What is this significant?  I will explain.  Fresh off the credit collapse and stuck with every negative connotation, demand for this product was at an all time low.   For the type of paper listed above, and other similar types, 20+% loss adjusted yields were available.

Banks and other investors who were either forced to sell due to ratings downgrades, or wanted to sell due to fear and panic found few willing participants in the market.  In retrospect, this was the time to load up on these securities as shrewed fund managers such as Jeffrey Gundlach of TCW did.  

Fast forward to current times and we have seen a dramatic rally in the non-agency space.  MBS such as I described above is now trading very close to par and sometimes even at a slight premium.  With loss adjusted yields in the 8-12% range now, taking the Treasury's "free" leverage to buy these securities is suddenly half as attractive as before. 

Should non-agencies be trading where they did in March, PPIP would be much more crucial to the recovery of the markets, however the repricing of risk and willingness to hold private label MBS has helped the market tremendously.

Problem For Banks

For Banks that need to raise capital, it is unlikely that the rally has helped them enough.  Most of the Banks who bought non-agency MBS did so at prices near or above par.  Despite the massive run-up, it is unlikely that they would be able to sell their best MBS at break-even.  The bottom line is that even PPIP will not be able to bridge the gap that exists between fixed income managers and institutions who need liquidity by selling these securities.

Disclosure:  No Positions