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.

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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

As we look forward to Q2 earnings, it will be interesting to see how Banks responded to Fed's continued agency MBS purchases.  While the majority of the press has focused on lowering primary mortage rates to spur the housing market, relatively little attention has been paid to how it affects the Banks themselves.  It is unknown how the future regulatory reforms will unfold, but this much is certain: banks will be more motivated than ever to shore up their capital position.  This will happen whether its the raising of capital ratio requirements, or just pro-active urging of investors.
 
It is clear the most the best option for banks would be to raise private capital.  Since very few banks will have the luxury to do this at an acceptable price, they must look for other ways to raise capital.
 
When Q2 earnings come out, I would look for Banks to have taken significant gains in their available for sale (AFS) securities portfolio, buy selling off Agency MBS that had been propped up by the government purchases.  As stated above, these purchases were the government's way of "raising capital" for banks.  With fannie and freddie 4'5's trading into the 102's, large gains were to be had on these sales.  When earnings come out, don't be surprised to see these gains taken.
 
Disclosure:  No positions