The federal government has abandoned the idea of buying toxic mortgage securities at the heart of the credit crisis, but Uncle Sam may still grease the wheels for the private sector to do such deals and get credit markets flowing again. The Term Asset-Backed Securities Loan Facility, or TALF, unveiled last week is intended to provide up to $200 billion to finance purchases of consumer loans like auto, student and credit-card debt. Treasury and Federal Reserve officials say the program could later be expanded to include commercial mortgage-backed securities, residential mortgage-backed securities not guaranteed by Fannie Mae ( FNM) or Freddie Mac ( FRE). If it does, it could fill a gaping hole created by the change in direction to the $700 billion Troubled Asset Relief Program, or TARP. The rescue plan originally intended to buy up such assets, which had become impossible to sell as investors' fear of defaults mounted, but the government abandoned that idea before it got off the ground. That left non-agency, mortgage securities available at fire-sale prices and very attractive yields -- for anyone with the risk tolerance and financing to buy them. "For investors with a sharp eye and steady nerves, we believe value is waiting to be discovered in the non-agency mortgage and asset-backed securities markets," Dean Di Bias, high-yield portfolio manager for Advantus Capital Management, wrote in a recent report. In an interview, Di Bias said distressed funds such as his are exploring opportunities in the space, along with hedge funds, mutual funds, banks and institutional investors. He has been pursuing the strategy since April, and his criteria are strict. Bonds must have high ratings and ample credit support, or be backed by mortgages with minimal delinquencies or defaults, and borrowers who have lived in the home for an extended period of time.
Because non-agency bonds are not backed by Fannie, Freddie or the Federal Home Loan Bank program, there is more implied risk, and therefore, much higher yields. Dave Luczkow, vice president of business development for OptHome, notes that performing loans guaranteed by agencies are yielding 5% to 5.5%, while similar, non-conforming bonds can be above 7%. Di Bias has found opportunities yielding in the mid- to upper teens. Through the end of the most recent quarter, Di Blasi says his clients "have been very pleased and returns to-date have been positive." Still, he acknowledges that uncertainty about the housing market has pushed less savvy investors out of the game, bringing a liquidity trap along with higher yields. "These are the same assets that people were champing at the bit two or three years ago to buy at spreads that were excessively tight to the Treasury or swap curve," says Di Bias. "Now that they are at exceedingly wide spreads to the curve, you can't give them away." Indeed, according to a report issued by several securitization groups, global issuance of loan vehicles has dropped severely. Compared with a height of $3 trillion in 2006, issuance is down more than 80% so far this year on an annualized basis, at $594 billion worth of securities backed by mortgages and other assets. In light of that environment, the report, titled "Restoring Confidence in the Securitization Markets," notes that market participants do not expect even the most prime vehicles to recover until the end of 2009. They don't expect more complicated assets, like collateralized debt obligations of asset-backed securities to recover until after 2010.
The major challenge to wooing investors back to the market is that they are rife with uncertainty over how far home prices will drop and how long the economy will take to recover. That uncertainty makes it difficult to ascertain the value of underlying mortgage assets and the financial stability of borrowers who undertook the loans. As a result, buyers for banks' troubled assets are few and far between, says Benjamin Pace, U.S. CIO of Deutsche Bank's ( DB) private-wealth management group. "They might be able to sell them off to distressed securities funds, but we don't see that happening yet," Pace says. "The market is not there as long as prices are getting marked down." When Merrill Lynch ( MER) sold a large portion of its bad assets to the private-equity group Lone Star Funds for 22 cents on the dollar in July, it created something of a benchmark for such transactions. Some heralded Merrill for dumping the assets, while others scoffed, saying the loans were enormously undervalued. But in a market where those calling out for buyers are met mostly with echoes, the fair value tends to be the one offered. Similar assets can trade in a wide range of 20 cents on the dollar to 80 cents on the dollar, according to Andrey Krakovsky, who dealt in the market as a former director and portfolio manager at the hedge-fund firm Highland Financial Holdings. Krakovsky notes that not all mortgage securities were created equal, and it takes a sophisticated investor to separate the wheat from the chaff. Furthermore, he adds, not every investor has the patience to wait for soured mortgage assets to return to par value.
"I think it's really an expert's call," says Krakovsky, who is launching a long-short credit hedge-fund called Tacticus Opportunity Fund. "Some of these securities will not recover, or maybe they will be par eventually, but it could take many, many years. It's not just about getting your money back; it's about when you're going to get your money back." Luczkow says that while active players like Di Blasi and Krakovsky exist, they are in the minority, as other interested parties search for funds to dive back into non-agency mortgage debt. "There has to be a huge opportunity there, because there's a 200-basis point spread," says Luczkow, a former manager of a Fannie Mae mortgage-security portfolio at Morgan Stanley ( MS). "The issue today is not finding good investments; it's finding the money to make good investments." It's unclear whether the Fed will expand the TALF program to finance mortgage assets. But Treasury's announcement last month that it no longer intended to invest TARP funds in distressed assets spooked the market, particularly among financial sector stocks. Jonathan Scott, an associate professor of finance at Temple University, and a former CFO of the Federal Home Loan Bank of Dallas, says the government will have to provide incentives for banks to start selling their bad mortgage debt, and for buyers to re-emerge. He suggests guaranteeing the troubled assets while charging a fee to the banks that hold them, similar to last week's deal to provide emergency aid to Citigroup ( C). "Something is going to have to happen here to trigger those sales," says Scott. "And the policy initiatives that have been suggested to date haven't done it."