Repo was a key source of funding for leveraged investors in private MBS and a host of other “rates” products before disaster struck capital markets. That it dried up with the crisis helped drive the prices of subprime MBS and other structured products to levels well below “intrinsic” value. Now, there are signs that repo financing is reviving, improving 2010 prospects for private MBS markets. First, a Little Background ‘Yuck,’ ordinary citizens might be thinking, ‘Why would I want risky investment practices to return?’ So, let me provide a little background, starting with some nomenclature. From the point of view of the party seeking financing, repo is a sale and repurchase, at a later date, of the same security. Ownership passes to the lender/buyer, but normally the borrower/seller continues to receive the coupons. The sale price is today’s market value, and the repurchase price reflects the implied financing rate of interest. In addition, the lender “haircuts” the face amount it is willing to lend against to protect against a decline in market value of the collateral (the haircut amount is equivalent to borrower’s equity). In effect, a repo is a secured financing, as the lender/buyer keeps the security if the investor doesn’t buy it back. Repo, in which the identical underlying bond is repurchased, would be used to finance investments in non-agency MBS. An investor looking to finance with repo would buy the security and, at the same time, arrange to repo it with the broker/dealer. Most repo transactions are short term, not a problem as borrowers with good credit and collateral can roll the transaction so long as they want to own the bond. A related mechanism called a “dollar roll” is used to finance TBA agency MBS (the same amount and coupon of MBS are repurchased, but not necessarily the same pools). Dollar rolls are not our subject. Because the dollar roll market is sustained by the deep liquidity of TBA markets for guaranteed MBS, it continued to function relatively normally during the crisis. Leveraged Investors Provide a Floor on Prices The use of borrowed funds also gives us a convenient way to think about investors in MBS (and other kinds of bonds and “rates” products) is to divide them into two main categories, real money investors and leveraged investors. The real money players are insurance companies, mutual funds, pension plans, foreign governments and so forth. Banks in truth are leveraged investors – the money they invest is borrowed (deposits and such), but for various reasons (including the stickiness and social utility of deposits) they are often lumped in with real-money players. For that matter, Fannie and Freddie are also leveraged MBS investors. (Complaints about the enterprises’ low cost of funds, from banks and foes of government involvement in free markets, tend to ignore the fact that bank deposits are cheap financing as well, and also reflect explicit government support, e.g. deposit insurance, and implicit government support evidenced by the host of measures taken to prop banks up as well as the solidification of the too-big-to-fail doctrine). In contrast, by leveraged investors, we are usually referring to hedge and private equity funds, proprietary trading desks and REITs. Leverage Adds Risk It’s tempting to dismiss leveraged investors as somehow dangerous to the markets’ health. Leverage jacks up risk (in terms of both potential loss and, when lots of leverage is present in a market, of price volatility). It can (did) feed asset bubbles. For the guy or gal on the ground, who invests hard-earned dollars, being able to use somebody else’s money to garner outsized returns can seem downright unfair. Worse, it seems that when the leveraged gorillas lose, households and taxpayers lose more. What is not apparent to the average citizen is that leveraged investors play an important role as buyers on the margin. Before the crisis, by employing short-term repo financing to fund purchases of longer-term and or higher yielding securities, hedge and private equity funds leveraged relatively low market yields on highly rated securities into 15% – 25% returns on equity. Leveraged investors will move to the sidelines when real money demand is so great that they can’t meet those fat “yield bogeys.” (This includes banks and the GSEs, though with less leverage, their thresholds are more comparable to real money yield requirements.) When prices soften in securities that can be leveraged, and yield bogeys can be hit, their demand returns. In effect, hedge and similar investors provide a floor on prices and help hold them in a tighter range than real money demand alone can achieve. The Floor Fell Out When mortgage (and other asset) performance began to deteriorate (and dealers’ own sources of liquidity began to dry up), dealers raised their repo rates and haircuts, cut financing for many products altogether and pulled lines to floundering customers. Their demand shrank with permitted leverage. For example, in 2007 before the crisis, haircuts on triple-A subprime bonds were as low as 5%, but ballooned to 50% and more in the crisis. The sharply de-levered funds that remained moved from buyers on the margin to the only buyers, adjusting their yield bogeys to reflect much lower leverage. Given the prices they were willing to pay, most sellers moved to the sidelines and the market froze. Many holders protested having to mark their holdings to onerous fair values, and there was much public babble that mark-to-market accounting was destroying bank capital and their ability, by lending, to save the economy from recession. What a Difference Half- to a Dozen Months Can Make That was then, but now, leverage is returning to the markets. Analysts heralding this positive for pricing and liquidity give much of the credit to TALF and PPIP. Indeed, as I wrote in a May 2009 HousingWire article “Save TALF,” and here, last June the purpose of these programs was to offset, temporarily, the loss of repo financing and permit leveraged investors to raise the floor on “distressed assets.” Government-provided leverage visibly helped prices stabilize in 2009. A host of technical obstacles prevented TALF for MBS, but prices firmed on anticipation of PPIP demand and were further buoyed by re-REMIC buying. (That is, tranches of outstanding mortgage securities can re-securitized and re-tranched. It sounds as suspect as leverage, but, like leverage, in the hands of investors who know how to do their own due diligence – instead or relying on ratings – it’s common sense relative value investing. And it realizes value that equilibrium market prices weren’t reflecting.) With the return of price stability dealers have been more willing to provide repo financing and third-party repo is reviving as well. Analysts at Barclays Capital noted in their December “U.S. Securitized Products Outlook 2010,” an attractive option for money market investors “would be to provide repo leverage to buyers with more risk appetite. We have already seen a sharp rise in availability of third-party repo funding over the last 6 months.” Haircuts have shrunk accordingly. For example, haircuts once as low as 5% for some AAA private-issue MBS before the crisis, soared to 50% and beyond in the crisis (quoting myself, from May HousingWire magazine). At the end of 2009, BarCap analysts spotted haircuts for prime MBS at 15%-20%, current pay subprime bonds at 20% and last-cash-flow (last to receive principal and first in line for losses after credit support burns off) subprime bonds at 45%. Lower haircuts means leveraged investors can pay more for bonds and hit their bogeys. In turn, real money investors see fair values rise on their holdings. Ultimately, the return of leverage and falling private MBS yields work their way back into securitization markets. Glenn Shultz in Structured Products Research at Wells Fargo Securities made this point in a report last week, “The Bootstrap Effect.” Improved secondary pricing, he said, “suggests that the funding of nonagency loans in the mortgage capital markets is beginning to look economically feasible.” NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.
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