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How Real Is the Rally in Real Estate Bonds?


Companies are jumping back into mortgage securities, but they may regret their moves

As the U.S. Treasury laid out plans to bolster the housing market last spring, Chimera Investment (CIM) jumped into action. The New York real estate investment trust raised $1.45 billion in two stock sales and used the proceeds to scoop up distressed mortgage-backed securities for as little as 50 cents on the dollar. Chimera figures it can earn double-digit returns on the bonds, even if many of the underlying home loans aren't paid back. "Our latest offering is now fully invested," Chimera CEO Matthew Lambiase said in a conference call this summer. "The early results are promising."

After warily circling the market for months, big investors such as Chimera are bulking up on residential mortgages and the investments filled with them. The additional demand, sparked by a modicum of good news in housing and government purchases of the securities, has helped drive up prices on such bonds by as much as 30% since March. But will the rally last?

So far this year mortgage-related REITs have raised $4.6 billion from investors. Among the recent initial public offerings: PennyMac Mortgage Investment Trust, founded by former Countrywide executive Stanford L. Kurland. Even banks are getting into the game, aggressively buying government-backed mortgage bonds just as they consider selling some of their junkier holdings.

Some players are betting on the housing market, which is showing signs of life. Home sales were up 7.2% in July. And the Standard & Poor's Case-Shiller U.S. National Home Price Index climbed 1.4% from May to June. As recently as December, home values were falling at twice that pace. "People are feeling pretty good and wondering whether the worst is over," says Bryan Whalen, a mortgage fund manager at Metropolitan West Asset Management.

Other investors are chasing government dollars, which are flooding the mortgage market and boosting prices. The Federal Reserve is little more than halfway through its commitment to buy $1.25 trillion worth of securities sold by the troubled mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). As part of a public-private partnership designed to cleanse toxic assets from banks' books, the U.S. Treasury will pony up as much as $30 billion to money managers, funds they can use to buy old mortgage investments.

The federal funds have motivated Kevin E. Grant, CEO of Cypress Sharpridge Investments. His New York-based mortgage REIT, which raised $100 million in an IPO, is focused on securities backed by the government. Grant says he can collect a tidy profit on the bonds: Their yields hover around 4.25%, while his borrowing costs stand at 2%. "[Mortgages] are the largest opportunity I've seen in my entire lifetime in any industry in the world," says Grant.

BOON FOR BIG BANKS

The rush of investors is only pushing prices higher. The junkiest bonds, those that invest in subprime and other risky mortgages, have jumped by 30% since March. Some of the higher-quality securities are trading at 100 cents on the dollar, or par, a sign that investors think there's little or no risk the home loans won't be repaid.

Big banks are benefitting. The troubled firms own $1.3 trillion worth of mortgage securities, roughly 10% of their total assets. Those bonds, which have been a drag on their books for a while, are showing gains. According to an analysis for BusinessWeek by investment bank Keefe, Bruyette & Woods, more than 360 banks reported an increase in the value of their mortgage-backed securities in the second quarter. The portfolios of both Fifth Third Bancorp (FITB) and Comerica (CMA) rose 2% in the period. "It strengthens their balance sheets," says Frederick Cannon, director of research at KBW.

Given the price spikes, some analysts figure the banks may decide to start cleaning up their books and offloading the riskiest securities they own. "You'll see them selling securities, residential loans, construction loans," says Mark T. Fitzgibbon, director of research at Sandler O'Neill & Partners, a brokerage firm. The firms had been reluctant to sell in a depressed market, since it would have meant taking a big writedown.

For investors, the easy profits may be gone. Some analysts worry that the Fed will lose its appetite for mortgage securities now that housing is on the mend. Already, there's speculation the central bank won't reach its $1.25 trillion goal. Such fears, founded or not, could spook buyers, sending shock waves through the market.

The other wild card: housing, wherein the fundamentals remain weak. As unemployment rises, more borrowers may fall behind on their mortgage payments, potentially triggering losses in the securities that contain the loans. Each 1% rise in the annual jobless rate will cause another 1.2% of mortgages to go into foreclosure, estimates Stan Liebowitz, an economics professor at the University of Texas at Dallas. Says Jeffrey Gundlach, chief investment officer at money manager TCW: "The claim that housing is out of the woods is greatly exaggerated."

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network

Commercial Market Woes

The commercial real estate market, which typically lags the residential one, continues to deteriorate. Commercial property deals, notes a Bloomberg piece, are expected to fall to the lowest level in almost two decades. About $16 billion of office transactions will be completed by yearend, according to data compiled for the media outlet by Real Capital Analytics, a New York research firm.

To read the full article go to http://bx.businessweek.com/commercial-real-estate/reference/

Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau. Francis is a correspondent in BusinessWeek's Washington bureau.

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