Hidden Financial Bombs: Margin Calls Hit Hedge Funds Speculating in Freddie/Fannie Bonds With High Repo Leverage

By David Stockman

Markets are more dangerous than ever before because six years of radical financial repression by the central banks have planted booby-traps everywhere. Ground zero consists of massive and reckless speculation in newly invented “structured finance” products which were designed to quench the market’s insatiable thirst for yield in the Fed’s whacky world of ZIRP.

So below is news of margin calls on hedge funds that had piled into a 12 month old product called “risk sharing RMBS bonds”. It seems that Wall Street dealers had provided 80% leverage on these

new fangled securities issued by the nation’s accomplished market wreckers—Fannie and Freddie. Various tranches of this new variant of synthetic CDOs—-that is, the Wall Street created toxic waste that blew-up in 2007-2008—- offered yields of 200-700 basis points over LIBOR, but so great was the demand for an alternative to the Bernanke-Yellen ukase of zero return that prices of the first Freddie Mac issue were driven up by 30% over the past year.

Now imagine that. Speculators purchased newly invented and unseasoned securities from proven financial malefactors on 80% leverage and then saw their price rise by 30% in 12 months, meaning that the return on their own invested equity was a cool 150%. Stated differently, the scramble for yield got so frenzied that securities originally issued at a yield premium of 7.15% over LIBOR last summer had soared to the point that they yielded only 2.5% over LIBOR before the market broke a few weeks ago. A recent WSJ article captured the thought that irrational exuberance had indeed erupted in this newly invented “asset class”:

But, the rally was overextended by investors’ search for yield as Federal Reserve stimulus cut returns on safer assets, some investors said. Prices on Freddie Mac’s first issue of July 2013 had soared more than 30% through May, reducing yield premiums over the one-month London interbank offered rate to 2.5 percentage points from 7.15 percentage points.

“Investors got too complacent,” Mr. Hentemann said. “They kept buying high-yielding assets to a point where prices and yields didn’t compensate you for the risk.”

Given the financial mayhem that the GSE had already caused, it might be asked why the government’s bankrupt housing guarantee agencies were back in the fray peddling a new form of securitized snake oil in the Wall Street casino. The answer is that some well-intended bureaucrats at the GSE regulatory agency told them to off-load onto private capital markets some of the GSEs’ accumulated risk to the taxpayers.

So the financial engineers at Freddie Mac invented what should have been a completely unsaleable product. Namely, an unsecured bond of an agency that might be heading for legislative extinction that was based not on what real homeowners were obligated to pay on their mortgages, but on the theoretical possibility that they wouldn’t pay!  Specifically, the fat yields being offered were to be derived from the default performance of a reference group of $30 billion of Freddie’s guaranteed mortgages.

In other words, there was no real collateral at all and no real mortgage borrower cash interest to pay the alluring 700 basis point yields on the lower tranches of the offering. It was all synthetic——that is, computer generated waterfalls of digital money flowing down the tranches of something called “STACR” or Structured Agency Credit Risk bonds.

And how would an investor evaluate this purported risk? Well, he would simply have to drink the Washington Cool-Aid which holds that Keynesian money printing is reviving the US economy and housing market. Therefore, housing prices will continue to rise, mortgage delinquencies will continue to fall and the reference portfolio of $30 billion mortgages will continue to trigger full payment on the various tiers of STACR obligations.

Another word for this would be rank speculation. Even in an honest free market with two-way trade, it would be nearly impossible to accurately price the “pot of risk” extracted from GSE mortgage pools that these new “structured finance” products actually represent.  But in a financial system bubbling with speculative fevers, cheap debt and an assumed central bank “put” under the stock averages and risk assets generally, “price discovery” is literally impossible.

This whole story is about speculative short-term gambling. Not surprisingly, therefore, the recent 10% break in prices for this newly manufactured form of GSE toxic waste threw the tiny and illiquid market for these securities into a tailspin.

Hedge funds piled aggressively into the riskier (and often unrated) tranches of the deals, looking for yield pick-up at a time when returns had shrunk dramatically just about everywhere else.

But those deals have recently tumbled dramatically. Between July 11 and July 29, the unrated bonds favored by hedge funds gapped out as much as 50bp to roughly LIBOR plus 330bp in the secondary market, according to Wells Fargo data.

“Generally the sell-off has all the signs of a levered unwind,” the mortgage strategist said.

In short, Wall Street prime brokers looking for trades and spreads offered cheap carry trade financing to the “credit” oriented hedge funds so that they could arb the GSE risk-sharing RMBS bonds based on money market interest rates that are pegged and controlled by the Fed. Needless to say, were the Fed to actually begin normalizing short-term money market rates, the recent disorder and margin calls in this market would amount to a mere Sunday School picnic. And if the current already 61 month long business cycle expansion should meet its inexorable end and roll-over into another recession, the watchword would be “look-out below!”

Yet here’s the thing.  The structured finance product calls STACRs issued by the GSEs are just a tiny microcosm, and a tepid one at that, of the trillions in structured finance products that have been issued by Wall Street dealers and their counterparts around the world. Overwhelmingly, these products are not backed by real collateral or cash flows, but instead, are the embodiment of computerized algorithms based on reference pools of other securities—-some of these being synthetics, too.

So the central banks have unleashed a devils work shop. The story below provides but a glimpse of their handiwork. When the massive tide of central bank liquidity and cheap debt finally begins to recede, there will be margin calls everywhere. And the list of exploding acronyms like STACRS will stretch on as far as the eye can see.

From Reuters Hedgeworld

Several hedge funds have received margin calls in recent days on their holdings of risk-sharing RMBS bonds from Freddie Mac and Fannie Mae, market sources told IFR.

The sources said the margin calls were met, but the event still unnerved the structured finance market, which has again become reliant on cheap leverage to sustain momentum.

One banker said brokers’ margin calls required the hedge funds to pony up an extra four to five points of their equity against what they initially borrowed to purchase the bonds – understood to be more than 80% of the purchase price in some cases – to cover any losses.

“Dealers that lead these trades offer attractive financing of two to three times leverage,” one mortgage strategist said. “But if the investor is forced to unwind, it can get ugly.”

In the first quarter, some hedge funds were locking in 30-day repurchase agreements to buy risk-sharing bonds at a rate of 1.9% to lever 2.14 times, according to SEC filings.

Risk-sharing RMBS are barely a year old, having sprung up as a new asset class after U.S. regulators issued guidelines urging the government to reduce its footprint in the massive U.S. residential mortgage market.

Hedge funds piled aggressively into the riskier (and often unrated) tranches of the deals, looking for yield pick-up at a time when returns had shrunk dramatically just about everywhere else.

But those deals have recently tumbled dramatically. Between July 11 and July 29, the unrated bonds favored by hedge funds gapped out as much as 50bp to roughly LIBOR plus 330bp in the secondary market, according to Wells Fargo data.

“Generally the sell-off has all the signs of a levered unwind,” the mortgage strategist said.

And at a time when volatility is high – Lipper this week reported the largest one-week outflow from high-yield funds ever, at more than $7 billion – the risk-sharing bonds are continuing to struggle.

On Wednesday [Aug. 6] Freddie Mac had to price the unrated tranches of its latest Structured Agency Credit Risk (STACR) trade at LIBOR plus 400bp and 410bp – a whopping 100bp to 120bp wide of Fannie Mae’s last risk-sharing deal in July.

And while cheap money certainly enticed some players to buy into the risk-sharing sector in the first place, record volumes lately have led players to look for a way to trade out.

Approximately $135 million in risk-sharing bonds was out for bid in each of the past two weeks, the highest levels by far since the program started in July 2013, according to Adam Murphy, president of market data company Empirasign.

Positive Approach

Despite these stumbles, Freddie Mac is counting on being able to attract a broader base of buy-and-hold investors to the asset class, and remains optimistic.

For one thing, each of Freddie’s four STACR deals prior to July had printed at successively tighter levels, as did the three prior Fannie trades.

“Maybe spreads tightened too much and are now back to a more sustainable level,” Mike Reynolds, a director of portfolio management at Freddie Mac, told IFR.

“We definitely think the investor book should include hedge funds, and it’s natural for them to use [financing] to get the yields they need,” he said. “But we prefer [them] to be a smaller percent of the total distribution.”

And that seems to be happening already. For the 2014-DN3 portion of the new STACR trade, 20% went to hedge funds, down from a 30% participation in April for its DN2 deal, Reynolds said.

Meanwhile the 2014-HQ1 deal – the first from Freddie to include mortgages with loan-to-values above 80% – saw just 5% participation from hedge funds.

http://www.hedgeworld.com/open_news/read_news.cgi?section=peop&story=peop6036.html

David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission.