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Opinion

Boost to US MBS adds to bankers’ schizophrenia

Ronald Reagan once joked that the nine most terrifying words in the English language are: “I’m from the government and I’m here to help.” Wall Street traders tend to share the view that the business of profiting from capital flows works best with minimal interference, but the government in the form of the Federal Reserve recently gave the moribund market in mortgage-backed securities a big boost.

The adrenaline shot came in the form of a decision to auction the last $6 billion of mortgage bonds held by the Fed in its Maiden Lane portfolio of securities assumed as part of the 2008 bailout of AIG.

The move to clear the Federal Reserve’s AIG holdings removes an overhang of potential supply that had been depressing mortgage security prices since the 2008 credit crisis and is likely to extend the sharp rally in the sector that has been running since the start of this year.

The rally has come as a welcome surprise to Wall Street mortgage-backed security desks that had a disastrous 2011 on the back of drops in the value of their inventory, dislocation between cash bonds and related derivatives, and the stubborn failure of the primary market to revive. It has also provided a boost to the hedge funds that had positioned themselves in the wake of the credit crisis for a recovery in MBS values only to provide dismal returns to investors in 2010 and 2011.

The jump in MBS prices that began in the fourth quarter of last year has been given momentum by piggybacking on the rally from nonspecialist investors such as mutual funds and hedge funds with a broad credit or macro mandate.

That has fuelled a startling price rise that in some cases outpaced the global surge in corporate credit instruments in the first two months of 2012, with some mortgage securities rallying over 15%.

Among dealers, Credit Suisse is likely to be a big beneficiary of a revived mortgage securities market. Credit Suisse increased its market share from 13.1% to 14.3% last year to leapfrog Deutsche Bank and Goldman Sachs to the top slot in the annual Greenwich Associates fixed-income investor survey. Credit Suisse also won the most recent Federal Reserve auction of Maiden Lane bonds in late January, when securities with a face value of $7 billion were sold.

The winning bid from Credit Suisse on the securities will not be revealed by the Federal Reserve until April but given market prices in the high 40 cents on the dollar level prevailing in January it might have paid about $3 billion. Credit Suisse should be sitting on a profit on any of the securities it retained, while the continuing rise in prices will have aided the sale of repackaged bonds to investors and left the bank’s customers with an appetite for further deals.

It must feel like 2006 all over again for some of the battle-scarred Credit Suisse mortgage staff at its New York headquarters on Madison Avenue, as mortgage-backed deals prove an easy sell to clients, while inventory that is warehoused provides a bonus profit. Any profit from the January Maiden Lane auction will obviously be the main comfort for the Credit Suisse MBS staff in New York as they try to convince fixed-income division head Gaël de Boissard in London and ultimately group chief executive Brady Dougan in Zurich to maintain commitment to their business line. The move from number three to top slot in the Greenwich Associates investor survey last year will have been a welcome boost to the Credit Suisse mortgage staff, but it was not accompanied by impressive performance where it matters, on the bottom line.

Wild swings in the basis between mortgage bond prices and their related derivatives hedges compounded the effect of the broader debt crisis for most dealers last year. This contributed to a weak year in fixed-income sales and trading for Credit Suisse, whose revenue fell from $6.19 billion equivalent in 2010 to $4.3 billion in 2011, with just $28 million of fourth-quarter net revenue.

A good start to 2012 in mortgage trading P&L might also give Credit Suisse confidence that it can pursue its current policy of selective withdrawal from sectors of the fixed-income markets without losing critical scale. Credit Suisse completed its pullout from CMBS origination in the fourth quarter of 2011 and recently announced that it intended to shed another $11 billion of risk-weighted assets under Basle III measurement in securitized products (which are chiefly mortgage trades) by the end of this year. If that target is hit, Credit Suisse will have cut its securitized product RWAs by roughly half from $73 billion in the third quarter of 2011 to $37 billion.

Goldman Sachs will also be hoping to profit from a revival in the mortgage-backed securities market. It suffered badly from the swings in the basis between cash mortgages and derivatives last year, then suffered the indignity of being thwarted in an attempt to buy much of the outstanding Maiden Lane portfolio from the Federal Reserve in a private trade.

BlackRock, which is administering the Maiden Lane portfolio for the Fed, declined Goldman’s private approach and instead received instruction to put securities out for the auction that Credit Suisse won.

In retrospect Goldman would have turned a healthy profit had it been able to buy a big chunk of the Federal Reserve’s holding privately at mid-market prices late last year, so the central bank deserves some credit for holding out for an auction that obtained a higher end price for the US taxpayer.

The whole process underlines how fraught with difficulties the involvement of the government can be when it comes to disposal of complex securities, however. Auctions of individual securities in the Maiden Lane portfolio early last year proved a disaster, as investors were spooked by the prospect of heavy supply just as the global credit markets were starting another bout of upheaval. The Federal Reserve has also faced criticism for its approach this year of holding auctions that are confined to a relatively small group of the main dealers and it will probably take more flak if it transpires that auction winners have been able to turn a good profit on the securities.

Dealers will take profits anywhere they can find them of course. But bankers, and the former bankers who staff mortgage trading hedge funds, are acutely aware that what the government gives it can take away. It would be no surprise for a bank to win an auction of securities from the Federal Reserve only to find itself under renewed legal assault from the SEC for its former mortgage securities sales practices, for example, with a resulting plunge in its own stock price and the value of the bonds it had just bought from the government. Federal Reserve interventions to hold down yields also have a big effect on prices and the shape of curves. The life of the modern financier is nothing if not schizophrenic and the government can quickly shift from friend to foe in the business of turning a securities trading profit. 


Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks
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