Alluring subprime debt can still poison investors

January 19, 2012

By Agnes T. Crane

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Subprime mortgage debt has got its mojo back. A growing number of investors reckon there’s life yet in the mortgage market’s toxic sludge from the crisis – and that now’s the time to buy. But buyers should tread carefully.

Yields are certainly enticing. Last year’s battering lopped up to a third off the value of subprime mortgage bonds, leaving some fetching 10 to 12 percent, according to Barclays estimates. U.S. junk bonds, by contrast, offer less than 8 percent. Moreover, while the U.S. housing market is hardly in a recovery, few think home prices will fall by more than a few percentage points from here.

Investment banks in particular look eager to scoop up the mortgage sludge. Credit Suisse has just bested Goldman Sachs and two other broker-dealers to a $7 billion slice of the subprime holdings the Federal Reserve took from American International Group in 2008 – though the central bank will not disclose the price until April. It’s not the first time this year the Swiss bank has been involved in the market: the bank’s senior managers are getting in on the act, too, voluntarily buying $450 million-worth of securities and putting them into a fund of mostly subprime bonds that the bank set up in 2008 to pay staff bonuses.

Less swift investors may be focusing on the chance of a good deal of supply coming onto the market. All in, some $1.2 trillion is walled up in U.S. banks, insurers, hedge funds and European firms, according to Barclays. Banks, especially, may be big sellers as Basel III capital rules are onerous for securitized debt. Europe’s lenders hold some $70 billion, with up to $20 billion potentially for sale, while U.S. banks are sitting on around $200 billion, according to Barclays’ tally.

But subprime mortgage bonds have long been an illiquid asset. The analysis required to price such complex securities makes trading them incredibly difficult. And any attempt to sell more than a small amount can quickly whack prices. That happened last year when the Fed used public auctions to get rid of some of its AIG waste and ended up offloading less than it hoped.

Buyers with a longer-term investment horizon of a couple of years or more can usually stomach some short-term volatility, especially if they don’t need to mark to market. But those who are looking for a quick fix risk getting slimed.

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