Wall Street makes hay with defaulted mortgages

As mortgage delinquencies climb near historic highs, Wall Street is finding new ways to make hay with the assets.

So-called "vulture" firms have been snapping up troubled home loans at a faster pace, and are expected to ramp up securitisations of the assets in coming months. That should give a modicum of life to the private mortgage bond market that has been dormant since it imploded during the subprime home loan crisis in 2008.

In a twist, loans supporting these new securities aren't the kind that provide credit to home buyers, but the wreckage of defaults left over from the era of loose lending that sparked the crisis.

The securitisation, or bundling assets into bonds, of these delinquent loans is the latest phase for investors who have found ways to profit in repairing the troubled loans that many had a hand in creating.

Mortgage companies "are cleaning up their inventory and finally getting to move some of those loans that they bought over the last couple of years," said Sue Allon, chief executive officer of Denver-based mortgage risk consultant Allonhill.                                           

The firms -- including PennyMac Mortgage Investment Trust, the company run by former Countrywide president Stanford Kurland -- have increased purchases of discounted troubled mortgages as they help borrowers with refinancing or modifications, or through seizure of the property.

Countrywide was the biggest US mortgage originator in 2006 and a pioneer of nontraditional and subprime loans before its exposure to this debt brought it close to collapse.

The mortgage bonds planned by PennyMac and others will fill a void for yield-hungry investors in a market struggling to recover as banks find it more profitable to funnel loans through government programs, or keep mortgages on their books.

For banks, offloading the distressed mortgages is an important step forward after they did everything they could to avoid taking losses during the financial crisis.

Another loan buyer, Residential Credit Solutions, is backed by Equifin Capital, a private equity group that funded subprime lender Aames Investment Corp. before selling it in 2006 as it saw the market begin to falter. 

The market for "non-performing loan" bonds may be modest -- maybe less than $1 billion this year -- but it is still welcome to specialized investors desperate for yield and dealers seeking fees as the traditional RMBS market idles. For the issuers, proceeds can go toward more loan purchases.

"The street guys are trying like heck to structure them up," said Rudy Orman, director of business development at Fort Worth, Texas-based RCS. "There is going to be more of them. When we talk to bankers they say there is still good demand." 

Among these firms, Kondaur Capital is structuring a $79 million bond backed by delinquent assets, through RBS Securities. Other big buyers of delinquent loans are Carrington Mortgage, a Greenwich, Connecticut, hedge fund with subprime roots, and Ranieri & Co, the investment firm started by legendary mortgage bond trader Lewis Ranieri, according to Carrington and a source with knowledge of loan sales. 

Arch Bay Capital, which spearheaded issuance earlier this year, will consider more securitizations as low interest rates keep money managers searching for yield, said Shawn Miller, CEO of the Irvine, California company. 

"It's an attractive time for anyone who can create a short-term yield product," Miller said.

The potential supply for non-performing RMBS is huge.

Foreclosures are rising in most places, and completing them can take as long as two years in some states.                                           

Still, there won't be a rush of deals, given the conservative  structures issuers must adopt, said David Spector, chief investment officer at PennyMac, in Calabasas, California, who previously worked at Morgan Stanley and Countrywide.

To be rated, bonds must set aside half or more of their  assets as a cushion from loss and direct cash flows to the senior investors. This reduces the proceeds and incentive for issuers, which typically use the bonds to disperse risk. 

The market is "not deep," but nonetheless an attractive way to raise money for growth, said Spector, adding that he "wouldn't be surprised" to see PennyMac and one of its private equity funds complete two deals this year.

At one private equity manager, loans reviewed over the first six months of 2010 neared $4 billion, twice what it saw during all of last year. Volume seen by RCS has tripled. 

PennyMac is considering $2 billion to $5 billion every month, versus less than $2 billion per month in the last  quarter of 2009 before volume rose in December.

"Typically, when we say ''not deep,'' a lot of the time it has to do with the amount of potential available assets," Spector said. "That's not the case here. There are more than enough non-performing loans."