“Never let anyone say that Wall Street history lacks irony. Remember those “toxic” mortgage bonds at the epicenter of the 2008-09 financial crisis? Turns out they’ve been nothing but tonic to a select group of mutual fund managers’ portfolios ever since…

…Since its inception in June 2011, the Angel Oak Multi-Strategy Income fund (ticker: ANGLX)—the oldest retail fund to invest primarily in such bundles of residential and commercial mortgage loans—has delivered a 9.2% annualized return, almost triple the Barclays Aggregate Bond Index’s 3.1%. That a beaten-down asset class should rally during an economic recovery is not remarkable. What is surprising is how stable the once-distressed sector has been. Since inception, the Angel Oak fund has had volatility identical to its Barclays benchmark, which holds only high-quality corporate and government bonds. Even better, the fund has had more upside and less downside—82 positive and 18 negative months since its launch, compared with 65 and 35 for Barclays. How is this possible with once-toxic assets? “We don’t call this sector toxic or distressed anymore,” says Sreeni Prabhu, chief investment officer of Angel Oak’s management firm. “Today, I call it opportunistic fixed income.” That may sound like the worst Wall Street euphemism ever, but Prabhu insists that it’s accurate.”, Lewis Braham, “’Toxic Mortgages’, Healthy Gains”, Barrons, December 5, 2015

“Yet the FDIC-R sold IndyMac Bank (a large RMBS issuer and investor) right at or near bottom, at a time in early 2009 when its Chairperson Sheila Bair herself was quoted in The New York Times saying “asset prices were irrational.” And despite this fact, they sued me and falsely alleged I was a negligent banker, because I could not foresee in early 2007 the crisis coming and/or successfully manage massive and unprecedented external economic events, beyond any individual financial institution’s control. (The FDIC approved our non-conforming mortgage business model for federal deposit insurance in 2000. Prior to then, we were a mortgage REIT.)That’s not right. In late 2008/2009, the FDIC-R didn’t need any foresight and their decisions and actions were all within their control. All they had to do was act like any other prudent receiver/conservator (like the Fed did with Bear and AIG assets, like Treasury did with GM and others, and like the Lehman BK Trustee did with its assets) and not fire-sell assets at or near the bottom of a panicked marketplace. I think this might be why the U.S. Treasury’s material loss report on IndyMac Bank never reconciled the components of the deposit insurance fund’s losses, as required by law?”, Mike Perry, former Chairman and CEO, IndyMac Bank

Fund of Information

“Toxic” Mortgages, Healthy Gains

Subprime mortgages, once scorned, are producing nice returns for some mutual funds

By Lewis Braham

Never let anyone say that Wall Street history lacks irony. Remember those “toxic” mortgage bonds at the epicenter of the 2008-09 financial crisis? Turns out they’ve been nothing but tonic to a select group of mutual fund managers’ portfolios ever since.

Since its inception in June 2011, the Angel Oak Multi-Strategy Income fund (ticker: ANGLX)—the oldest retail fund to invest primarily in such bundles of residential and commercial mortgage loans—has delivered a 9.2% annualized return, almost triple the Barclays Aggregate Bond Index’s 3.1%. Newer mortgage-related funds, such asSemper MBS Total Return (SEMPX) and Voya Securitized Credit (VCFAX), have also topped the charts.

While many giant funds such as Vanguard GNMA (VFIIX) own mortgage bonds, these are mainly invested in low-yielding bonds backed by government agencies such as Ginnie Mae. Currently, only 14 funds invest primarily in the other forms of securitized credit called nonagency residential mortgage-backed and commercial mortgage-backed securities, or RMBS and CMBS, respectively. These funds specialize in the higher-yielding prime and once-dreaded subprime loans, which the agencies deemed too risky or unusual to back.

That a beaten-down asset class should rally during an economic recovery is not remarkable. What is surprising is how stable the once-distressed sector has been. Since inception, the Angel Oak fund has had volatility identical to its Barclays benchmark, which holds only high-quality corporate and government bonds. Even better, the fund has had more upside and less downside—82 positive and 18 negative months since its launch, compared with 65 and 35 for Barclays.

How is this possible with once-toxic assets? “We don’t call this sector toxic or distressed anymore,” says Sreeni Prabhu, chief investment officer of Angel Oak’s management firm. “Today, I call it opportunistic fixed income.” That may sound like the worst Wall Street euphemism ever, but Prabhu insists that it’s accurate. “The fraud in the sector is gone,” he says. “The average mortgage borrower who was struggling has already defaulted out. What you’re left with is a good pool of borrowers.” That said, Prabhu largely avoids the subprime, lowest-quality securities.

One misunderstanding about RMBS is that they don’t default like a conventional bond. With a corporate bond, for instance, the end result is binary: Either the bond pays income until it matures or it defaults. But since an RMBS is a bundle of mortgage loans, some borrowers can default and the bond can still continue to pay income from its remaining loans. Since there has been little issuance of RMBS post-crisis, most of the securities today are of an earlier vintage with now-stable borrowers.

“Now we have borrowers who have made several years of payments into the trust, and the average loan to value of their homes is below 80%,” Prabhu says. “So they are eligible for refinancing their mortgages.” Refinancing is good because that means the borrower must first repay her previous mortgage loan. Loan repayments cause RMBS’ credit quality and prices to improve.

Consequently, Prabhu expects RMBS to deliver 7% to 8% total returns going forward—5% to 5.5% yields plus the remainder in price appreciation. And that’s with less credit risk than competing junk bonds: “These securities should be compared with high-grade corporate credit now.”

Of the retail funds in the sector, perhaps Semper MBS Total Return is the most interesting. That’s because it has only $427 million in assets, and its management firm runs a total of $1.1 billion. It also has no load and a lower expense ratio, 1%, than the $4.8 billion Angel Oak, at 1.24%. “Our size allows us to be extremely nimble and opportunistic,” says Semper Capital CEO Gregory Parsons.

BEING NIMBLE HELPS, as RMBS liquidity has been drying up since the crisis. “Roughly $700 billion of legacy nonagency debt still exists,” says Parsons. “The supply is shrinking 10% to 15% a year as securities mature.” Consequently, Parsons plans to close the fund to new investors at about $2.5 billion.

There is hope for new issuance, however. Since the crisis, some new nonbank lenders have gradually emerged to issue loans that are structured similarly to RMBS but have more-stringent lending standards. “This year, these new loans will be a $2 billion marketplace,” says Prabhu. “We think it will be a $200 billion marketplace in the next five years.”

One of the biggest problems during the crisis was that banks seemed ignorant of RMBS’ credit risks. Since then, their transparency level has improved. “These are still complex instruments,” says David Goodson, manager of Voya Securitized Credit. “But a number of companies have emerged offering data that help make the analysis easier.”

Still, given the sector’s complexity, having an experienced money manager is paramount. The cruelest irony: Top managers often come from the banks that originally issued the toxic loans. Goodson used to work at Wachovia. Prabhu’s team worked at the infamous Washington Mutual. But then, who better to dissect these securities than someone who watched them collapse firsthand?

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LEWIS BRAHAM is a free-lance writer, based in Pittsburgh.

Posted on December 14, 2015, in Postings. Bookmark the permalink. Leave a comment.

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