The subprime mortgage crisis of 2007, when a growing wave of house mortgage defaults caused the value of mortgage-backed securities plummeting, was a significant contributor to the global financial crisis of 2008. According to Business Insider, mortgage-backed securities (MBS) are now locked in a vicious cycle known as a negative convexity, whereby declining interest rates are forcing the values of these bonds to decline rather than grow.
Colleen Denzler, an investment manager at Smith Capital Investors with over $350 billion in assets under management (AUM) and formerly the global head of fixed income at Janus Henderson, told BI that “they’re in difficulty right now.” She is now overweight, MBS. Bubbles burst when circumstances change, whether as a result of a crisis or a shift in the factors that led to them, she said. We’re in a situation where this might take some time, she said.
Significance For Investors
Homeowners are being encouraged to refinance their mortgages as interest rates decline. Investors in MBS are thus receiving their investment back faster than anticipated. Although dropping interest rates increase the value of the majority of bonds, this macro environment also has the potential to lower the value of callable bonds as well as other assets like MBS that may provide surprise early payback of principal. This is the negative convexity paradox.
The U.S. Treasury Bond market is a popular place for investors who have gotten early returns on their capital to reinvest their money, according to BI. However, rising purchasing activity in T-Bonds is driving their yields further lower. This is speeding the refinancing of mortgages and the consequent drop in the value of MBS since decreasing yields among these benchmark assets are driving mortgage rates to be reset at even lower levels.
According to MBSQuoteLine.com, “Mortgage loan interest rates, and the related fees or points imposed for varied rates, are influenced by the values of MBS.” If this is the case, a negative feedback loop known as negative convexity further aggravates the issue.
The Wall Street Journal says that private equity company Cerberus Capital Management LP is bringing back a specific kind of mortgage bond that vanished during the financial crisis and is backed by home equity lines of credit (HELOCs). According to Grant Bailey, who at Fitch Ratings is in charge of residential MBS, “there has been some hesitation from issuers” around the introduction of new MBS types, the Journal. Due to the lack of interest in the Cerberbus transaction, only the tranche with a AAA rating was offered.
According to Neil Aggarwal, head of trading and deputy chief investment officer (CIO) at Semper Capital Management, “We are beginning to see a lot more innovative issuance around mortgage credit.” After this purchase, “I wouldn’t be shocked if there’s more to come,” he said.
Today, more people are becoming interested in more sophisticated debt instruments whose falling prices were a contributing factor in the 2008 financial crisis. One of these is the synthetic CDO, a collection of derivatives connected to several types of debt. Optimists worry that history might be about to repeat itself and advise cautious investors to seek shelter.
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