Subprime Bonds Come Roaring Back

LAS VEGAS — No doubt about it. Subprime is back. Mortgage backed securities are hot again.

George Diebold | Photographer's Choice | Getty Images

Many of the hedge fund traders gathered at the Skybridge Alternatives investor summit at the Bellagio Hotel in Las Vegas are enthusiastically seeking out the once "toxic" mortgage bonds for their portfolios.

Even Kyle Bass, the Texan hedge fund manager who made billions shorting mortgage bonds in the years before the financial crisis, is bullish on mortgage credit. The "worst" bonds, those not backed by Fannie Mae and Freddie Mac, could see gains of 15 percent, he said Thursday.

The primary attraction of the bonds is their price. Although in recent months the bonds have rallied by as much as 20 percent, they still trade at steep discounts to par value. Last year they fell 40 percent.

The hedge fund mangers attracted to the bonds believe that even with massive defaults, they will continue to generate cash flows in excess of what current market prices indicate.

Some of the enthusiasm for the bonds is rooted in the idea that the housing market may be reaching a bottom. If home prices began to rise, mortgage defaults would likely decline and the prices of the bonds rise. But some traders believe that even if housing declines further and the economy stalls, the bonds could be profitable because the Federal Reservewould step in and buy them as part of a new round of quantitative easing .

One trader said that having Fannie and Freddie out of the market and having the Fed in the market has made all the difference. When Fannie and Freddie were building up their portfolios, they had teams of experienced professional traders and very deep pockets. Because of their implicit government backing, they could finance purchases of mortgage bonds cheaper than private rivals. They often bought the best available mortgage bonds.

The Fed acts differently. It is not trying to profit from the mortgages it purchases. It uses its purchasing power to support broader economic goals.

"In some ways, they want the worst quality bonds they can find because that gives them more stimulus for the dollars they spend," the trader said.

The biggest worry for traders buying mortgage bonds is government action. If the government were to force banks to forgive portions of the loans pooled into the mortgage bonds, the bond holders could suffer serious losses. One trader told me he worries that the Obama administration could try to "buy votes" with a mortgage forgiveness program.

Even this danger is limited, in the view of some at the conference. A large scale debt forgiveness program would take months to be put in place, so it would need to be announced over the summer to be effective by election time, one trader said.

"I think we have a six week window left of political danger. After that, it's over. And after the election, regardless of who wins, we're free and clear," he said.

Not everyone loves subprime mortgage bonds, of course. Some are still wary, scarred from the financial crisis. But this looks increasingly like a minority view, at least among the hedge fund managers and backers at the Bellagio.