Mortgage-Backeds Seen Subject to Hedge Fund Selling

A question on the minds of Wall Street traders and analysts is how broker-dealers are handling their relationships with hedge funds since the bailout of Long-Term Capital Management and the auctioning of securities by hedge funds forced to meet margin calls.

Last week, in response to margin calls, Ellington Management of Old Greenwich, Conn., sold about two-thirds of the $1.5 billion of mortgage- backed securities it tried to auction during the Columbus Day holiday weekend, a spokesman for the firm said. It has done some additional selling since then, he added.

Treasury securities and pass-through, mortgage-backed securities are the most liquid and, therefore, usually the first in line to be sold by hedge funds, said Inna Koren, first vice president at Prudential Securities in New York.

What does this mean for the mortgage-backed securities market? Some liquidity problems have been evident with securities issued by Ginnie Mae, said David Lereah, chief economist for the Mortgage Bankers Association. But the overall market is "pretty favorable right now," he said.

The Federal Reserve's reduction of two key interest rates by 25 basis points each last week would be factored in to investors' buying decisions. "With rates going down," Mr. Lereah said, "there is some prepayment risk that's entered into the equation again."

One mortgage trader predicted that investment banks would regulate hedge funds for the moment by increasing margins and raising the cost of borrowings but that in a year's time the bankers would be lending as aggressively as ever.

A senior executive of a Wall Street mortgage trading group said the Street is still in the middle of "a big old thunderstorm." But he said firms were not stopping the flow of money to hedge funds, just curtailing it.

Wall Street brokers will demand higher rates from hedge funds, Mr. Lereah said. "Rates adjust," he added. "They'll make the loans as long as the rate is high enough. Price is a great equalizer."

Hedge funds usually have multiple brokerage relationships in order to benefit from Wall Street research and other broker-dealer services, said Bill Bates, a partner in the McCutchen, Doyle, Brown & Enersen law firm of San Francisco.

The margin calls have not been unexpected, he said, adding, "Most margin agreements are fairly mechanistic." In periods of volatility, a domino effect takes hold as brokerage houses issue margin calls, he said.

Bank stocks have also been hurt by hedge funds' "downward spiral of liquidating," said James Rockett, another McCutchen, Doyle partner. Meanwhile, Fannie Mae and Freddie Mac are taking advantage of a "huge economic window to buy assets" because of dramatic widening in the spread between mortgages and the agencies' debt, said Kenneth A. Posner, vice president of Morgan Stanley.

Fannie and Freddie borrow at close to Treasury rates and now have "tremendous opportunities to accelerate their portfolio growth," he said. "Everything except Treasuries is going at fire sale prices right now."

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