A flurry of mortgage prepayments has put some hedge funds in the hot seat and Wall Street traders on the sidelines.
Some hedge funds that invested heavily in interest-only, mortgage-backed securities have been hit with multimillion-dollar losses in recent days because of prepayments. Wall Street investors are now standing by, on the lookout for bargains.
Interest-only and principal-only securities are created out of mortgage pools by stripping the interest payments from the repayment of principal.
Some traders say they will now have difficulty placing interest-only securities, despite the drop in price that has occurred. But firms also are carefully monitoring the low prices in search of opportunities to invest.
One derivatives trader on Wall Street said that most of the hedge funds that lost money were actually "unhedged." Wall Street firms tend to run balanced books, he said, investing in interest-onlys and principal-onlys and seeking returns based on bid-offer spreads. Hedge funds make money on "short options" by being long on interest-onlys or on 10-year Treasuries, he said.
But some hedge funds were caught by surprise when interest-onlys, or IOs, underperformed because of faster-than-expected prepayments, this trader said.
"With the recent IO widening, we think that collateral cheapened up a lot and IOs cheapened up a lot," he said. Wall Street firms and more sophisticated hedge funds may allocate more capital now toward derivative securities because of the more attractive pricing, he added.
Any mortgage instrument has some risk if rates go down, because of homeowners' ability to refinance. Interest-only strips are particularly risky because investors get nothing back on loans that refinance as rates go down, said David Berson, chief economist at Fannie Mae.
"A lot of the hedge funds were making bets on interest rates," Mr. Berson said. "And they were betting that rates would go up."
Some investors view mortgage-backed securities backed by subprime loans as being less vulnerable to prepayments than those backed by conforming loans. But Mr. Berson said this distinction may be disappearing as homeowners find it increasingly easy to refinance.
IOs look "reasonably cheap" now on most option-adjusted spread models, but if the market continues to rally, prepayments will increase and interest-only securities will decline further, said Alec Crawford, vice president for mortgage strategy at Morgan Stanley. His firm is not recommending IOs to investors, he said.
"As the market has rallied, prepayment fears have continued to increase," Mr. Crawford said, while the IO market was exhibiting "negative carry" - when the balance declines more quickly than coupon income can compensate for.
While some hedge funds have lost money because of their speculating, a lot of big mortgage servicers buy principal-only securities to hedge servicing portfolios in the event that rates fall.
"As interest rates rally, the loans get refinanced, and they lose the servicing rights to those loans," Mr. Crawford said.
Over the last couple of months, servicing has performed much better than IO securities, said Joel Shaiman, managing director at BlackRock Financial.
Servicing looks a lot like IO securities because homeowner payments are taken in every month and then funneled to Fannie Mae, Freddie Mac, or Ginnie Mae investors, Mr. Shaiman said. But this is a much less liquid market, he added.
Meanwhile, investors in IOs and principal-onlys will continue to monitor rates closely.
"The market is very directional," Mr. Crawford said. "If the Treasury market continues to rally, we could see further underperformance in IOs."
According to Mr. Berson of Fannie Mae, the direction of rates will be determined by a tug of war between the pull of Asia on one side and the pull of inflation on the other.