NEW YORK — Wall Street is finding a way to salvage some of the toxic debt that torpedoed the financial industry.
Wall Street banks this year have significantly ramped up efforts to repackage once-unwanted mortgage bonds to make them more enticing to investors. The bonds are stripped of risky loans, and presented to institutional investors with new triple-A ratings.
That repackaging could translate to some surprising trading gains for banks such as Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co. when they report earnings next month. If successful, the strategy could grow in popularity as the credit market opens up.
"You'll see a surprise in trading books," said Ajay Rajadhyaksha, head of U.S. fixed income and securitized products research at Barclays Capital.
The reincarnation of these mortgage-backed securities takes place as issuers repackage these bonds into two new bonds. They take the form of a senior bond with greater credit protection and a subordinate bond with the same credit support as the underlying bond.
These are known in the fixed-income industry as Re-Remics, which stands for "resecuritization of real estate mortgage investment conduits."
The process represents only a small sliver of the hundreds of billions of dollars of risky assets stranded on banks' books. But there is evidence that the volume of Re-Remics has tripled in just the past few months compared to the middle of 2008.
"We have seen a significant uptick in Re-Remic activity from banks and non-bankholders like hedge funds and insurance companies," said Roelof Slump, a managing director in Fitch Ratings' residential mortgage-backed securities group.
Market participants said more than a dozen bonds have been restructured in just the last few weeks alone. That compares to only one in January.
"The primary goal is improved liquidity because it is easier to trade a triple-A [rated] bond," he said. "For investors, it is better to hold a triple-A bond. By repackaging these bonds, it is easier to understand their performance."
Some of these securities could have hundreds of different types of mortgages within them, varying from loans extended to risky borrowers to those with high credit scores. Banks are now repackaging these bonds using a smaller spectrum of higher quality loans.
Bond holders use this process to sell better-quality debt to safety-minded investors such as pension funds, and then peddle what is left over to riskier players such as hedge funds.
"The banks could sell the junior portion to hedge funds or money managers," said Derrick Wulf, senior portfolio manager at Dwight Asset Management in Burlington, Vt. "It would be an extremely illiquid instrument but an opportunistic or flexible investor might get it."
With lower-quality loans jettisoned, even if it makes up only 10% of the security, the value of the remaining bond would be enhanced.
Buyers are typically willing to pay as high as 40 cents on the dollar for double-A rated bonds.
An investor may believe that a ratings agency is being "very tough," so the bond's performance could be better when the housing market rebounds, according to Slump. This could be a strategic investment for an investor looking to buy distressed assets.
Meanwhile, the government's $700-billion bank-bailout program could help investors buy distressed securities. Once this part of the plan is enacted, it could also help stimulate sluggish credit markets.
The banks are completing Re-Remic deals mostly on behalf of clients, but might adopt them as a strategy for their own assets, analysts said.
It is also expected to contribute to what analysts believe will be a strong quarter for trading at the banks. Financial companies such as Goldman Sachs and Morgan Stanley have been able to collect bigger fees after many of their competitors were driven out of business amid the credit crisis.
"There seems to be some realization that the market has painted everything with the same brush," Rajadhyaksha said. "We're seeing some interest in the better parts of the mortgage credit spectrum."