The Return of Subprime?

While everyone has been focusing on interest rates and quantitative easing programs, stories on subprime bonds and other mortgage-backed securities (MBS) are coming back in vogue.

Yes, that’s right folks, Wall Street is at it again!

But first, what exactly are mortgage backed securities?

Mortgage-backed securities are financial instruments that are backed by thousands of mortgages, or loans used to purchase a property. Since subprime loans are loans made to people who have spotty credit history, financial institutions packed these loans into a MBS and offer it to its clients who will then have claims to the cash flows of the mortgage payments.

Now, for those of you who don’t remember (or perhaps, don’t WANT to remember), mortgage-backed securities were at the center of the financial system collapse back in 2008. The problem was that banks were writing way too many subprime loans that would later be repackaged into MBSs.

When people started defaulting on their subprime mortgages, a widespread panic took hold of the financial system. Prices of MBS’s and other financial assets declined, as nobody was willing take on the additional risks.

Fast forward two years, and it looks as if investors are giving in to the risky business itch. Taking a look at some bond indexes, it seems that subprime mortgage bonds are starting to get some lovin’ again!

The ABX.HE.AAA 06-02 is an index that measures the performance of 20 different types of subprime mortgage-backed securities. This particular index measures the subprime MBSs that were formed during the second half of 2006 and was originally priced at 100. After hitting an all-time of 28 cents in 2009 (that’s right – the index lost about SEVENTY PERCENT of its value), it has doubled up and is currently sitting at about 58 cents.

It is heavily-followed by investors because it provides a pretty accurate representation of how investors feel towards subprime mortgage-backed securities, and even provides a glimpse of overall market sentiment. Take note that when investors are bullish, MBS bond prices should rise as investors are confident and gutsy enough to take on the risk of holding the MBS bond.

To give you an idea how popular it is, in 2007, a well-known hedge fund manager by the name of John Paulson (shame on you if you don’t know him!) sold this index and made a bajillion dollars!

With the index slowly climbing, does this mean that traders have turned the risk switch back on?

Speaking of risk switch, let’s take a look at the forex market’s very own barometer of risk – EUR/JPY!

PoD Chart

Looking at EUR/JPY’s weekly chart we can see that the pair had been steadily climbing since October 2000 when it reached a bottom of 88.87. Around 2007, the pair started consolidating on a 1500-pip range just above the 150.00 mark. Now notice how the pair suffered a steep drop in 2008 when the financial crisis in the U.S. started unfolding. The pair fell by 5,600 pips in just 13 weeks! Heck, that’s even shorter than the time it took Cyclopip to lose 2 lbs.!

What’s interesting about EUR/JPY’s price action lately is that is seems to have broken up from consolidation and the double bottom formation that started May 2010. In fact, the pair has already rallied by more than 1,500 pips since the G7 launched a coordinated currency intervention in March.

Wait a second… So when subprime MBSs prices dropped during the financial crisis, so did EUR/JPY. But now that MBS prices are back on the rise, EUR/JPY seems to be rising as well. Coincidence?

Hmmm… let’s think this through first.

Remember, the low-yielding yen is used as a funding source by investors who want to invest in higher-yielding assets. During the crisis, investors didn’t like the outlook of the market and decided to unwind their positions in risky assets. Thus, it should come as no surprise that MBS prices fell. After all, who would want to hold an asset where there was a high chance of default?

But now that the ABX index is trending higher, maybe risk sentiment is in fact improving. If this is true, then perhaps we’ll see the return of the carry trade, which could boost EUR/JPY higher. Is 135.00 out of the question? I don’t know about you, but I’m definitely gonna be keeping an eye on this pair to help me gauge risk sentiment.

  • donkeykong

    wall street needs to go to rehab.

  • donkeykong

    wall street needs to go to rehab.