Existing issues of mortgage-backed bonds secured by longer-term, fixed-rate loans are now trading at about 85 cents on the dollar. The trading levels are up from just 55 cents on the dollar as recently as March. By any stretch of the imagination, this is a significant jump in the price investors are willing to pay for bonds backed by an asset class many forecast to be in an all-out bear market well into 2010.

Even during a normal debt trading market, a rise in prices this steep and in this short a period would be considered an aberration. While some of the price increases can be attributed to the announcement of U.S. Treasury's highly anticipated Public-Private Investment Partnership (PPIP), and the Federal Reserve's Term Asset-Backed Securities Loan Facilities (TALF), other developments have altered market sentiment.

Chasing debt yields

In both government programs, the Federal Reserve and Treasury Department are attempting to help the market flush out illiquid assets, and remove an overhang of nonperforming loans from the balance sheets of banks and other financial institutions. But considering that at the beginning of the year — at the height of turmoil in the credit and financial markets — these bonds and loans were virtually illiquid, the price run-up begs the question: Why is real estate debt now so attractive?

To begin with, debt investors abound, and chasing after yield spreads has become an investment activity considered comparable to buying stocks. This was the conclusion of analysts at JPMorgan Chase in its recent letter to its bond-trading clients. The analysts concluded that investors should be wary of the recent run-up in prices, referring to investors' hunger for debt yield as a “crowded trade.”

Then, banks and other lenders are not readily disposing of loans they have already written down. And while the armies of investors seeking to capitalize on distressed debt are growing, an equal number of lenders appear to be countering these opportunity buyers by holding on to debt positions in hopes of working out troubled loans directly with borrowers.

So the hunt is on for any debt sellers these days. In fact, many investors who had previously refused to stand in line for loan auctions are now keen to join the bidding war. For instance, many have been flocking to the Federal Deposit Insurance Corp.'s Legacy Loans Program, hoping to find bargains. FDIC reports that the number of investors inquiring about, or registering for, available loans has jumped more than 40% in the last eight months alone, and that number is expected to climb further.

But for now these inquiries and registrations will be limited to the sale of loans from failed banks because the solvent banks are opting out of the government's programs to “help” them rid their balance sheets of toxic assets. Instead, these institutions believe they can do better on their own, and therein lies one of the greatest reasons for firm pricing in both the mortgage-loan trade markets and the securities they back.

Desirable toxic assets

Adding further fuel to the fire of firm or rising prices is the Treasury Department's recent announcement that it is relaxing rules that stated Real Estate Mortgage Investment Conduits (REMICs) could not modify their mortgage pools without tax penalties or potentially losing their REMIC status. Treasury has now granted borrowers and their asset management representatives the reprieve of beginning loan modification talks with servicers well in advance of an actual default or distress event.

The upshot is that loans that are part of a securitized pool can now be worked out, extended, or otherwise modified without changing the way income and capital distributions are taxed. It is another attempt by the Obama Administration to stabilize U.S. financial markets, and minimize the flood of toxic assets.

How this will affect the positions of bondholders is unknown, but expectations of such a relaxation in the strict tax structure of CMBS is enough to firm up prices. It is yet another mitigating factor to suggest buyers of distressed debt and securities may be disappointed, as potential distressed loans are removed from pools earlier in the cycle. It may also confirm that the easy, short-term profits in the purchase and resale of distressed debt and securities is over.

CMBX Trading Reflects Rising Prices

Mortgage-backed securities AAA prices spiked from about 75 cents on the dollar in July to roughly 80 cents on the dollar in September.

Class/Issue 05-1 9/15/09 8/19/09 7/20/09
AAA 79.91 74.19 75.21
AJ 49.04 39.3 35.64
AA 29.07 22.56 19.64
A 22.23 18.08 16.68
BBB 16.3 14.21 13.05
BBB- 14.61 13.13 12.18
BB 5.88 5.38 6.42
Sources: Standard & Poor's

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance training consultant.