Subprime security prices gain 30% as traders bet that a bigger fool will buy their positions

Bloomberg carried an interesting article on how prices on subprime mortgage-backed securities have increased this year as Goldman and the hedge funds load up.

Regular readers know that due to a lack of transparency, buying these securities is nothing more than blindly betting.  A point that the article confirms.

Growing interest in a diminishing asset has bolstered a rally that’s pushed returns on subprime-backed securities to almost 30 percent this year. 

Cerberus Capital Management LP and Goldman Sachs Group Inc. (GS) are among firms that have raised money for new funds targeting the bonds, as investors speculate on the real-estate recovery or seek to earn higher returns as the Fed pushes yields on safer debt to record lows. 

“The contraction is a huge part of the story of why non- agencies have outperformed almost every other asset class,” said Bryan Whalen, co-head of mortgage bonds at TCW Group Inc., a Los Angeles-based firm that oversees about $130 billion.... 

Canyon Partners LLC, Brevan Howard Asset Management LLP and D.E. Shaw & Co. have also said this year that they planned to bet on home-loan bonds as buyers wagered prices were low enough to compensate for a lack of a housing rebound or would be available cheaply as European banks sold assets. 

At the same time, money has flowed to mortgage specialists including Greg Lippmann’s LibreMax Capital LLC hedge fund and Two Harbors Investment Corp. (TWO), a real-estate investment trust. 

Daniel Loeb’s $9.3 billion hedge fund Third Point LLC has also been betting on the bonds, according to an investor letter. 

The biggest risk is that hype around mortgages has brought in too many investors and that a “herd mentality applies in both directions,” Loeb said in the letter yesterday.

The article then describes how these traders are looking for the bigger fool to buy them out of their position.

After a “wave of opportunity seekers” targeting non- agency securities, the move should further increase interest among a broader range of more-staid investors, such as mutual- fund managers and insurers, said Brad Friedlander, head portfolio manager at Atlanta-based Angel Oak Capital Partners. 

“I don’t see the momentum ending, with yield being just that much more difficult to obtain,” Friedlander said....

Houston, we have a problem.

On Wall Street there is the story of the client who calls his broker and day after day tells him to buy a stock.  Soon the stock has doubled in value and the client decides its a good time to recognize his profits.  So, he calls the broker and asks the broker to sell the stock.  The broker responds 'to whom?'

This is the problem the wave of opportunity seekers has.

It is a particularly big problem since the National Association of Insurance Commissioners (NAIC) published a white paper on the future of mortgage-backed securities and linked the amount of capital that must be held against these securities to the frequency of disclosure.

Specifically, they linked observable event based reporting to low capital requirements and current disclosure practices to high capital requirements.

This standard doesn't effect just the money managed directly and indirectly by the insurance industry.  It also effects the rest of the buy-side, except for the hedge funds.

After gaining 25.6 percent in 2010, the debt lost 5.5 percent last year. 

The contraction in supply, which is “just one part of the puzzle,” didn’t prevent a sell-off in 2011 as “fast money” such as hedge funds and dealers dumped bonds, said Glenn Boyd, chief investment strategist at Zais Group LLC, a Red Bank, New Jersey-based asset manager that oversees $5.8 billion....