Hedge funds blindly gambling on private label RMBS nervous as $8.7B portfolio goes on sale

Hedge funds that have been blindly gambling by buying private label RMBS securities are getting nervous as an $8.7 billion portfolio of these securities is being offered for sale.

The sale of the portfolio could hurt their gamble in two ways.  First, the seller could accept prices that are lower than the hedge funds are currently exchanging these bonds.  Second, if the portfolio clears at close to market prices, it might encourage other holders of similar portfolios to try to sell their holdings.

As reported by the Wall Street Journal,

The riskiest types of residential mortgage bonds that rewarded investors with double-digit gains last year and almost that again in 2013 are about to be tested. 

Investors are atwitter with anticipation over what will be one of the biggest sales of non-government mortgage bonds since the financial crisis knocked them into deeply distressed states. 

Wall Street dealers are circulating an $8.7 billion list of subprime and other risky residential mortgage-backed securities (RMBS) to investors for a sale next week, demanding that terms be kept quiet until the mission is accomplished, according to Empirasign Strategies, a trade database. 

But the sheer size of the list, whose source isn’t being disclosed, has investors reconsidering the risk-reward equation after the market’s feverish rally over the past year. 

The supply is rivaling multi-billion dollar sales of RMBS by the Federal Reserve Bank of New York in 2011 and 2012, the earliest of which overwhelmed demand and helped drive the market into a tailspin....

The reason the Fed sales overwhelmed demand is that there is no "market" for private label RMBS securities.

Yes, these securities trade.  But because they are opaque, the trades are typically between one hedge fund and another as they gamble on the value of the contents of the brown paper bag that is the security.

In general, nonagency mortgage bonds have gained almost 10% already this year, after more than 20% last year, said Bryan Whalen, a managing director at TCW Group. 

The market — comprised of subprime and other bonds that aren’t backed by the government — has seen consistent demand for the past year as the U.S. housing market recovers and because of its relatively high yields.

Demand from hedge funds has consistently been on the long side as these gamblers are looking for something to buy.

“As deep as the bid has been, seeing close to $9 billion in a short time period is still a lot to digest,” Whalen said....

The fact that $9 billion is considered a lot to digest is a sure sign that there isn't a market for these securities.

In their heyday before the financial crisis began in 2007, there were $2 trillion of these securities outstanding.  So a sale of $9 billion was a non-event.

What would be worrisome is if other sellers also decide that now is the time to capitalize on today’s higher prices. 

Brad Friedlander, a portfolio at Angel Oak Capital, says he is still bullish on nonagency RMBS, but with the caveat if “we see a real cascade of these sales.”

Translation: the hedge fund gamblers only have so much capacity to buy these opaque, toxic securities.