2014: The Year Bad Mortgages Became Good Investments

Soured mortgage debt is a new favorite among investors looking for spicy yields

Aug 24, 2014 at 9:44AM

Flickr / Jeff Turner.

In a strange twist of fate, toxic mortgages – the very loans that became synonymous with the housing crash and the attendant financial crisis – are experiencing a sort of renaissance. Once reviled, these loan products are quickly gaining in popularity among investors tired of lethargic yields resulting from the low interest rate environment prevalent since the Great Recession.

Buying smoldering crisis-era debt isn't a novel idea
The idea that bad debt can turn a good profit isn't new. For instance, crummy mortgage-related products that caused the failure of Bear Stearns and the near-death of global insurer American International Group were whisked away by the Federal Reserve Bank of New York in 2008, saving the financial system from ruination.

Those toxic assets, which included collateralized debt obligations on the part of AIG, weren't just swept under the rug. The FRBNY created three portfolios named Maiden Lane LLC, the first of which received $30 billion of toxic assets that JPMorgan Chase & Co. wouldn't touch in its purchase of Bear Stearns.

Maiden Lane II and III were, in turn, stuffed with AIG's disgraced mortgage-backed securities and CDOs from the pre-crisis era. The Maiden Lane assets were sold to the highest bidders, beginning in early 2012. For all three portfolios, the Fed netted a profit for taxpayers of $10.2 billion.

Increasingly favored by investors
The demise of Lehman Brothers has also spawned some lucrative deals for investors. The company filed for bankruptcy in 2008 with over $600 billion in debt on its books, and creditors, courts, and investors have been sifting through the wreckage ever since. As settlements and payouts top long-ago estimates, the debt has become coveted by investors. In a little over 18 months, the value of the debt has risen 45%.

With that kind of track record, it's easy to see why big investors want in on these kinds of deals. With the economy improving and housing prices rising, institutional investors like PennyMac Mortgage Investment Trust note that troubled loans are either moving more quickly toward becoming current again, or going into default. Payoffs for investors in the latter case occur when the foreclosure process resolves the issue.

PennyMac recently reported realized and unrealized gains on its distressed mortgage loan portfolio of $73.6 million in the second quarter, compared with just under $40 million in the previous quarter – indicating just how hot these assets have become over the course of 2014.

HUD fans the flames
Sales of delinquent mortgages by the Department of Housing and Urban Development over the past four years have also fed the frenzy. Freddie Mac has joined in recently, as well, selling $659 million worth of distressed mortgage debt. Both HUD and Freddie Mac held the auctions to decrease taxpayers' obligation in regards to seriously delinquent loans.

It's a winning situation for banks saddled with heaps of rotten mortgages, too – institutions like Bank of America, which recently put up for sale bad loans with balances totaling $3 billion. For the firms that buy the debt and securitize it, the process can be very lucrative, as well.

Another bubble?
Analysts note that the market for bad mortgage debt is beginning to get a bit frothy, with the Freddie Mac sale garnering prices of $0.76 on the dollar of unpaid principal, compared to $0.49 in January 2013. There is little doubt that the higher demand will spur additional mortgage debt offerings over the next several months. 

Could this craving for bad debt by investors result in another catastrophe like the subprime crisis? Probably not. Although feverish demand for MBSes during the run-up to the financial crisis most certainly drove the generation of dodgy loans, only the housing crash stopped the creation of new mortgages. In this case, the fodder for this new investment trend – those very loans – are limited in quantity. Financial reforms enacted since the crisis will put the brakes on any repetition of the subprime mortgage craze.

Though it has taken years to do so, it seems that these loans have come full circle, at least in the eyes of investors – once beloved as subprime mortgages bundled into coveted MBSes, now experiencing renewed ardor as mere shadows of their former selves, once again being stuffed into high-yielding mortgage bonds. This time around, however, the love affair between investors and mortgage debt should have a happier ending than it did the first time around.

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Amanda Alix has no position in any stocks mentioned. The Motley Fool recommends American International Group and Bank of America. The Motley Fool owns shares of American International Group and Bank of America and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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