NEW YORK: Hedge funds might have just found the next "greatest trade ever" as they begin betting against US prime RMBS via a synthetic index tied to the bonds.
Markit's PrimeX indices, which allow investors to synthetically gain exposure to non-agency prime RMBS collateral, have been gradually losing ground since September, and dropped below par over the last two weeks.
This means that there has recently been a significant sell-off of prime RMBS, despite the recent so-called "bear rally" in stocks and other segments of the fixed income markets.
The drop in prices means that more market players are making bearish bets on prime mortgage collateral.
The PrimeX, which was created in April 2010, was meant to be the prime market sibling of the ABX, which was created in 2006 to allow investors to gain exposure to subprime RMBS. The PrimeX index was meant to serve as a standardized, diverse, and liquid tool referencing securitized non-agency fixed-rate or hybrid ARM loans.
But many in the blogosphere this past week expressed concern that the recent PrimeX price moves echo too closely the sharp drop in the ABX in 2007 that was a harbinger of the financial crisis.
Others disputed the comparison, noting that the rating agencies have already downgraded US prime RMBS heavily over the last three years -- meaning that increasing delinquencies have already been priced into the market -- and that the thinly traded, illiquid market was instead likely impacted by a handful of hedge funds taking a negative view on prime collateral.
"There are bearish fast-money accounts coming to the plate, including private equity accounts, who think that lightning will hit the same place again, as it did in 2007 with the success of shorting subprime through the ABX index," said Ying Shen, an RMBS researcher at Deutsche Bank.
"But the difference is that now, very few people want to take the long position on that bet. The decrease in PrimeX is more likely due to the general 'risk-off' in the broader market and a bet on the possibility of further home price declines."
Shen noted that home prices are likely to decline between 3% and 12% over the next year, while Fitch addressed the threat from defaults.
Prime jumbo mortgage performance has continued to erode for the last three years, according to the agency, and more than 12% of all prime borrowers are seriously delinquent.
"Default rates are expected to remain elevated over the near term, as home prices fall further and unemployment levels remain high", said Rui Pereira, the head of RMBS ratings at Fitch .
Moreover, more than a third of all performing prime borrowers are currently in a negative equity position. This dynamic, coupled with limited refinancing alternatives for borrowers, will continue to be a major driver of defaults over the near term, Pereira said.
Some securitisation specialists say that the decline in the PrimeX might have been precipitated by Fitch's completion in early October of its review of 1,154 US prime RMBS transactions based on an overhaul of its prime loan-loss model criteria, which it introduced in February.
As a result of the ratings review, Fitch either affirmed or upgraded 58% of prime RMBS ratings, but downgraded 42%.
While it seems that a variety of factors led to the recent PrimeX decline, the comparison to the precipitous ABX decline in 2007 that preceded the financial crisis might be a bit overstated, some say.
For one thing, it costs much more to short the PrimeX index than it does to short the ABX index -- a factor which may prevent other market players from voting against prime mortgage bonds.
"Buying insurance on these indices is not free; you have to pay a premium," said Deutsche Bank's Shen. "On the ABX, that policy is cheap; but the PrimeX is not cheap at all. It's in the range of Libor plus 500bp to short that index."
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