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Margin Calls Push Values Toward Precipice
Asset Backed Alert, Harrison Scott Publications Inc. (July 25, 2008)

The secondary market for mortgage-related bonds found itself on shaky ground again this week, as some banks demanded repayment of margin loans they supply to opportunistic buysiders.

The main culprit in the leverage pullback is a growing perception that bets by certain bargain-hunting fund managers that home-loan bonds had hit bottom in March, April and May came too early- exposing them to potentially heavy losses as the market slumped instead.

Now, as margin calls force some of those buyers to sell their mortgage-bonds investments, a consensus is forming that the values of those holdings will keep dropping from already historic lows. That, in turn, is threatening to create even more losses while dashing earlier hopes for a market recovery in the second half of this year. "It's going to get worse," said Jeffrey Gundlach, who runs the $1.6 billion TCW Special Mortgage Credits Fund, a TCW vehicle that aims to buy troubled home-loan securities.

A similar fund run by Fortress Investment played a big role in this week's downturn, with the firm acknowledging that the entity, Fortress Mortgage Opportunity Fund, lost 30% of its value since launching in April. Word is that the decline, driven by wrong-way bets that the values of mortgage bonds would rise, prompted several margin lenders to demand repayment.

An other opportunistic fund was also on unsteady footing after seeing the values of some distressed mortgage instruments it bought fall from 15 cents on the dollar to just two cents. By midweek, a buzz was developing that margin lenders had identified a handful of other fund-manager clients that could be prone to similar losses - including both established players and opportunistic operations that formed to take advantage of credit-crunch-related declines in mortgage-bond prices. Many of the opportunistic funds had borrowed $3 for every $1 of equity they raised.

Margin calls on those vehicles present a double-whammy of sorts for secondary mortgage-bond values, which have already been depressed since the credit crunch took hold a year ago. Because the funds constitute a large percentage of the secondary-market investor base for home-loan securities, cuts to their buying power erode demand. That alone is enough to drive down prices even further. But margin calls also force the funds to liquidate holdings, possibly causing any remaining bidders to reduce their offers to fire-sale levels.

That's a scenario that occurred in March, when margin calls that forced a troubled Carlyle Group hedge fund to sell assets at bottom-of-the-barrel prices touched off a series of similar liquidations. While secondary-market values on mortgage bonds were falling this week, massive sell-offs of that sort had yet to materialize.

The biggest drops occurred among securitizations of so-called option ARMs, which are adjustable-rate loans that allow borrowers to pay less than the interest and principal due on their debts for several years. The super-senior portions of those deals saw their prices drop by 15-20 cents over the last several days, rocking investors who bought them for what they believed was a bottom of 80 cents three months ago. Some investors are projecting another 5-cent decline in the coming days. Option-ARM bonds are thought to be particularly susceptible to credit losses because their structures allow borrowers to add to their balances. Lately, fears have been growing that such products could be in for losses equal to those seen on floating-rate subprime mortgages. Steeper-than-expected declines in existing home sales have come into play as well.

The values of option-ARM bonds also took hits as Wachovia and Washington Mutual singled out those deals' underlying loans as particularly poor performers in dismal earnings reports they released this week. According to a research report from Merrill Lynch, Wachovia's option-ARM portfolio will suffer $19.4 billion of losses over the lives of the loans, while WaMu will lose about $10.5 billion on a similar book of credits.

The gloomy outlook contrasts with what many fund managers were saying just a few months ago, as they sought to lock in high yields on a range of mortgage-related assets. At the time, they believed the implosion of Bear Stearns and the bank's subsequent takeover by J.P. Morgan signaled the bottom of the market. "What they didn't realize is most of the stuff still had anywhere from a 10-20 point drop in value still to go," one trader said. v



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