Subprime: The Sequel
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Remember that subprime thing in 2008? Banks melting down ring a bell? Well those toxic assets didn't just disappear; they are still being traded by some financial institutions and investment funds and thanks to the creation of two ETFs, average investors can buy into non-agency mortgages as well.
The Return of the Debt
One may wonder why anyone would ever want to revisit the same investments that wreaked such havoc on the financial industry. But some investors see a recovery play and look at the gain of 30 percent this year in many subprime loans as a reason for bullishness on this beaten down investment.
Pure plays in the field of subprime are practically non-existent for the average investor as many of the purchases of MBS are taking place inside diversified financial firms or within hedge funds. Some REITs such as Two Harbors Investment Corp (NYSE: TWO) have subprime as part of their portfolio but for most of them it comprises less than half of their total assets, often with the majority being in far safer (and lower yielding) agency mortgages. While companies like Two Harbors would benefit from a subprime recovery, there are other investments which would stand to gain more if subprime continues its recent rise in value.
Fortunately for subprime speculators without hedge fund money, Nuveen Investments has created two ETFs, Nuveen Mortgage Opportunity Fund ) and Nuveen Mortgage Opportunity Fund 2 ), which are comprised of non-agency mortgages. However it should be pointed out that non-agency also includes Alt-A and ARMs as well and the Nuveen ETFs are not a pure play on subprime itself. Nonetheless, investors who are looking for subprime exposure are unlikely to find a purer play than these ETFs in the current environment.
What's in the Bag?
Comprised of non-agency mortgages, the ETFs are organized around the U.S. Treasury's Public Private Investment Program (PPIP) with the ETFs focusing on returns that beat those of the current low interest rate environment. The ETFs focus on the most shunned mortgages with over half of the each ETF being securities rated CCC or below and only about a quarter rated A or above. Of course these low rated securities come from all of your favorite financial firms including Bear Sterns, Bank of America ), Morgan Stanley, and Indymac.
B of A is already well known for its acquisition of troubled mortgage lender, Countrywide Financial, and the swallowing of this institution has been giving B of A an ulcer ever since. Many other low rated non agency mortgages, including many subprimes, have caused the bank to take billions in write downs and exposed the firm to billions more in lawsuits. As this article is being written, Federal prosecutors are suing B of A again, this time for an alleged defrauding of mortgage giants Fannie Mae and Freddie Mac. It has become a fairly regular occurrence at B of A to have earnings reduced due to a lawsuit and with many of these mortgages still outstanding the risk of future lawsuits remains high.
With names like these, JLS and JMT look like they are packed with toxic paper and ready to take a chunk out of your portfolio. But recent acquisitions of these types of securities by such REITs as Two Harbors and MFA Financial (NYSE: MFA) have shown the market is warming back up to owning these securities. Subprime investors are able to generate superior yields compared to safer agency mortgages while at the same time giving the opportunity for greater capital appreciation. The Nuveen funds JLS and JMT both offer juicy yields around 7.5 percent paid in monthly distributions and subprime investor Two Harbors pays a 12 percent dividend, although much of that yield comes from the leveraging of agency mortgages as many mREITs do.
Is Toxic Still Toxic?
Today's subprimes are still a risky investment but they are not as toxic as when the term was first coined. Many of the lowest quality subprimes have already been removed from the market because their borrowers were the least financially sound and often were the first to default on their obligations. This is not to say low quality subprimes do not still exist, but today's subprime are generally higher quality than those that brought Wall Street to its knees in 2008.
The recovery of the mortgage market will not happen overnight but the recent rise in subprime values indicates the appetite for these securities is picking up. Investors who are willing to assume some mortgage risk in pursuit of greater yields and capital appreciation, should take a look at companies and ETFs that invest in non-agency and subprime mortgages despite the negative history that continues to follow them, holding down their price in the process. And when price is unrealistically low, a good value could be there for those willing to take on the "toxic assets."
Dig Deeper
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