Mortgage Trading...Alive And Kicking.

I hope my wife is not listening...but...

Talking to a few of my former mortgage trading buddies, who have been throwing around the idea of getting back into the mortgage trading game. I have been contacted by more then one recruiter who has expressed interest in my abilities. I am thinking that now that the "young trader " with the "cowboy trading" style that only listened to the quants who were following flawed models have screwed up the system, they might now want more experienced "risk averse trader" who listens to risk managers more then the quants. Maybe.

One thing is certain...recruiters, headhunters, and HR personal are as clueless as ever, as they generally read off the job requirements like a ten year child actor. These people have no idea what they are recruiting for. They only rely on key words in the job recs, then look for those key words on your resume.

My colleagues have debated and wondered about the mortgage securities market for years now. We had come to the conclusion that the business that identified us during our 20's had become a commodity like dinosaur business. That the survival of that career choice depended not on the general economy, employment picture, or even the credit markets themselves, but a solid thriving secondary market for mortgage securities. That the secondary mortgage market had been saturated and commoditized by the likes of Espeed and Tradeweb, only enforced the idea that the modern mortgage trader had outlived their usefulness. The area to be in was the business of creating models that tried to predict shifts in the market itself. This was definitely the seismic shift that Wall Street took in the early part of the century. The "Quant" approach worked, because the models work 99.5% of the time, absence of a total credit meltdown would ensure billions of profits, while the leverage, securitization, and lack of risk controls continued. The mortgage trader was just like a waiter at a restaurant, taking orders from the quants,who were taking their orders from the models. Heck, why even need a trader, when the quants can just buy CMO's off the Espeed screen? The whole business had become mechanical and automated....until late 2007, when the cracks in the lending market started to appear. I remember working on the mortgage desk in 1999, looking over my P&L, my eyes glued to the inter broker market and Bloomberg, thinking that I like the rest of the people on the desk had the most coveted trader position on Wall Street. The mortgage trader had lots of power, were held responsible for 90% of the P&L of the entire trading desk, and most importantly paid very well...something had to give, the power had shifted from pure investment banking back to trading. Why pay 15 traders $200,000 plus, when you can pay 5 quants $100,000? This combined with the Dot Com bubble forced Financial Institutions to rethink everything. Gone were the proprietary mortgage traders and risk managers, in were the quants. Sprinkle in some Greenspan Magic (Lower Interest Rates), no regulation, more complicated structured financial products, The Bush Administration, and..oh yes... leverage...Presto!

Back to the Secondary Mortgage Market.

I’ve spoken to a person who actually has a job pricing and selling these MBS securities. He has been very busy for months. When Moody’s downgraded many of these securities last month, lots of institutional investors like pension funds, college endowments, etc had to liquidate them (because they can only hold investment grade securities) for whatever price the market could fetch. That meant realising the losses and often taking 30 cents on the dollar for them. Many of these MBS securities will yield a nice return in the long run for people who can hold these wither to maturity or ride out the credit mess. Apparently, Bank Of America, Citigroup, Morgan Stanley, Goldman and others are buying them up with TARP money. This is not making the Obama Administration very happy. But the bigger problem for the banks is that they own much more of these securities at these depressed prices then they have purchased. The banks have stated that they have been active in the secondary market as its part of their plan to breathe life back into the moribund securitization market. While I applaud them doing business in this frozen market, some have argued that they are gambling away taxpayer funds instead of actually lending and making new loans. Moreover, this same time last year some of the same distressed mortgage paper that Citigroup, BOFA, and JP are currently snapping up was trading around 50 cents on the dollar, only to plummet to their current levels. One trader friend of mine said that the banks' purchases have helped to keep prices of these troubled securities higher than they would be otherwise, so that the banks wouldn't be forced to write them down to where they are truly valued.

The problem is not that a market for these securities does not exist, it is that the market does not offer a price at which many sellers are willing to sell. Many banks and insurance companies still won’t take much less than par. That may be because some sellers are in deep denial and realise they will be insolvent if they sell at the current market price. This seems to be more of a problem with whole loans, not MBS. Goldman and Morgan Stanley at least have been a bit better at marking their MBS to market then the banks.

It also could be that the market simply is not offering a price that reflects the true value of the security. Prices may be depressed because of uncertainty or the premium on liquidity. Sellers also knew all along that the government would step in with a plan to narrow the bid/ask spread. With subsidies on the horizon, banks knew the market price would eventually increase. So it made sense to just hold on to the assets until the auctions commenced. But whether or not sellers actually participate still remains to be seen.

Now that the government has offered a subsidy to buy these assets the price will probably rise. If you expect the plan to work, buying up these assets for 30 cents on the dollar now may not be so crazy. I personally think it will to a certain extent, but wont make a big difference in the overall pricing environment, because if the securities are seriously undervalued and the Geithner plan is effective, the uncertainty will be resolved, we’ll see less of a liquidity premium, and the prices on these assets could increase. On the other hand what is happening is the secondary market is being dominated by few participants, so price discovery is still a major problem. Every one who is concentrating on the secondary market cant get out of the arbitrage mindset. They are looking for pricing discrepancies, but no pricing is available still. There is still too much emphasis and total obsessing over CDS and ABX Index Pricing to make an educated guess on the direction of future prices. Investors, hedge funds, and institutions have been badely jarred in this credit crisis, this problem will last a long time.

But what is certain is that the once frozen secondary market for MBS is now showing some life, which is good for both former traders, homeowners, and perhaps even institutions.