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What's old is new again

New pooled mortgage strategy touted for institutional investors

Growing: Matthew D. Bass, left, and Michael S. Canter think the institutional market could go as high as $500 billion.

Based on 'safe' loans, securities would carry government guarantee

Two AllianceBernstein (AB) LP (AB) mortgage specialists say they have hit on the next great investment for institutional investors: securities based on a pool of residential Freddie Mac and Fannie Mae mortgages that could blossom into a $250 billion to $500 billion institutional market.

Investors could fund the mortgage investment from their real estate or fixed-income allocations, said Matthew D. Bass, vice president, fixed-income/structured assets, who co-authored a white paper on the topic with Michael S. Canter, director, structured asset research and portfolio management.

They said in the paper that the safest mortgages would be included in the securities that would be fully guaranteed by the government. The Federal Home Loan Mortgage Corp. and Federal National Mortgage Association, meanwhile, would be able to transfer the “first-loss” slice of their mortgage pools to private investors. Freddie Mac and Fannie Mae would share the risk with private investors by buying insurance. (The “first-loss” piece of mortgage pools contains the most junior loans. Should there be a default, junior lien holders get paid last, Mr. Bass explained.)

So, for example, for a pool of “safe” mortgages, Fannie Mae or Freddie Mac would transfer the first 10% loss exposure — the risk of losing money should a homeowner default — to private investors, who would earn a coupon, getting income in exchange for taking the risk. Fannie and Freddie, in turn, would buy insurance as protection from losing money should property owners default on their mortgages.

Messrs. Bass and Canter also have a suggestion for securitizing riskier mortgages, which they call the “cash pool approach.” Under this approach, Fannie Mae and Freddie Mac would not buy reinsurance, they just would not provide a guarantee on the securities.

For the pools of safer mortgages, the pair insists that private investors' investments be unleveraged.

Having the private capital be fully funded and provided by investors like pension funds and sovereign wealth funds would result in a more stable mortgage market in the long term, they contend in the paper.

There is a big demand for income and yield in the fixed-income and real estate markets, Mr. Bass said in an interview.

“We think this is ideal for sovereign wealth funds and pension funds” because they have the money for such unleveraged investments and because the securities would provide income and return.

He said he expects some securities to be issued sometime this year that include private capital, possibly under a pilot program by either Fannie Mae or Freddie Mac.

“Personally, I would expect both Fannie and Freddie to bring transactions to market. Structures may be different. Timing may be different. Both are trying to solve the same problem in attracting private capital,” he said.

On the other side of the trades would be money management firms — including AllianceBernstein — buying these securities on behalf of their institutional clients.

Infusion needed

The housing market is in desperate need of a capital infusion to kick-start the market, industry insiders say.

Fannie Mae and Freddie Mac hold much of the residential and multifamily mortgages, noted Michael Feder, president and CEO, Radar Logic Inc., a New York-based research firm that tracks the residential market and offers a futures strategy.

Government-backed mortgages account for $5.4 trillion of the $10.4 trillion U.S. fixed-income market, according to the white paper, which cites June 30 data from the Securities Industry and Financial Markets Association.

“The idea of reigniting private market funding sources is not only appropriate, but it is necessary,” Mr. Feder said.

The residential market is ripe for investment because housing is cheap. There are more sellers than buyers because buyers are worried that prices will continue to drop, Mr. Feder said.

A program that allowed private investors to take the first-loss position could help return the market to normalcy, Mr. Feder said.

And institutional capital pools are looking for ways to invest in the residential market, Mr. Feder said.

Mr. Bass said that bringing private capital into the U.S. mortgage market would support the market's growth, especially if that private capital is not leveraged.

Excluding leverage from the first-loss piece of the pool held by private market institutional investors would bring in more stable buyers. Without leverage, demand would not be based on the existence of financing, he said.

“We think long term, real money investors are a great source of capital for the mortgage market, as opposed to levered hedge funds,” Mr. Bass said.

At the same time, U.S. government officials are looking for relief from one of the biggest risks they have taken on through government-sponsored enterprises: Fannie Mae and Freddie Mac. President Barack Obama's administration has indicated it wants to wind down their investment portfolios, making room for private capital to return to the market, according to its plan for reforming the residential financial markets released last year.

Andrew Wilson, senior manager, corporate communications for Fannie Mae, Washington, declined to comment on what programs the agency might pursue.

Michael Cosgrove, a spokesman for Freddie Mac in McLean, Va., referred questions to the Federal Housing Finance Agency, Washington. Corinne Russell, an FHFA spokeswoman, could not provide comment by deadline.