A new strategy promises junk-type returns at investment-grade risk, according to the mantra of Residential Capital Management LLC. And therein lies the problem in marketing the new investment: Prospects will ask, "how do you do that?" said Larry H. Mylnechuk, principal, who oversees marketing.
The strategy exploits the returns of subprime housing mortgages. The borrowers, who have inferior credit histories, can't qualify for conventional mortgages and have to pay higher interest rates to obtain loans, typically 200 to 400 basis points more than the current conventional rate of about 6%. Residential buys individual subprime mortgages, about $100,000 to $200,000 each, its underwriting staff scrutinizing each loan and borrower's credit history.
The firm then structures the mortgages into an actively managed pool with a five-year maturity. Based on staff analysis, delinquent mortgages are replaced by newly purchased mortgages while Residential attempts to recover losses. Residential also insures the principal - but not the returns - at a cost of about 35 basis points.
The result: returns of about 7% before fees and 5% to 6% after fees, or at least 150 basis points more than the current investment-grade three- to five-year yield of 3.5%.
Residential recently landed its first client, which Mr. Mylnechuk wouldn't identify. The client's $60 million portfolio will consist of about 500 mortgages.
State Street Global Alliance LLC, Boston, provided the seed capital to start Residential and is the majority owner. Residential hopes to eventually create a commingled fund and enter the 401(k) market. State Street Global Alliance "wants us to get a few more separate accounts before committing the resources to develop a commingled fund," he said.