The Renewed Allure of Risk

Demand for subprime products — in other words, the flotsam that the financial crisis left behind — is once again on the rise. However, junk bonds are showing no sign of a comeback.

Earlier this year, the Federal Reserve sold a large chunk of the toxic securities that it had bought up during the financial crisis. The question now arises as to who is going to take the rest — with a nominal value of $19 billion and an estimated market value of $12 billion — off the Fed’s hands. At the four junk bond auctions held by the Fed so far this year, the major banks have been lining up to take their pick. In January, Credit Suisse bought a portfolio of residential mortgage-backed securities worth a nominal $7 billion. Then, in February, the Fed sold a RMBS portfolio worth $6.2 billion to Goldman Sachs. At the next auction, which was held in the same month, Credit Suisse was back again and walked off with $6 billion worth of RMBS. Finally, last week saw a portfolio of complex financial securities (collateralized debt obligations) snapped up by Barclays and Deutsche Bank.

Junk Auction Planned

During the financial crisis, the Fed had bought up junk bonds that had been affected by collapsing prices in an attempt to shore up the financial system. For example, it purchased $20.5 billion worth of RMBS from the stricken insurer AIG (the Maiden Lane II portfolio) as well $29.3 billion worth of collateralized debt obligations (the Maiden Lane III portfolio). While the Maiden Lane II assets have now been sold off in full, Maiden Lane III still comprises securities worth a nominal $19 billion. These are likely to go under the hammer before the end of the year, with the banks once again set to line up in anticipation.

One reason for the growing interest in subprime securities is that investors are looking for returns. Loose monetary policy has pushed the yield on government bonds to a record low. For some time now, investors have seen the equity market and the market for junk corporate bonds as alternative investment areas. Institutional investors, in particular, are looking to boost the return from their portfolios with higher-risk investments. A handful of hedge funds and banks — as was the case with the Maiden Lane securities that have already been auctioned off — are also investing more heavily in subprime segments, so as to be in a position to offer these products to their clients.

However, the banks themselves are also prepared once again to incur more risks: They are increasingly granting loans to clients with relatively low credit scores. Thus the U.S. is currently seeing a rise in subprime loans granted for car purchases or via credit cards. In some segments, the securitization of these loans is also increasing significantly. So far this year, the banks have already generated securities based on loans or other assets (asset-backed securities) worth $61.6 billion. Of this amount, $34.7 billion relates to car loans, of which $12.3 billion comes from the subprime segment, in comparison with a mere $6.9 billion in the same period in the previous year. Another reason behind the banks’ increasing boldness is their hunt for increased earnings: The slow recovery of the U.S. economy and the substantial losses of earnings in the debit and credit card business due to legal issues are making it harder for banks to improve their earnings situation.

Dealings in this area become risky when further research and checks are not carried out when loans are granted to these client groups — as happened during the U.S. real estate boom. When these loans are then bundled several times and securitized, this can produce time bombs like the ones that blew up the financial system in 2008. And when the financial crisis sent the U.S. into recession, it was not just homeowners that struggled to pay their subprime mortgages: Many subprime car loans and loans granted via subprime credit and debit cards stopped being repaid as well.

However, we are some way from a repeat boom in the subprime segment. Both credit volumes and the scope of securitization are well below the levels seen in the boom years. Thus, loans worth at most $12.5 billion were granted via credit cards to clients with low credit scores in 2011. Although the credit volume is 55 percent higher than it was in 2010, it is a far cry from the 2007 record of $41.6 billion. And there is no sign yet of any loosening of lending standards.

Ultimately, the subprime market in the real estate sector is still at low ebb, even though the sale of the Maiden Lane assets may well have given a different impression initially. In addition, it always causes a stir when prominent players in the finance world — such as a few hedge fund managers — suggest a revival of the subprime market. In contrast to the subprime segment for car or credit card loans, there are still no new loans being granted in the subprime mortgage segment. The market for RMBS, on the other hand, is shrinking, with a current volume of about $1.3 trillion — around half of its record pre-crisis level.

Fragile Subprime Market

The prices for securitized subprime loans have also done no better than to trend sideways in the past few months — and at a low level. For example, the ABX index, which is produced by the derivative analysis specialist Markit, has flat-lined since the start of this year, following a period of recovery in 2010 and 2011. The index reflects the price of credit default swaps on 20 mortgages issued in the first half of 2006.

Although the index shows that the prices for mortgage-backed securities has recovered somewhat, they are still only worth around half as much as they were back in 2007. In addition, the market is clearly still very fragile: In mid-2011, the Fed was forced to hold off on the sale of parts of the Maiden Lane portfolio because it would have flooded the market, sending prices tumbling as demand dried up.