Gold News

MBS, CDOs & interest rates

An alphabet soup with a dash of high risk straight from the mortgage market...

MIGHT THE BANK of England raise UK interest rates this week – and keep raising Sterling interest rates in the second half of 2007, too? One million homeowners are hoping they don't.

   According to analysts at Credit Suisse in London, around £200bn in UK mortgages – one fifth of the total market – moved onto two-year fixed packages in 2005. Now reaching the end of their deals, says the Financial Times, these home-owners could see their monthly mortgage repayments jump by nearly one third.

   This shock to UK consumer spending will come even without base rates rising to 6.0% by September, as the London futures market now forecasts.

   Professional fund managers might also hope for an extended pause in the Old Lady's 'better late than never' fight against inflation, too. But you wouldn't know it from their love of fixed-income bonds – most especially securitized debt, backed by loans made on residential real estate.

   The City of London now leads the entire European continent in selling debt as an investment – most especially these mortgage-backed bonds, known as MBS for short.

   Sold to pension companies, hedge funds and investment managers, MBS give investors a chunk of the interest repayments made by home-owners each month. They barely existed a decade ago.

   During the first three months of this year, however, sales of residential and commercial MBS by UK mortgage lenders totalled £36 billion – well over half of all debt sold onto the investment markets in Europe. The value of new MBS issued in the UK rose 81% from the first quarter of 2006.

   With UK bankruptcy rates already at record highs – and the damage now leaching into mortgage defaults – you might expect demand for MBS bonds to be waning. But Abbey National, the UK's second-largest mortgage lender, plans to raise £5.6 billion this week by selling bonds backed by outstanding mortgage loans.

   The UK mortgage industry hasn't faced any trouble so far this year in finding MBS buyers. But any hedge funds or pension managers looking to take up Abbey's new offer might do well to note the currency market's opinion of where UK interest rates are headed.

   Repeating a pattern seen in each of the last four months, Sterling has been bid higher in anticipation of a hike on Threadneedle Street this week. By Tuesday morning, the Pound had reached a one-week high versus the Euro and also broken a one-month high versus the Dollar above $1.99.

   May's 0.25% baby-step disappointed the Sterling bulls, of course – and future decisions could cost short-term speculators dear if Mervyn King and his team delay taking base rates to fresh six-year highs over the next few months.

   But it's not only on Threadneedle Street that professional investors now expect interest rates to increase. All 52 professional number-crunchers surveyed by Bloomberg News saw the European Central Bank raising Eurozone lending rates to 4.0% this week.

   In Chicago, the options market put the chance of a hike in US interest rates at the end of June at 41%. Only in May, those same options traders priced the chance that US rates would actually fall as a 4/5 shot.

   Whatever drove this quick turnaround in interest-rate forecasts – whether it was oil prices above $70 per barrel, or the creeping rise of official inflation data towards multi-decade highs – government bond prices have begun to tick lower. The end of May saw UK gilts complete their third losing week on the run. Prices fell, pushing yields upwards and reflecting the City's consensus that interest rates are about to go higher.

   Yet no one seems to have told the institutional or hedge-fund investors buying MBS debt that the cost of money – and the risks to mortgage debt – are rising. New sales of MBS bonds in the US totalled $552 billion between January and March, reports Sifma, the securities association. And despite the collapse of the subprime US mortgage market – where 78 major lenders have gone kaput since the end of last year – private equity firms, hedge fund managers and investment banks can't get enough subprime MBS bonds right now, reports the New York Times.

   Super-high-risk MBS and other complex debt instruments are also starting to attract "dumb money" along with the "hot money", too. According to Bloomberg, Bear Stearns – a leading Wall Street investment bank – recently sold high-risk MBS to some fifty public-sector US pension funds at a meeting in a Las Vegas ballroom.

   "There is a lot of money pent up," said one mortgage-bond salesman. "A lot of people are betting that the US housing market will snap back quickly."

   Bear Stearns is also seeking permission to sell high-risk debt to retail investors via the stock market, reports Bloomberg. It wants to list CDOs – the collateralised debt obligations that made up $503 billion of the alphabet soup of global debt issuance last year, a fivefold increase since 2003 – in the same way as the London stock market listed Queen’s Walk Investment earlier this year.

   Run by hedge fund Cheyne Capital, shares in Queen's Walk lost 25% on one day in March after it said that poor-quality US mortgage loans would hurt dividend payments.

   Yet many professional investors, however, keep betting that interest rates will soon fall – and that mortgage-backed bonds will continue to pay. The next decision in Frankfurt – and the following vote at the Bank of England – could well be the start of much more than just belt-tightening by one million UK homeowners.

Adrian Ash is director of research at BullionVault, the physical gold and silver market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and is now a regular contributor to many leading analysis sites including Forbes and a regular guest on BBC national and international radio and television news. Adrian's views on the gold market have been sought by the Financial Times and Economist magazine in London; CNBC, Bloomberg and TheStreet.com in New York; Germany's Der Stern; Italy's Il Sole 24 Ore, and many other respected finance publications.

See the full archive of Adrian Ash articles on GoldNews.

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