The global financial crisis of 2008 was triggered by investors borrowing outrageous sums of money to place leveraged bets on mortgage-backed-securities in the US. The crisis remains one of the best lessons for investors on the perils of greed and unchecked leverage in the world of mortgage bonds.
Although the global financial crisis is now a footnote in market history, excessive risk-taking on mortgage bonds and related securities (which are backed by the cash flows generated from the interest and principal payments of the underlying mortgages) has never faded away. In fact, it’s making a major comeback in Europe, where an increasing number of hedge funds are making highly leveraged bets on mortgage bonds despite the lessons of the past.
Hawk-eyed Regulators Reassure Investors
However, unlike the past, regulators today are better prepared to curb excessive risk-taking in these securities. A case in point is the European Securities and Markets Authority’s (ESMA) recent disclosure that it is actively monitoring a group of highly leveraged hedge funds in the region with significant exposure to mortgage bonds.
These funds, notable for their astronomically high average gross leverage are being “closely monitored” by the EU watchdog due to the potential market risks they pose. The unnamed funds are said to be responsible for a substantial 15% of the trading volume in the region’s mortgage-backed note market, underlining the risk they pose to the wider market should their bets fail to work out.
Among the 130 hedge funds scrutinized in ESMA’s analysis, approximately 10% spotted obscenely high leverage ratios exceeding 2048%, while the median leverage commitment stands above 500%, according to Bloomberg. Simply put, more than half of the hedge funds assessed by the watchdog have borrowed five times over to maximize returns; a small number (around 13) have borrowed 20 times over. These alarmingly high levels of leverage place them among the most highly leveraged entities within the realm of alternative investment funds, a situation that ESMA is monitoring with an intensified focus.
“Leverage for hedge funds remains very high, and this may pose a risk of market impact,” ESMA said in its review of the broader hedge fund sector. Nevertheless, most funds have sufficient cash levels to handle potential margin calls, the hawk-eyed regulator said, reassuring investors of overall market stability.
The Paris-based regulator emphasized that these hedge funds’ share of trading volume in mortgage-backed bonds in the EU market remained stable at 15% through recent periods of shocks, particularly Russia’s war on Ukraine and the Covid-19 pandemic.
The Appeal Of Mortgage Bonds
Although ESMA hasn’t explicitly named the hedge funds diving headlong into mortgage bonds in Europe, it’s becoming increasingly evident that investors are extremely optimistic about these securities. To understand the appeal of mortgage bonds it’s important to look at the underlying asset – mortgages – and how they relate to interest rate risk.
Mortgage bonds tend to be attractive to investors because most mortgages have a variable rate and not a fixed rate. This means that investors who buy these securities can hedge against the risk of market interest rates moving against them. This factor has strengthened the appeal of mortgage bonds in recent years after central banks around the world, led by the US Federal Reserve, raised global interest rates to the highest levels in four decades, leading to an implosion in the value of outstanding bonds in the market.
Fixed-rate bond prices (majority of bonds are fixed-rate) and interest rates usually move in opposite directions – when interest rates rise, bond prices usually fall, and vice versa. In times of high rates (like now), the fixed interest rate of an actively trading treasury bond becomes less attractive to investors when a new bond with a similar tenor is issued at a higher coupon rate. Rising rates usually prompt investors to sell their existing bonds and treasuries holdings for newer issuances, or to pull their cash out of the fixed income markets for other opportunities.
Mortgage bonds that are backed by loans offered to home buyers at adjustable rates offer a hedge against these kinds of risks, as the rates on the underlying mortgages are typically adjusted to reflect prevailing market conditions. This could explain why a growing number of European hedge funds are borrowing hand over first to gain exposure to the asset class.
The Perils Of Leverage
However, the fact that the median level of leverage on mortgage bonds among the 130 sampled hedge funds by the ESMA is above 500% —meaning more than half are levered up more than five times their net asset values – suggests that some investors are getting carried away by greed. To be sure, mortgage bonds can offer some kind of advantage in a market characterized by high interest rate rates, but do the potential returns justify these dangerously high levels of leverage? Certainly not.
Leverage is like a double-edged sword. It can amplify gains but it can also magnify losses and has wiped out many portfolios. What’s worse is that if the opportunity fades or evolves and turns into a risk, investors will panic and unwind their leveraged positions simultaneously. This could destabilize markets and pose wider risks, explaining why ESMA has taken a proactive approach to curb this excess.
It is also important for investors to be wary of the risks in the European housing market, which underpins much of the mortgage bonds that some investors are aggressively betting on. According to the IMF, the cost-of-living crisis has eroded real incomes in Europe while interest rate surges have made borrowers more vulnerable to financial distress. Given that interest rates are still elevated, the risk of loan delinquencies and defaults in the housing market cannot be overlooked. This could adversely impact the value of mortgage bonds.
It’s not just defaults that mortgage bond investors should be worried about. When faced with financial constraints, some homeowners with sizable savings tucked away may decide to prepay their mortgages ahead of schedule. This can impact the maturity profile and valuation of mortgage bonds. These factors make investing in mortgage bonds on leverage all the riskier and demonstrate why the ESMA was right to proactively highlight its concerns around this trend.
Author: Acutel
We are global investors who invest in good companies at fair valuation and speculate on all else subject to the risk exposure we can afford.
The editorial team at #DisruptionBanking has taken all precautions to ensure that no persons or organisations have been adversely affected or offered any sort of financial advice in this article. This article is most definitely not financial advice.
