Option ARMs Become Obscure Objects of Bond Investors’ Desire

A structured-finance product once excoriated as a prime example of dodgy mortgage-lending practices has become the hottest part of the $1.2 trillion market for privately issued residential mortgage-backed securities.

So-called option adjustable-rate mortgage bonds returned 6% in January alone, according to J.P. Morgan Chase & Co. That’s triple the return on subprime RMBS and about twice that of bonds backed by prime jumbo loans. It also was enough to erase the losses those “option ARM” securities suffered in 2011.

The performance of option ARMs is remarkable because the underlying loans let borrowers roll part of their monthly interest into the principal, increasing loan balances when home values were plummeting. The resulting loss of equity is a risk because borrowers could just walk away from homes if they become worth less than the balance on their loans.

But investors are finding things to like about the securities. One was prices well below 50 cents on the dollar after the slide last year. Another is that analysts think homes financed with option ARMs may hold their value better than other parts of the market. Most of the 5.5 million homes that could be dumped on the market after foreclosure will direct pressure on lower-cost properties, worth $299,000 or less, not on those tied to option ARMs whose average balance is about $450,000, said John Sim, a strategist at J.P. Morgan Chase.

“There’s a belief that higher-priced homes are not under the same supply pressure,” said Mr. Sim. That may make them more sensitive to a market rebound. “If you believe in a recovery, there are reasons to believe that (option ARMs) might do better.”

One perverse reason to like option ARMs is that so many are deeply under water, which means the homes are worth far less than the loan balance. Some investors may anticipate they could benefit from principal reductions pushed by the government, Mr. Sim said.

The reversal of fortune for option ARMs has come as U.S. economic data fuels hopes that the housing market is near a bottom, and as investors grow more confident that Europe’s debt crisis will subside. Trading in private RMBS has surged this year and has led Wall Street to wake from a six-month slumber and bid for parts of a Federal Reserve Bank of New York portfolio, which has included option ARMs.

Option ARM bond prices climbed to 50.33 cents on the dollar as of Jan. 31, from 47.85 in December, J.P. Morgan data show. Despite double-digit gains in derivative indexes, subprime bonds were little changed at just above 28 cents on the dollar, J.P. Morgan data shows. Both have gained about a cent on the dollar this month.

Other pricing sources indicated bigger gains in the cash market.

With $166 billion outstanding, option ARMs are one of the smaller parts of the market for bonds issued by private issuers during the housing boom. Another $386 billion are subprime, with the majority in bonds supported by prime jumbo loans and mortgages to borrowers with limited documentation.

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