A major catalyst of the general financial crisis of 2008 was the subprime mortgage crisis of 2007, when a rising wave of defaults on home mortgages sent the value of mortgage backed securities plunging. Today, mortgage backed securities (MBS) are caught up in vicious cycle called a negative convexity, in which falling interest rates are causing the prices of these bonds to sink rather than rise, as described by Business Insider.

"They're in trouble right now," as Colleen Denzler, an investment manager at Smith Capital Investors, which has about $350 billion in assets under management (AUM), and who previously was the global head of fixed income at Janus Henderson, told BI. She is now underweight MBS. "Bubbles get popped when things turn around either through some sort of crisis or through a change in what caused them," she said. "This could be a while, and that's how we're positioned," she added.

Significance For Investors

Falling interest rates are spurring homeowners to refinance their mortgages. As a result, investors in MBS are getting their principal back earlier than expected. Although falling interest rates raise the prices of most bonds, this macro environment also can cause the prices of callable bonds, or other bonds such as MBS which can offer unexpected early repayment of principal, to fall in value. This is the paradox of negative convexity.

Meanwhile, investors who have received early returns of capital are seeking to reinvest them elsewhere, and a major destination for these funds is the U.S Treasury Bond market, BI indicates. However, increased buying action in T-Bonds is sending their yields down yet more, reinforcing the vicious cycle since declining yields among these benchmark securities are causing mortgage rates to be reset at yet lower levels, thereby accelerating the refinancing of mortgages and the resultant decline in the value of MBS.

"Mortgage loan interest rates, and the corresponding fees or points charged for various rates, are driven by the prices of MBS," observes MBSQuoteLine.com. To the extent that this is true, the negative feedback loop called negative convexity exacerbates the problem yet more.

At the same time, private equity firm Cerberus Capital Management LP is reviving a type of mortgage bond that disappeared during the financial crisis, one that is backed by home equity lines of credit (HELOCs), The Wall Street Journal reports. “There has been some caution from issuers” about rolling out new types of MBS, as Grant Bailey, who oversees residential MBS at Fitch Ratings told the Journal. As a result, demand for the Cerberbus deal has been modest, with only the AAA-rated tranche being sold.

"We are starting to have a lot more creative issuance around mortgage credit,” as Neil Aggarwal, head of trading and deputy chief investment officer (CIO) at Semper Capital Management, remarked to the Journal. “I wouldn’t be surprised if there’s more to follow after this transaction,” he added.

Looking Ahead

Other complex debt securities whose plunging values were a catalyst for the 2008 financial crisis are rising in popularity today. The synthetic CDO, a pool of derivatives linked to various categories of debt, is among them. Pessimists fear that history may be set to repeat itself, and that cautious investors should take cover.