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ICE Said to Seek Rebirth of Mortgage Swaps in Dodd-Frank Era

MAY 5, 2014 5:51pm ET
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IntercontinentalExchange Group Inc. is pitching Wall Street on new derivative contracts allowing investors to wager on U.S. homeowner defaults, six years after subprime-mortgage swaps helped fuel the financial crisis, according to five people with knowledge of the matter.

ICE, which owns the biggest clearinghouse of swaps tied to the creditworthiness of companies, is gauging interest among banks and investment firms for a contract linked to a new type of mortgage securities that Fannie Mae and Freddie Mac started selling last year, said the people, who asked not to be named because the discussions are private. The government-backed firms have issued $4.5 billion of those bonds, which share the risk of home-loan defaults, as policy makers seek to scale back their roles in the $9.4 trillion mortgage market.

Subprime mortgage derivatives were among the fastest- growing financial instruments during an era of innovation that fueled the credit bubble that triggered the 2008 crisis. As the market for the new risk-sharing debt matures, creating swaps that allow investors to start betting against it or hedging against losses would be “the logical next step,” said David Liu, co-manager of a securitized-asset fund run by New York- based TIG Advisors LLC.

“Having a healthy two-way market will actually keep things more balanced,” said Liu, whose fund, with about $450 million, has invested in the Fannie Mae and Freddie Mac notes.

Principal in the risk-sharing securities can be erased when homeowners stop paying their mortgages.

After the first sale of the bonds in July by Freddie Mac, the riskiest portion has soared from par, or 100 cents on the dollar, to about 129 cents on April 29, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The debt carries a coupon that floats 7.15 percentage points above a borrowing benchmark. The rally allowed the company to sell similar debt in April at a spread of 3.6 percentage point.

Unlike the mortgage-linked swaps created during the credit bubble, the new contracts would be backed by ICE’s clearinghouse, the people said. The Dodd-Frank Act has been pushing most trading in the market into such entities, which are intended to curb risks to the financial system by collecting margin to ensure deals are honored and holding billions of dollars in reserves from banks.

Some banks have expressed reluctance to support swaps that may jeopardize their ability to win underwriting assignments or hamper development of the new market, the people said. At the same time, dealers are looking for ways to boost trading revenue after volumes in other markets shrunk.

Freddie Mac hasn’t been involved in the discussions, said Patricia Boerger, a spokeswoman for the company. Brookly McLaughlin, a spokeswoman for Atlanta-based ICE, declined to comment, as did Fannie Mae spokesman Andrew Wilson and Denise Dunckel, a spokeswoman for the Federal Housing Finance Agency, which oversees the mortgage-finance giants.

Policy makers see the risk-sharing notes as a way to reduce taxpayer dangers and assess whether the firms are charging enough to guarantee their traditional home-loan bonds. The sales also resemble the future under a bill by the leaders of the Senate Banking Committee, which would replace the companies with a government reinsurer that bears losses after private capital.

Fannie Mae and Freddie Mac were seized by the U.S. in 2008 during a crisis that was exacerbated by the wagers on subprime mortgages made with credit-default swaps. The side bets multiplied losses at banks such as Citigroup Inc. and insurers including American International Group Inc. and allowed bearish investors to accelerate the contraction in credit.

“There is a definite potential downside, as history clearly shows,” said Michael Canter, head of securitized assets at New York-based AllianceBernstein Holding LP. On the other hand, there’s already a series of index-based swaps that serve important roles in corporate-credit trading, he said.

Derivatives tied to the loss-sharing deals could allow dealers to hedge their inventories and investors to take positions more quickly, helping the market’s functioning, Canter said. They also would let underwriters and the issuers prepare for future sales, Liu said.

Mortgages since the crisis haven’t been as risky, suggesting a new swaps market wouldn’t pose any immediate danger, Liu said.

ICE’s plans, which it’s working on with EBond Advisors LLC, may also include futures contracts tied to the privately traded mortgage swaps, as well as instruments tied to the performance of a broader pool of loans that Fannie Mae and Freddie Mac back, two of the people said. Richard MacWilliams, managing partner of New York-based EBond Advisors, which advises on notes called exchangeable bonds, declined to comment.

The market for mortgage swaps has shriveled since the crisis. Just $460 million of most-active ABX index contracts tied to subprime loans traded in the week ended April 25, compared with $106.7 billion for the busiest index swaps tied to corporate credit, according to data from the Depository Trust & Clearing Corp.

ICE stumbled last year in its effort to create a futures contract based on corporate credit swaps. That idea was ahead of its time and “largely failed,” ICE Chief Executive Officer Jeff Sprecher said last year.

The company is close to offering a new futures contract based on the most-active swap indexes owned by Markit Group Ltd., replicating the lineups of investment-grade and high-yield companies, a person with knowledge of the plan said last month.

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