PrimeX - The Time For The Next "Subprime Trade" Has Come

Several years ago Paolo Pellegrini, Kyle Bass, Michael Burry and several other visionaries were well ahead of the conventional wisdom groupthink curve by not only sensing that the housing market was massively overvalued and riding on the crest of a huge leverage bubble (many others agreed) but by finding a ridiculously cheap, low theta way of expressing an uber-bearish long-term outlook with negligible downside and virtually unlimited upside by purchasing billions in ABX index notional at a cost of a few basis points, and watching it explode as one after another asset manager figured out just what "subprime" means and why it may not be conducive to a healthy career in finance. Virtually all of them ended up being very, very rich in just a few short years having had the foresight and, more importantly, the way to express that vision. Lightning may be about to strike twice as the Subprime implosion of 2007 becomes the Prime implosion of 2011. Back in December 2009, when musing on the very interesting topic of the advent of a new ABX-like index, this time tracking Prime mortgages, we asked, rhetorically as so often happens, "Will The New ABX Prime Index Be The Reason For The Next RMBS (And Thus, FHA/GSE) Collapse?" (for more on this index which MarkIt now markets as PrimeX see here). And while the rest of the world is fretting about Europe, Morgan Stanley, lack of decisive political decision-making in a pseudo union of 17 different countries, lack of decisive monetary intervention, a Chinese hard landing and everything else that makes front pages these days, slowly our prediction is starting to come true. But you won't hear about it anywhere else, because if the market understands that in addition to a global solvency crisis, America has another Subprime contagion on its hands actually being expressed in the markets as we type, and potentially costing banks, pension funds and various asset managers billions in losses behind the scenes, that may well be the last straw. 

The symptom

Yesterday a blast Bloomberg message from a Barclays trader had this to say (emphasis ours):

PRIMEX - OVER THE LAST 2 DAYS PRIMEX HAS REALLY SOLD OFF AND IGNORED THE RALLY IN STOX, CREDIT, AND CMBX. HARD FOR ME TO  PINPOINT A REASON WHY ALL THE SUDDEN HATE FOR THE SECTOR BUT I THINK THAT AT THESE LEVELS WITH A 442BP AND 458BP COUPON AND 4-6 YR DURATION ITS WORTH DIPPING YOUR TOE IN THE  WATER. IF YOU HAVE ANYTHING TO DO PLS LET US KNOW.

In addition to telegraphing to the world that Barclays, and incidentally virtually every other dealer, is very much wrong way in the trade confirming that history does in fact repeat, the fact that Barclays was not able to "pinpoint the reason", doesn't mean others were also unable to do so.

The underlying cause

What happened a day prior is that Fitch came out with an eagerly anticipated report titled, "U.S. Prime RMBS Performance Declines Continue- Negative Equity Drives Weak Performance" (linked here) which may just have been the nail in the RMBS Prime coffin. The report prompted real estate expert Mark Hanson to release a note to clients in which he said, among many other things, that "Digging a little deeper into yesterday's Fitch jumbo sweep (initially thinking it would not be too significant), Barry points out that the PrimeX ARM1 took a much bigger hit than he expected...the biggest hit by a decent margin in term of notches in a long time." He then followed up by saying, 'This morning I profiled ARM 1 and Fixed 1, as the hardest hit by Fitch. This was big.   BUT we just discovered this on ARM 2 had it's recovery ratings torn apart.  This is not as big as the downgrades on the 1's but it means ARM 2 -- already the weaker of the two ARMs -- is just am Alt-A disaster."

Digging into the actual Prime constituency, it appears that the bulk of holdings are California private label jumbos, which are ~50% third party originated, ~55% based on "stated" income and ~60% with second liens subordinated to the firsts. Translated, this means that forecasts that just one in three homeowners being upside down are woefully wrong, and the real number is far higher. When Fitch catches up to this particular reality, the bottom out of the Prime market will fall out and go practically bidless... Just like ABX did back in 2007.

Bottom line, the Prime market, just as we suspected back in December 2009, just got its inflection point catalyst, courtesy of the dealer community waking up to the reality that Prime is really Subprime in sheep's clothing, and that Dealers are now scrambling to find a justification to mark their PrimeX positions higher... or else. Which, naturally means, getting buyers. The problem, however, is that the biggest potential marginal buyers are already quite pregnant with exposure and as of a few days ago just became net sellers, as instead of liquidating precious metals during the second part of the market rout, they turned to PrimeX.

The evidence

As always, one chart is worth a thousands words. In this case, we present a few charts via Bloomberg.

Needless to say we will have much more to say on this topic in the coming days, as we watch the imminent devastation in this latest index quietly from the sidelines. If we are correct that the inflection point has finally come, then everyone who missed the sheer panic associated with unwinding the Subprime trade back in the lofty days of 2007 will have the pleasure of observing it all over again... and with it the arrival of the next black swan that nobody could have possibly foreseen...