Big Long Is New Big Short as Bass Joins Subprime Bet

Investors who made some of the biggest profits from the 2007 bust in U.S. mortgages are once again in agreement. This time, they’re going long.

Hedge fund manager Kyle Bass, who made $500 million betting against subprime debt in the crash, is raising a fund to buy home loan securities. He’s joining Greg Lippmann, a former Deutsche Bank AG trader, and John Paulson, who made $15 billion in 2007, in betting on default prone mortgages. Goldman Sachs Group Inc. (GS) and American International Group Inc. (AIG) have also emerged as buyers this year as trading more than doubled for non-agency mortgage notes.

The $1.1 trillion market for U.S. mortgage bonds without government-backing is joining a global rally in everything from stocks and commodities to company loans, as confidence grows that Europe’s sovereign debt crisis will be contained. Investors are speculating the riskiest mortgage securities are priced to withstand an economic slowdown and home price declines even as President Barack Obama and the Federal Reserve pursue policies to combat the six-year residential real-estate slump.

“You can end up, even using severe assumptions on things such as home prices and defaults, with a very high yield based on the prices that bonds are trading at,” Larry Penn, chief executive officer of Old Greenwich, Connecticut-based Ellington Financial LLC (EFC), said yesterday in a telephone interview. “Especially with interest rates this low, if you can buy something where you can end up with a double-digit yield under severe assumptions, that’s great.”

Toxic Debt

Typical prices for the most-senior bonds tied to option adjustable-rate mortgages rose to 55 cents on the dollar last week from 49 cents in November, according to Barclays Capital.

Option ARMs, a type of loan that allowed borrowers to pay less than the monthly interest due with the shortfall added to the balance, were among the “toxic” debt that the Financial Crisis Inquiry Commission said was at the center of the “corrosion of mortgage-lending standards” that helped fuel the housing boom and subsequent bust. About 45 percent of the option ARM loans that are in bonds are delinquent, according to JPMorgan Chase & Co. data.

The rally may help bolster fixed-income trading revenue that fell at the five biggest U.S-based Wall Street banks by more than 20 percent last year, excluding accounting gains, according to data compiled by Bloomberg. (more)