Why Toxic Debt Looks a Lot Less Toxic

Some of the same investors who made big profits betting against mortgage bonds before the 2007 housing bust have started snapping up the toxic assets. Hedge fund manager Kyle Bass, who made $500 million when subprime debt cratered, is raising a fund to buy them. He’s joining John Paulson, who made $15 billion in 2007 thanks to the housing bust. Goldman Sachs Group has bought the bonds this year. Remarkably, so has American International Group —the insurer that had to be rescued by the U.S. government in 2008 after its wagers on risky mortgages went bad.

These investors are jumping in as the $1.1 trillion market for mortgage bonds without government backing joins a global rally in everything from stocks and commodities to corporate loans. They are attracted to the riskiest mortgage bonds by their high potential yields. And they are speculating that the bonds’ prices have fallen so far that even continued weakness in the housing market won’t drive them down much further. “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,” says Larry Penn, chief executive officer of Old Greenwich (Conn.)-based investment company Ellington Financial. “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.”