Deutsche Bank Securities, which aspires to build up a top-flight mortgage-backed securities shop, has come up with an unusual way of accomplishing that onerous task: It is bucking market tradition by aligning its fledgling MBS trading operation with its existing derivatives group.
The bank has just hired Nicholas "Trip" Mestanas, a longtime Goldman Sachs mortgage-backed pro, to build up an agency MBS trading platform. Bankers are intrigued that Mestanas and his staff, rather than reporting to Deutsche's structured finance heads, will instead report to Jon Kinol, a managing director in charge of various types of derivatives, including interest-rate and mortgage-related derivatives. One of the reasons Mestanas left Goldman was his interest in the MBS/derivatives combination, sources familiar with the situation said.
The marriage of MBS and derivatives is a sharp contrast to the usual way MBS trading is run-typically as a sector of overall fixed-income trading, as it is at top-notch MBS shops like UBS Warburg and Goldman. MBS is also usually joined at the hip to ABS, which is logical given that most existing ABS groups were spun off from mortgage-backed finance departments in the early- to mid-1990s.
What Deutsche is betting on-and some rivals agree with it-is that MBS and ABS are aligned mainly because of tradition, and that mortgage-related debt trading works much better when tied to various types of derivatives. MBS and derivatives share many of the same investors, as many mortgage investors use interest-rate swap derivatives as a way to hedge against interest-rate volatility.
"I would say that about 40% of all the flows we've had off the derivatives desk have come back to mortgages in some way, shape or form," Kinol said. Many market players "are hedging the volatility imbedded in the mortgage market. We want to manage a very strong interest-rate derivatives group, and leverage what we've done to develop a mortgage market-making group."
Other bankers agree that MBS' current status as an adjunct of agency and ABS trading doesn't really make much sense anymore. "If you ask a pass-through [mortgage] trader that's trading a 30-year TBA [mortgage bond], he doesn't care at all about what's happening in the credit-card markets," one banker said, noting however that such traders are often still slotted next to credit-card ABS traders.
It has long been apparent that the ties between derivatives such as interest-rate swaps and MBS are growing stronger, as some of the largest purchasers of mortgages-such as Fannie Mae and Freddie Mac-have been purchasing derivatives for some time. At the end of last year, Fannie's derivatives holdings alone had a notional principal value of $533 billion.
Yet because the MBS businesses of some shops have been a part of traditional fixed income for so long, uprooting MBS and aligning it with derivatives would be a political nightmare at many investment banks, sources said. Deutsche was able to pull it off only because its MBS business is still a fledgling one, staffed mainly by newcomers imported in some cases from derivatives businesses. For example, recent hire Felix Partow is an MBS derivatives trader from Nomura Securities.
Some more established MBS rivals, however, see Deutsche's break with tradition as a wild card strategy that will likely not have many imitators, noting that the current market leaders have held their positions for years-a strong argument that their MBS departments are aligned well enough to keep raking in business.
Deutsche's plans
Deutsche has had a fairly minor presence in MBS for some time. As of first-half 2002, the bank was ranked fifteenth in U.S. MBS with $2.4 billion in deals underwritten, compared with fourteenth in the same period last year with $2.3 billion in deals. By contrast, a market leader like UBS Warburg logged $52.3 billion in MBS underwritten for the 2002 first half.
The German bank plans some aggressive hiring in the next six months, however, which it hopes will help boost the MBS group's standings. Deutsche is feeling bullish on debt, and has improved its profile in recent years in selected debt sectors, at times dramatically. It is on a major winning streak in high-yield corporate bonds, where it currently ranks fourth, and has a top-five presence in commercial mortgage-backeds and U.S. ABS, and is improving its standing in high-grade debt.
For MBS, Deutsche's plan was to first establish a solid mortgage research department and then build up trading. Deutsche hired Alec Crawford from Morgan Stanley a year ago to spearhead an improved mortgage research effort-now it is counting on Goldman's Mestanas to do the same for mortgage trading.
