Saturday, March 24, 2007

Everything that you Wanted to Know about ...

Mortgage Backed Securities but were afraid to ask.....No, I'm not really going to give you that. If I did, I'd have to charge you for it, and it would be worthless, for I'm not really qualified to opine. But remember the name of the blog: The Perplexed Investor. I'm just an ordinary person trying to make sense of things.

I do have a few things to share with you. Note that I'm doing this only to raise your awareness about some of the underlying issues--issues that I really do not fully understand. Caveat...I may have this totally wrong.

I found Accredited Home Lender's (LEND) S-3 (Registration statement) for its very first issue of 2007 (2007-1). This is a whopping doc 390 pp.. I'm not able to devote the sort of time needed to review it.. But there are some gleanings that I wanted to share with you...... First, though, I want to make a couple of comments as to why any of this matters. Any there are smarter people reading this blog than the writer, so PLEASE FEEL FREE TO CORRECT MY ERRORS.

  • We are hearing that subprime will not spill over. Well, I think it has spilled over in the worst sort of way because these loans have largely been part of a securitization machine led by government entities and the investment banks. So yes, this crap is in lots of porfolios--pension funds, insurance companies, fixed income portfolios.
  • Due to the liberal lending policies, these loans can have LTV ratios as high as 100% (for the securitization that I'm commenting upon), but had appraisals been done, those ratios might change--for better or naught. So the quality of the underlying securities (and their commensurate ratings) might be materially different than expected. All manner of bad things can happen because of that as you will see if you read.
May I suggest that before you go further that you get something to drink, and if your eyes begin to glaze over, do some jumping jacks.

Let's look a moment at the structure of these collateralized instruments:

There are two things that are important.
  1. Each tranche represents a different risk (quality) level--greater risk = greater interest
  2. Each tranche represents a holder that gets lower in the food chain as you move down.
Per theLink: "Rating agencies rate the different ‘slices’ (from AAA to
unrated) in order to provide market participants and investors with an assessment of the risk associated with each. Performance is largely driven by the collateral manager’s ability to avoid defaults and maintain creditworthiness of the investments." [I do not understand yet how the rating process is effectuated, but I imagine that it is due to FICO, LTV, level of loan documentation and other factors that would provide one with greater comfort of ultimate payback--that's another day. ]
Here's another concept to be aware of and that is "credit support" or enhancement. You can read about it in greater detail here. IF you want your offering to be considered attractive, you need to offer some comfort--some cushion. There's a couple of ways to do that: (1) through structuring subordinated tranches (low on totem pole) as you see in the above diagram, and/or (2) through overcollateralization. Think about overcollateralizaton as a LTV ratio for the securitization (structured debt obligation).

The example above shows the tranches--think about it as a food chain or totem pole. It's not going to be a pretty place to be. An example, then, of support/enhance might be your issuing $100M of underlying assets (loans to borrowers) but only issuing $80M in securities. IN this example, the difference of $20M would be the equity portion retained. Now look at the diagram (above) again. The equity portion is unlikely to be the cream. So if you see issuers (such as Accredited) with these loans (equity) on their books, my understanding (I could be wrong) is that these would be drecht loans--and you would likely see higher default rates. Accordingly, loan loss reserves may need to be beefed up. Additionally, one could get an insurer (such as FGIC, Ambac, XL Capital, Radian et al) to take on risk in this area.

Let's follow the money. This is from LEND's S-3 registration Even if you click to make this larger, it will be a bit fuzzy, that is from the original. Do notice that everyone gets their fees first before anything gets disbursed to note holders.

I do not fully understand this diagram with respect to the Overcollateralization Deficit. But there appears to be cross collateralization between A-1 and A-2 notes, and if there is some deficiency, then the note insurer must be increased to maintain the appropriate reserve. I apologize for not having this more fully researched, but I wanted to post some general things first. If I waited until I fully understood all of the ins and outs (which I'm not equipped to do), then this post would never happen. Again, full disclosure of underlying ignorance.

Now what can go wrong? When you buy bonds supported by indebtedness (or if you make loans), you have two types of risk:
  • market (interest rate) risk. Rising rates lowers the value of the instrument. This risk is mitigated through interest rate derivatives;
  • credit risk: the risk that the borrower will be unable to pay. This is mitigated through the collateral support, enhancement (to include having an underwriter to insure the risk, remember MGIC and Fidelity Guaranty).
If the level of defaults are beyond the expected levels--and remember, there is not much "experience" yet regarding the level of default rates because there are not many resets--I see the following types of problems:
  • Ratings of tranches may prove misleading--the underlying notes are assigned to each tranche--these are specific notes, not a fungible pool of securities. So what? If ratings have to be changed, and former investment grade securities are now looking like something different (think pig's ear v. silk purse), holders who are required by their charter, etc to hold investment grade, must do some dumping of these securities. That is called a sell-off. and those are not pretty.
  • Holders in the lower tranches run significant risk of not getting paid their principle--they will start dumping those securities (and calling their lawyers).
  • The equity portion of these tranches (and I'm sure some hedge funds may be involved in these as well as the issuers) will need to be written down to reflect the net realizable value--these impairments could affect required capitalization of issuers (this happened to LEND) and cause their being in default of credit agency requirements and/or contracts with their underwriters. (Again, this happened to LEND).
  • The insured portion of these securities may cause greater payouts from the insurers, so their earnings and their capital ratios could be affected. Those insurer's are dependent on their agency ratings, too. So I see Fitch, Moody's and Standard& Poor as being quite busy in their assessment of these exposures and what it means to the people they rate.
To my simple mind, there will need to be a re-calibrate risk reward for holding these securities that will be reflected in the discounting of these securities in the market. Now, I'm sure credit default swaps are part of this scenario, and I imagine that these premiums will go up considerably. (I don't pretend to know a thing about these.) So bond holders who wish to protect their underlying assets are going to have to pay more IF they are even allowed to continue to hold these securities.

So...all of the above is how subprime potentially reaches into our financial system. Until these issues are addressed by trusted financial leadership, do not think for a minute that it is a "contained contagion". And I would urge you to look at any fixed income holdings you have to see if YOU have any portfolio exposure. I just do not understand why you have the financial leadership (economists, money managers) speaking about this issue. Maybe I have the whole thing wrong, and I would welcome that criticism.


Joel said...

Rather than read through all of this stuff, I wonder if you or anyone else could provide me with or refer me to a definition of "default" so that I can determine if a mortgage is in default if 1, 2, 3 or more payments are late, or whether a mortgage is only considered to be in default when foreclosure has been commenced. It makes a big difference.

Leisa said...

Mortgage default definitions are generally listed in the underlying loan documents. In general, if you fail to make any payment on time it is delinquent and delinquent payments (in addition to other items) are one means of default.

Larry Nusbaum said...

Guess what another form of default is?
When you transfer title from yourself, the borrower, to your Living Trust.

Joel said...

Very interesting Leisa and Larry. By using an all inclusive definition of "default" the sellers of these mortgaged backed securities can conceal the number and amount of mortgages that are incurably in default and on the cusp of foreclosure that they packaging in each tranche. Its just an eyes closed grab bag. You pay your money and hope you don't get a booby prize.

Leisa said...

Joel, it's important to note that not all delinquencies lead to foreclosure. The key statistic is the % of delinquencies (and it failing to pay that is going to lead to foreclosure almost all of the time). THOSE are the numbers that are being incubated now.

Joel said...

Many people often pay late, but they pay. If a payment due in 10 days is paid in 20 days it was in default for 10 days. In fact these are the customers the banks prefer because they are the source of exhorbitant fees.

Leisa said...

Joel, I lost my train of thought after the parenthetical clause and of course didn't proof...I meant to complete this thought: % of delinquencies that fail to cure that go into foreclosure. But with respect for the threshold regarding qualification for an asset backed security holding, it is % delinquent.

In the registration statement, there should be a delinquency history that shows the number of loans and principal balance delinquent 30-59 days, 60-89 days an 90+ days. Though I found this information on the pro-forma registration (blank) I did not see it on the one that I reviewed for the actual issue.

Anonymous said...

the question then arises who if anyone and at what price will want to buy these things, and or who will have to do so?

Hence govt help?