CDO's

For those of you who were kind enough to follow me through CDO's in my series of posts (as well as those by Calculated Risk), you are not surprised, and more importantly, you are knowledgeable about the issues being discussed. I know that I feel better prepared to understand the issues. And if you are hearing "this is contained to BSC" that's BS of the lowest sort. HSBC already had a hedge fund in this area blow up and now BSC. These are hedge funds attached to very well-capitalized firms.

There are hedge funds with bank, insurance, pension fund and other private-held funds that are certainly exposed to these areas. The insurance companies, AXA, HIG also have exposure. Will this be the great unwinding? I don't know, and I'm not trying to engage in hyperbole. But remember the housing recovery? It ain't happened yet--but like the second coming of Jesus (no offense to the devout--my Armenian grandmother predicted every year for that event) it has been oft predicted to be just around the corner. Sub-prime contagion contained? Nope. We later found that Alt-A had similar problems.

I'm out now to enjoy the weekend. It's been three weeks since I've felt well enough to have some fun.

Counterparty Risk

Whatever happens with respect to all of this structured debt obligations/financing, there are a few concepts that are important. Again, remember, I'm introducing myself to these concepts--you probably understand them better than I. But I'm approaching this as a tutorial to enable my understanding of these issues as they unfold.

Here's Counter Party Risk Definition

"A counterparty is a party with which a transaction is done. If A sells something to B, then B is a counter-party from A's point of view and vice-versa.

The risk that the counterparty will fail to fulfil their obligations - usually either by failing to pay or by failing to deliver securities - is called counterparty risk.

There are a number of ways of controlling counterparty risk. Some are trading mechanisms such as DVP or the use of a central counterparty.

Financial institutions should track and manage counterpart risk in much the same way as any other credit risk, and this should be integrated into institutions' overall risk management system.

The counterparty risks from securities trading are either simple credit risks (where the risk is that the other party will not pay) or a combination of credit risk with the risk of a position in a derivative (where the risk is that the other part will not deliver securities).

Counterparty risk tends to be at least as much of a concern to regulators as to the institutions exposed to it. This is because a large financial institution will be a counterparty to many others, and therefore the knock-on effects of its failure pose a systemic risk."

Mortgaged Back Securities--Bankruptcy Risk

I found this clause in the GS S-3 registration
What is says to me (and I'm not lawyer nor do I play one on TV) is that in
the event of a bankruptcy (think New Century), that the
loans might end up the property of the issuing entity. What does this mean?
I think that it means that these loans could be grabbed by the creditors
of the sponsor (such as New Century)and the certificate holders will be left
high and dry.

Let's watch the news for these items.  I cannot stress how critical this clause
is--and I'm not sure how remote a probability such action could/would be.
Here's an interesting conflict of interest.  You have Morgan Stanley (or any
other mortgage banker) who has securitized these notes and they are
left holding the bag for warehouse loans.  How do you think THEY would want
a bankruptcy judge to rule? I think that they would want the judge to rule
these loans as assets of the depositor (e. g. New Century) so they can get their
loans paid from the proceeds of the loans.  Very strange circumstances, you think?




Bankruptcy of the Depositor or the      The depositor and the sponsor may be
Sponsor May Delay or Reduce             eligible to become a debtor under the
Collections on Loans                    United States Bankruptcy Code. If the
                                    depositor or the sponsor for the
                                    certificates were to become a debtor
                                    under the United States Bankruptcy Code,
                                    the bankruptcy court could be asked to
                                        determine whether the mortgage loans
                                        constitute property of the debtor, or
                                        whether they constitute property of the
                                        issuing entity. If the bankruptcy court
                                    were to determine that the mortgage
                                    loans constitute property of the estate
                                    of the debtor, there could be delays in
                                    payments to certificateholders of
                                    collections on the mortgage loans and/or
                                    reductions in the amount of the payments
                                    paid to certificateholders. The mortgage
                                    loans would not constitute property of
                                    the estate of the depositor or of the
                                    sponsor if the transfer of the mortgage
                                    loans from the sponsor to the depositor
                                    and from the depositor to the issuing
                                    entity are treated as true sales, rather
                                    than pledges, of the mortgage loans.

                                    The transactions contemplated by this
                                    prospectus supplement and the related
                                    prospectus will be structured so that,
                                    if there were to be a bankruptcy
                                    proceeding with respect to the sponsor
                                    or the depositor, the transfers
                                    described above should be treated as
                                    true sales, and not as pledges. The
                                    mortgage loans should accordingly be
                                    treated as

                                  S-22

---

property of the related issuing entity and not as part of the bankruptcy estate of the depositor or sponsor. In addition, the depositor is operated in a manner that should make it unlikely that it would become the subject of a bankruptcy filing. However, there can be no assurance that a bankruptcy court would not recharacterize the transfers described above as borrowings of the depositor or sponsor secured by pledges of the mortgage loans. Any request by the debtor (or any of its creditors) for such a recharacterization of these transfers, if successful, could result in delays in payments of collections on the mortgage loans and/or reductions in the amount of the payments paid to certificateholders, which could result in losses on the certificates. Even if a request to recharacterize these transfers were to be denied, delays in payments on the mortgage loans and resulting delays or losses on the certificates could result.

MBS-S-3 summary

I had a thought of doing something that goes above and beyond my typcal nerdiness--The time requirement is great, so I may do it very selectively. That thought was to take all of LEND's securitizations an line the up so that you could see the evolution of the characteristics affecting these loans. Here's what I was thinking about in terms of format.

Unfortunately, the earlier formats were different, and these docs are a little cumbersome, but I plan to complete this for a few offerings. Here's something worth noting, in looking at the 2003-2 securitization, the % of baloons was only 5.46%. Also, the average loan size was 153.2K the overall pricnicpal was $416.8M--less than half of what you see here.

MBS Fundamentals--Structure

This is from Wikipedia:



You've seen this in another form, but seeing a different view cements the concept(s). I will be covering how certain aspects of this structure are covered in filings. I will post this chart in each entry for ease of use.

MBS Fundamentals--Why?

Wikipedia does a nice job of explaining these issues, so I will borrow liberally (with attribution) from them.

Reasons for issuing mortgage-backed securities

(Link above to Wikipedia from which this is lifted)

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities

1. transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.

--------------------------------------------------------------------------------------------
It appears, then, that these securities go along way towards providing substance for derivative instruments such as cash flow swaps and interest rate swaps.
-----------------------------------------------------------------------------------------------

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.

SEC Regs on Asset-Backed Securities

I'm declaring that I've officially gone over the edge, for I have searched out, found, copied and am beginning to read the SEC regs on Asset Based Securitizations. I'm not really sure why I have latched onto to this subject, and it is probably best that I don't probe deeply there. Nevertheless, I have and I want to drag you through it a bit too! I'm beginning to see that these ABS's with all of their participants is a big ball of string. The regs are 320 pages long, and I've read up to page 50. It is slow going, particularly for someone like me who is pretty far away from any real knowledge of securitized transactions.

I'm not going to even try to post a summary of what I'm reading, but I do plan to post a few tidbits.

These SEC regs are designed to "consolidate and codify existing interpretative positions."

Here's a tidbit: One can issue asset based securities where the underlying pool has as many as 50% delinquencies. To qualify, though, for S-3 registrations, as many as 20% of the underlying assets can be delinquent.