How Can Mortgage Securities Be Worth So Little When Houses Aren't Going To Zero?

[girl gone mad]

Confusion on this subject still abounds, so I thought I would post this concise explanation here:

From http://www.businessinsider.com/how-can-mortgage-securities-be-worth-so-little-when-houses-arent-going-to-zero-2009-4">Clusterstock:

How To Make An Asset Backed Security

Let's illustrate this with an example of an asset backed security built on home loans. (We're borrowing the example from the excellent Acrued Interest blog.) These weren't exotic credit products. In fact, for most of the years building up to the crash, HEL ABS (as they were known in the business) was the dominant credit product. In 2005, something like $400 billion were issued. At the time, JP Morgan Chase was urging clients to buy this stuff by saying the pricing was "cheap" because of "irrational fears" over a housing bubble.

So let's say our imaginary bank, CitiMorganAmerica, decides it wants to sell HEL ABS built from mortgages with $100 million face value. One of the first things it does is cut this up into tranches to reflect the risk and price points of various customers. For simplicities sake, we'll just pretend that there are only three tranches. (In reality, there could be dozens of tranches).

* Senior: 5.75% coupon, $80 million
* Mezzanine: 6.50% coupon, $15 million
* Subordinate: 8.00% coupon, $5 million

The reason the lower tranches get bigger coupons is that they are riskier. They only receive interest payments after the tranche above them have received all interst payments they are due. Each tranche below senior receives principal payments only when the tranche above them has been full paid off. Any short fall hits the lowest level first.

Here's where things start to get scary. If just 5% of the mortgages in that HEL ABS default, the subordinate tranche is worth zero. We're just about at 5% national default rate for all mortgages right now. Default rates on more recent mortgages are even higher. Fortunately, the ratings agencies were pretty good about this level of stuff so the Mezz and Sub investors knew they were getting riskier products, and only the senior deal would be rated AAA.

How To Make A CDO

Now lets see what happens when we build a CDO on these types of deals. CitiMorgan America takes $1 billion and buys the Mezz and Sub tranches of 50 HEL ABS deals that are built just like this. It slices up the CDO just like it did the earlier deal.

* Senior: 5.45% coupon, $800 million
* Mezz: 6.00% coupon, $120 million
* Sub: 8.00% coupon, $40 million
* Equity: $40 million

These pay out just like the ABS, a waterfall filling up each bucket before anything gets paid to the next level down. The top tranche of this CDO can be rated AAA even though it is built out of already subordinated debt. You see, even though it is technically subordinated debt, there are so many underlying mortgages spread out across the country that the odds of systemic defaults materially affecting the cash flow would have been viewed very remote. After all, what are the odds that defaults will suddenly tick up all around the country?

How To Lose Your Shirt

See the problem? Here you have $1 billion of assets that can be devastated by a small increase in the default rate. If defaults climb to just 5% for the underlying mortgages, the cash flows will drop 25% as the portion of the CDO built from the Sub HEL ABS stops paying. Everything but the senior portion of the CDO gets wiped out.

If the losses on the mortgages rise to just 10%--high defaults from those bubble years from 2005, lower than expected recovery rates from foreclosures on houses with falling values, cram downs--even the most senior piece will lose 30% of its value.

In short, structured debt can rapidly decline in value even though the underlying assets don't decline as much. The benchmark index of the market for securities backed by home loans shows that the AAA tranches for deals made in 2007 are valued at about 23% of their original value. The lower tranches show losses greater than 97%. Some of this may no doubt reflect a bit of irrational fear and illiquidity. But claiming the overwhelming majority of these losses aren't real is just wishful thinking.

[sendero]

1. I've been telling folks here..

... the simple fact that LEVERAGE means that only a small percentage of defaults wipe out the entire value of the security.

Some are simply incapable of getting it.

[soryang]

2. When is a security not a security?

Derivative contracts on structured financial products are regarded as proprietary and confidential precisely because they do not withstand legal scrutiny. MBS are not really securities in the sense they purport to be because they are not secured in the legal sense. They are defective because they are removed from their tangible basis in real estate. A AAA rating therefore is little more than a fraud, even there were ever a justifiable basis for such a rating which there wasn't. One really cannot package mortgages in the hundreds or thousands and pretend that they are secured transactions. This is where the need for derivatives arose. If they were secured there wouldn't be an apparent need for insurance. The notion of a private insurance contract on a financial investment is absurd on its face because it is an intangible transaction. One always invests at risk and matheticians who felt that they could calculate correlated risks in intangible investmests merely provided defective cover for confidence men. Those fools or frauds who betrayed their fiduciary obligations and legal principles to issue such contracts (previously against public policy) should be held personally liable for their tortious activities and prosecuted wherever possible. The proceeds of these transactions should be followed for the establishment of constructive trusts to recover the monies on behalf of taxpayers.

That the current administration needs to repudiate the derivatives market as it relates to mortgage administration is too obvious to mention. That it has been paying off on them in the tens of billions is an outrageous swindle.

[depakid]

3. One of the key points from the originating blog:

Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake.

The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

http://accruedint.blogspot.com/2009/04/leverage-doesnt-kill-investors-bad.html

There's obviouly been widespread and systemic fraud at the ratings agencies for years and the most distirubing things about the Obama aministration is that they seem unwilling if not downright hostile to the notion of holding these folks (or thousands of others) accoutable under the law.