Wednesday, September 30, 2009

Re-Remics: Financial Folly?

The WSJ reports:
The popular deals are known as "re-remic," which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.

Regulators are pushing back, saying the transactions don't have enough substance and stand to benefit bankers and ratings firms...U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, "The credit-rating agencies could be setting us up for problems all over again."

The process of securitization allows diversification: you can take a pool of assets, called collateral, and then assign various priority to the cash flows of these assets (which are basically bonds). Diversification is generally a good thing. The most senior is rated AAA, and when done appropriately, has an extremely low default rate. Then there are AA, A or BBB pieces, and sometimes a mezzanine piece rated BB or B (ie, junk). The least senior piece is simply equity, and the issuer generally retains an interest in the most junior set of residual cash flows. is mainly one of diversification.

Many firms specialize in holding AAA debt, and it often is efficient to move this from the loan issuers, to other institutions. Now we know everyone screwed up with rating mortgage AAA bonds, they assumed housing prices would not fall. It was not a subtle mistake only perceptible via reverse engineering a complex security or copula.

The continued resistance to anything similar to what blew up before highlights the adage about generals are always fighting the last war. Many people lost money on mortgages. Those mistakes will not happen again in that asset class for a generation. Yet, regulators and regulators are finely attuned to anything with mortgage securitization.

I remember when I worked at Moody's and someone was telling me that since the 1990 Commercial Real Estate debacle, defaults in this asset class were well below average across the board for the subsequent decade. In the aftermath of that crisis, newly issued Commercial Real Estate Asset Backed securities did very well, because everyone was especially cognizant of the risk factors involved: investors, ratings agencies, regulators, issuers, even borrowers. A similar thing happened in railroads after the Penn Central railroad defaulted in the early 1970s.

It would be wise to focus not on mortgages, which have enough skepticism, but rather the current 'low risk' investments. Things related to energy, or health care, seem highly risky because they have done relatively well, and regulations could drastically change profitability within those sectors. A good rule of thumb in debt is whatever sector did worst in the last recession, will perform above average in the next.


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Michael Stastny said...

I would like to know to what extent such deals are driven by regulatory arbitrage? I think that tranching serves the economy by allocating risk but to me it seems that banks do the slicing just to lower regulatory capital requirements (i.e. the whole deal stays on the book). Any numbers?

Ptldr said...

I really don't follow your logic. Are you forgetting that we've had other blowups in mortgage-backed securities in previous years, most notably 1993? How well did all of the "kitchen sink" bonds that came out of that era work out for investors? I was there and I remember them as follows: opaque, difficult to model, illiquid. It looks to me like history repeating itself, and that's why it's worth it to continue fighting "the last war."

Eric Falkenstein said...

Ptldr: I'm not familiar with 'kitchen sink' bonds.

Michael: I'm doubtful that this lowers capital requirements on average in a current environment. For most mortgages, you have low capital to begin with. Then add that you keep a residual amount on your books which has 100% capital charge. This amount is now considerably higher than before, and I bet the regulatory charge is now less than what is being charged by the market.

Ptldr said...

Kitchen Sink bonds were re-remics of mortgage derivative securities, including inverse floaters, inverse IO's, and weird jump Z-type securities, and anything else that could be thrown into a structure than re-tranched. They were agency MBS re-securitizations, so they didn't have the credit risk issues of this current round of re-REMICs. They helped sink a number of investors in the mid-90's.

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