Yesterday I received the following email from a reader of the blog. In it he asks about "trusts managing pools of securitized mortgages". Because I did not have an answer for him (and also because he suggested starting a thread on the subject), I am presenting it to the blogosphere for discussion. Anyone want to chime in?
Subject: what is the Wall St Journal talking about in today’s edition on C1, about subprime bond holders?
Hi Guy,
I am a reader of your blog. I know the banks bought bundled mortgages, but what are "trusts managing pools of securitized mortgages"? In Atlanta, these homes are selling cheaper than what the banks will sell [them] for; and [they accounted for] six times the volume during the six months ending March 31.
How do we tell which is which, on the MLS or what? Is it happening here now or soon? Maybe Commercial Lender would know? Would you like to start a thread on this?
Thanks,
Z
Note: I believe this is the link to the WSJ article referenced in the subject line of Z’s email:
http://online.wsj.com/article/SB124709571378614945.html
If you are not a subscriber to the WSJ online, here is another link I’ve found of the story on another blog:
http://www.investorvillage.com/smbd.asp?mb=476&mid=7556400&pt=msg
Former MBS Mutual Fund Manager
Well this is a complex question and I’m not sure any one person truly understands what will ultimately happen. I can at least share a little background information. The WSJ appears to be referring to private label mortgage backed securities.
bondstevenbond
This is a complex subject. I don’t think any one person really truly knows what will ultimately unfold, not Alan Greenspan, not Bill Gross and not Warren Buffet. But I can at least share a little background. The WSJ appears to be referring to the Private Label or non-Agency (non-Freddie and non-Fannie) guaranteed subsector of the mortgage backed securities (MBS) sector of the the bond market.
The reader was correct. These are securities are Special Purpose Vehicles (otherwise known as bankruptcy remote entities, hahaha that is legal-speak for shell corporations) whose sole purpose is to acquire bundles of mortgage loans as assets of the corporation. Then the corporation issues fixed income securities to scores of different institutional investors all of whom have some claim to the cashflows paid by the borrowers of the underlying mortgage loans. The cashflows are prioritized according to each investors risk appetite.
This fixed income security or bond is known as a collateralized mortgage obligation (or CMO) and here’s how it is supposed to work. Banks, property and casualty insurance companies, short-term fixed income mutual funds, municipalities and other risk adverse investors would buy the short maturity slice of the CMO. Life insurers, pension funds, and long-term fixed income mutual funds would buy the long-maturity slice of the CMO at a higher yield to compensate these investors for the greater uncertainty. The brokerage firm who issued the CMO would retain whatever cashflows remained from the CMO or sell this slice to hedge funds or other speculators.
This process worked fine for over a decade. Borrowers got loans, each investor got compensated for the risk of their investment, and whichever broker/dealer created the CMO structure (Lehman, Bear, Citi, Wamu, Countrywide, Wachovia, or whoever) made a lot of money both retaining the residual CMO structures and by buying and selling CMO’s in a marketplace which they created and controlled.
As time passed more complexity arose. Often times the broker/dealers held big inventories of bits or pieces of old CMO’s whose cashflows had mostly paid-off (called MBS tails) or odd-ball structures who none of the institutional investors wanted, or other risky CMO paper that they couldn’t sell. Thus came the next invention, the repackaging of old CMO’s into new CMO’s. These were bundles of CMO’s known as “collateralized debt obligations or (CDO’s). Over the past 5 years or so other related financial products appeared on the institutional investment scene. Bundles of high yield bonds were called CBO’s, bundles of bank loans were called CLO’s, etc. Eventually CDO’s were bundled into more CDO’s. These were called “CDO squared” ….and well you know the rest of the story…i can hear Don McClaine’s famous song ringing in my head…”Now for 10 years we’ve been on our own and moss grows fat on a rolling stone but that’s not how it used to be!!!
The real question now is who owns all this paper which is trading at pennies on the dollar, if it ever trades at all, and what will they do about it? Each of the these investors owns the house if any borrower in the pool defaults on the loan. But how will they collect? Do they even know how to collect? For example, suppose you are the portfolio manager of a local teacher’s pension plan in Australia. Just how do you foreclose on the subprime loan, kick the deadbeat out of the house in some small town in the USA, fix up the house, and sell the property??? You don’t and you can’t! Apparently, some of these investors are figuring out ways to do so in Atlanta. Only time will tell what happens next. Watch the PPIP (Private Party Investment Program) that the US Treasury is trying create as a mechanism to fix the problem.
The private label mortgage market’s issuance has dried up 90%. It doesn’t appear to be coming back any time soon. Even the conforming loan MBS market is dead if not for Uncle Sam’s propping-up the two biggest empty zombie corporations on the planet, Freddie and Fannie…..now that song is ringing in my head again….”Did you write the book of love and do you have faith in Barney Frank above?”
Who’s to blame? borrowers, lenders, regulators, investment bankers, appraisers, real estate agents, and most of all, foolish institutional investors like myself who bought toxic investments for their clients.
I don’t think I answered your questions. Hopefully someone can. I’d like to know the answers too. My name is Steve and I am a recovering MBS mutual fund portfolio manager.
smarten
I am constantly amazed by the sophistication that is expressed on this site.
Bondstevenbond’s post is another example of the principle! Thanks for the explanation.
Guy Johnson
bondstevenbond,
Yours was an excellent post. Thank you for your insight, as well as your time and effort in sharing with the blog. Much appreciated.
p.s. Loved the “American Pie” references.
bne
After party conversation, I have decided my EPL team will be Stoke City. Mostly because their mascot is a Harley-riding Hippo.
CommercialLender
I can add a few things only, mainly because BondSteve did such a great job. Answer to ‘how do you know’ which home is a bank REO versus trustee of an MBS pool? Dunno, that’s RI or Smarten, etc.
I can tell you when these MBS and CMBS (C for commercial) were done, and boy was there a huge mass of volume each year, the pools were rated by a rating agency (joke), then sliced and sold piecemeal to individual investors (someone wants high yield, they buy the B piece and unrated tranches; someone wants low risk, they buy the AAA slices and ‘super senior’, ‘Duper’ class, they even came up with a AAAA! Yes, many ‘creative’ ways to slice and dice.)
At any rate, these buyers all have different motives, despite that these pools of loans were sold via slices/tranches using a prospectus and what’s known as a PSA or Pooling and Servicing Agreement governing what is supposed to happen in good times or bad. However in practice you can expect that different motivations among different owners will result in differences of opinions, resulting in a litigated mess. For instance, a B piece buyer is the first to be wiped out in a foreclosure, while a buyer of the 55% AAA slice (or other subordination level) would be protected even if the asset was foreclosed and sold at a deep discount. So, the guys losing money might litigate there. Or, imagine what would happen if these guys turned to the rating agencies in a suit for gross negligence in their ratings……..hmmmmm.
For scope, in 2007 alone there were well over $200B in CMBS issued, and commercial is just a fraction of the single family market. We are seeing many commercial loans start to go back to the lenders now, and then lenders are starting to read the PSA’s to figure out what to do. I read my first one only last week as a client of mine missed his maturity date on the loan.
At least in commercial, the Trustee of the pool has authority and delegates it to the Special Servicer entity to take care of a problem asset. Their delegation is to protect the pricipal, so workouts, extensions and loan modifications can be used in lieu of foreclosure proceedings, if its reasonable to expect greater principal return to the bond holders by doing so. And then again, maybe the special servicer doesn’t want to play ball or does not want to risk being sued for mishandling a loan mod. Again, this is just now picking up steam in the commercial world, so it remains to be seen how this will all play out and what willingness the Special Servicers have to allow for such modifications.
I can’t speak to single family, though in the case of the article, it appears many of these Specials or Trustees have said ‘screw it, just sell at any price’. I would only imagine regional and local banks in contrast have a better understanding of the local markets and values of individual loans they did in-house and never sold into these pools. I can imagine these Trustees or special servicers of MBS pools have lesser capacity to understand value in a submarket they otherwise know little about, and certainly lesser staying power to hold out for the best deal, so they would tend to dump assets on the market.
Great deals were made in the last correction in the RTC days of the early 90’s in large part because the Gov’t took over pools of loans from defunct S&Ls and then sold them largely en masse. I see a decent resemblance of these 3rd party Trustees and Special Servicers of today to the RTC of old, in that they will likely dump much real estate and loans on the market and at much deeper discounts than those offered by non-defaulting banks.
Back to the questions at hand: how do we know what is being sold, by whom, and is it a good deal?
Guy Johnson
CommercialLender, Thank you for your post.
billddrummer
Excellent posts and insight, all!
The biggest problem with these securities is the lack of a market, leading to a fuzzy valuation on the balance sheets of the holders. This puts mark to market out to pasture, because you can’t mark to a market that doesn’t exist.
I think that was the motivation behind FASB 157-3, Determining the Fair Value of a Financial Asset when the Market for that Asset is Not Active. It provided some complex ways of valuing financial assets that had no ready market. The good news for the holders was that they didn’t have to write down the assets to their net realizable value. The bad news for investors is that we still don’t know whether they are worth anything.
And that’s the rub identified by CL and bondstevenbond. Unless someone is willing to swallow hard and take the losses, no one will really know how badly they’ve been hurt.
I personally think that the amount of water in these deals is in the neighborhood of 30-40%. Obviously, no counterparties have enough capital to absorb even a fraction of those losses.
Which brings us to another part of the mystery–credit default swaps (CDSs) written against the default potential of the pools. When times were good, the swaps worked well, and you could garner a AAAA rating on CCC junk if you had a swap covering loss of principal. As long as you got some payments, and the rating agencies didn’t look too closely, you could make money trading the swaps and pick up a reasonable yield on the securities too.
That was then, this is now. Swap exposure sank Merrill, Lehman, and AIG. CIT is on the ropes now (but for different reasons), although whoever is holding swaps for their debt is probably burning up their PDAs looking for additional collateral.
You’ve raised some excellent questions, and it doesn’t appear that anyone has any good answers.
Isn’t finance great?
billddrummer
Question for CL,
Is this what we will be able to expect from the CMBS pools now experiencing distress?
Especially with the number of non-amortizing deals that were written on newly developed commercial property beginning in the mid 2000s, I wonder if when the loan terms change, the properties can’t cash flow the resets, and new appraisals plunge, will agents for those pools resort to the same tactics?
CommercialLender
BDD,
Good question, but I just don’t know – yet. For now, the industry is experiencing relatively low defaults of ~1-5%, but it is picking up steam. Average loans might range in the $10M per range, while SFR MBS loans might be $250K ish (?), so you can imagine the volume of MBS and volume of distressed CMBS are different, yet the amount of work to workout or extend a distressed loan might be similar. Besides, very few CMBS deals were done with higher than 80% debt (CMBS, not bank or CDO structured debt), while many SFRs were done well above that, so commercial developers at least had more equity to protect in each deal than many SFRs and often a higher level of sophistication to boot. Further, CMBS loans have or are supposed to have some level of existing cash flow, so there’s not only principal to protect but cash flow, too. Often times it is more advantagous to simply allow the same distressed professional developer/borrower to continue to manage the asset for another year or 2 via a loan mod or extension until market conditions improve, cash flows are increased, and the asset can be refi’d or sold more opportunistically. Thus my above post.
As for a SFR gone back to the lender, obtaining cash flow from a currently vacant house costs money, is labor/mgmt intensive, and is definatly not what banks or bond trustees do for a living. So in my book, their decision to fire-sale a SFR is made more readily than to fire-sale a commercial asset.
I do see what appear by historical standards of recent to be very good deals such as office assets for $30 psf….but in Michigan. How about $20,000/unit apartment deals….but in Atlanta. Hard hit places where jobs are scarce and development was overplayed might have good relative deals at the moment, but only if one can wait out the recession (and find financing for the purchase BTW).
You mention ‘non-amortized deals’ or Interest Only. In the commercial world, we still underwrote to fully amortizing debt service payments, but in the past 3 ish years allowed some period of the loan to be I/O payments at the onset of the term. There might have been a few bad apples out there underwiting to the I/O payments, but that was not the norm. So, everything else held equal, the assets should not skip a beat in paying a P&I payment at some future date up from an I/O payment, ….. but for the perfect economic storm we are facing of dropping rents, increasing vacanies, lack of financing, rising unemployment, major BKs, rising tax burdens, an over-intrusive government, and rising cap rates.
Again, the amount of commercial defaults right at this writing seems manageable, but it is increasing and it remains to be seen what Special Servicers / Trustees will do if they accumulate more distressed assets en masse. If you subscribe to my theory that commercial was 18-24 months behind the single family bubble, then if no cure has been found for this mess and quickly, I suspect pools of commercial loans or assets will come to the market in the not distant future. Finally, watch out for commercial specialized lenders going BK and failing, as this would also tip the scales to bulk sales.
Hope this rant helps.
billddrummer
To CL,
Thanks for your insights. This is proving an invaluable resource for all of us.
I appreciate you sharing your knowledge of the industry and its dynamics.
Please keep it up. I think all of us benefit from your wisdom.