In The Year 2010: Residential Mortgage Edition

Okay, in a series I just thought of, called “In The Year 2010” I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000”). This is a thought experiment, nothing more.

Residential mortgages. What can be said about where they’ve been that hasn’t been said already? I can’t even pepper that sentence with links because I wouldn’t know where to start. I mean to cover this product from the capital markets side, but let me starts by saying that this industry will probably be scared of it’s own shadow when it comes to making loans–probably for quite some time. Gone will be the sub-prime loans we all know and, well, we all just know them… 720 FICO, 25% DTI, 72% LTV? Greenlight. 600 FICO, 50% DTI, 90% LTV? Redlight. It’ll nearly be that simple.

Now, given that the loans will likely be much cleaner, what will the capital markets products look like? Easy! Well… hold on. First, there are some powerful subtleties. First, Fannie and Freddie won’t be nearly the same presence as they were in the residential mortgage markets in general, and probably sub-prime and Alt-A mortgage markets specifically (buying AAA’s). That’s one source of liquidity down. Second, CDO buyers are gone (this product will be a different post, but keep in mind CDO’s are not all mortgage related). CDO’s would buy the lower credit pieces, such as BBB’s (including BBB+, BBB, and BBB- … For Moody’s lovers, Baa1, Baa2, Baa3) and lower rated classes. Oh, and not as many investment banks are around. Guess what they bought? The residuals. Residuals were the 1-5% of the securitization that was unrated by the agencies and took the first losses of every pool. Banks “took these down” assuming they would pay off and that was how they would make their money. Most of those banks are also either not around or hurting.

So, we have fewer AAA buyers, fewer buyers of the lowest rated pieces, and fewer buyers of the lowest unrated pieces. Hmmmm…. I’m guessing there will be less securitization volume. However, I do think there will be securitizations going on. The financial technology is sound–slice up risk to those who can best take said risk. However, securitizations will be much simpler beasts. Gone will be the reliance on the rating agencies to evaluate risk. I doubt anyone will see a AA+ and a AA tranche on deals, risk will be cut into much broader swathes.

With these facts in mind, will AAA’s (or, more generally, high quality low-leverage securities) have a home? Well, at 10+% returns with banks paying 5% to the government for billions in new equity capital (just an example), which they can still lever over 10x (from what I can tell banks generally run 11-15x leverage), AAA’s seem like a good buy. Now, granted, those estimates for returns aren’t adjusted for losses, although AAA’s taking a loss hasn’t happened yet to my knowledge. This would seem to indicate that banks (there are no more investment banks) have a compelling value proposition when it come to holding market-rate AAA securities that are higher quality than found in ABX, but still not prime. Even if these AAA’s only returned 7%, and with current prime mortgage rates at around 6.5% that seems ridiculously unlikely, with 5% cost of capital they could be making over 20% ROE (way over, I’m being conservative and fudging downward). A lot of the these numbers aren’t apples to apple, but we’re also guessing at the future, so we use what we have.

If AAA’s have a home, the next question is what becomes of the lower-rated pieces. Well, my belief is that these will go wholesale to hedge funds and specialized funds focused on these products. The returns will be something in the 20-30% realm, near current levels. Credit analysis will drive value in this market, but if loan pools are kept clean enough then there can be sufficient liquidity to ensure a given securitiation can be sold (i.e. there will be enough funds bidding to ensure that, at a price, bonds will be sold). This is probably the easier problem than the AAA’s to be honest. The hedge funds that will do a lot of work to get a good return already exist, AAA buyers will need to convince themselves that they should be doing those transactions before anything starts happening.

Lastly, I think a market that will grow is the whole loan market. There will be a lot more trading volume in raw loan positions–transactions that aren’t driven by securitizations and don’t need to have tranches of risk in order to sell. Without going too much into the details, this market will be driven by dynamics of servicing arrangements, accounting rules, and detailed credit analysis. Currently this market is thriving, but in the form of “scratch and dent” trades of non-performing and re-performing (people that stopped paying and restarted paying later) pools of mortgage loans.

So, to sum up, what I believe the residential mortgage market will see is a return to simpler times. Selling off loans either a pool of actual loans or in two tranche securitizations seems reasonable. Indeed, this theme will most likely hold for other products as well, but the reasons fit here, so I’ll call it now and risk sounding redundant later.

Now, just to mess with everyone, I’ll use a newly added WordPress feature: polls! Tell me your thoughts on this…

More Bear! (Part Two)

The next installment in the WSJ’s look at Bear’s Collapse hit today. To be honest, nothing interesting stood out. Well, except the following..

1. Why was a Moodys downgrade of Bear Stearns–branded RMBS bonds cause the stock to drop? Something there makes no sense. These are insulated from the credit of Bear Stearns itself and the bonds are issued by a SPV. Seems off, or, perhaps, smacks of normal financial journalism that takes a fact and conflates it with the cause of the markets moving on that day.

2. I have to profess not knowing a ton about prime brokerage, but it seems that if, as it normal to do, Bear provided leverage on trades for prime broker clients, they need to borrow that money and as funds fled they would be able to require repayment of those loans. Also, since most funds are loathe to keep a lot of cash, as it hurts their performance, there shouldn’t be much cash fleeing with these funds.

3. Spitzer hosed Alan Schwartz. There is Alan Schwartz, talking about how super awesome Bear Stearns is, and Spitzer’s scandal starts interrupts him from saying things like, “Bear made money this past quarter.”

4. They had their lawyer call the Fed. I guess I’m not sure why the chairman of Sullivan & Cromwell was charged with calling the Fed to talk about Bear Stearns situation. Seems very odd. And why was it that when Alan Schwartz called the Fed, he struck a less alarmist tone?

5. J.P. Morgan representatives arrived and were shocked at Bear’s books. We don’t know what that means (their liquidity position? the marks they had on their positions?) exactly. But here’s an odd thing: The JPM crew asked for the Fed–and they were already there! Setup in a conference room was the Fed, having already been there for several hours. Maybe it’s completely logical that the Fed would be there, even if they hadn’t been asked for help yet… Just seems to not jive with Alan Schwartz being cautiously optimistic earlier.’

Ok, like I warned earlier, no much to really talk about in this one…. Soon, part three! The conclusion awaits.

Dear Financial Media: Please Rise Above the Least Common Denominator

It’s a simple request. Here’s an example, when a T.V. network talks about Wall St. being happy or sad, “the market” being up or down some percentage, etc. based on what “stocks” do. The S&P 500 represents about $13 trillion (slightly lower, as of this posting). The bond market, though, is over $27 trillion dollars (a statistic from 2006). Now, while the stock and pure interest rates sometimes move in correlated directions, the credit markets or mortgage market can be experiencing a very different directional movement. As recent history has shown us, fixed income markets can be more important to consumers and the economy over a period of days, months, or even longer. So, then, why don’t media organizations describe the financial world based on how fixed income instruments perform? Oh, and lest I forget the $516 trillion notional of outstanding derivatives contracts ($11 trillion in net amount, but counterparty risk makes both numbers valuable) that have been pushing around the larger bond markets recently (ABX, the storied sub-prime index, is a member of the derivatives segment). I realize that these nuances and different markets aren’t easy to explain, but why should that stop the financial media from explaining it?

(I’ll completely skip the fact that it’s often the Dow Jones Industrial Average that’s cited and the issues associated with that index!)

Assume all Bonds are Spheres: Part I

This segment is a regularly occurring feature. It gets its name from a joke that is commonly made about technical people. Usually a very simple problem is presented about horses (or sometimes cows) and a physicist/engineer/mathematician is asked to provide a solution. The solution is made complex because incorporating the nuances of the animals in question is extremely difficult, hence the highly technical person is required. The solution then starts with the technical person saying, “I made two assumptions. The first assumption is gravity. The second assumption I made was that all horses are spheres.” The crux of the joke, which is often found in the markets, is that approximating is both easier and “accurate enough.” Hence the naming of this series on mathematical financial tricks and other interesting tidbits.

Loans are simple enough. I tell you that I would like to originate a loan, which I will securitize, and your interest rate on a loan is going to be 10%. Easy! You just send in 10% of the loan amount every year. Well, not really:

• If I followed convention, I quoted you an Act/360 rate (it accrues yearly based on the actual days, but assumes a 360 day year)–the interest you pay is really 10.14% (~ 365/360 * 10%). (Note that the lower the interest rate, the lower the impact of converting to Act/360.)
• If this was a 10 year loan, those 14 basis points (bps, 1/100th of a percent) are worth about 1.11% of the total notional of the loan (don’t forget, that’s 14 bps extra one pays per year, for 10 years–take the present value of all those cashflows).

Now, let’s look at what happens when I securitize the loan.

• I monetize the 14 bps because the bonds I sell accrue on a 30/360 basis (market convention), so those extra days of interest never get paid to bondholders–I keep it.
• Another nuance: The bonds are priced to the market convention, which is assuming a semi-annual yield. Investors will demand, say, a 10% coupon on their bonds. The bonds, though, match the loan–they pay monthly. What is the 10% worth on a monthly basis? About 9.80% (see below). What do I earn on arbitraging the difference? Well, about 20 bps per year, which, present valued, is worth about 1.59% of the loan amount.

Let’s review: I quoted you a loan at 10%. The 10% tuned out to be more than 10%. I then sold the loan using a completely different set of assumptions and, doing nothing at all, managed to pocket 2.7% of the loan amount. On $10 million dollars that’s $270,000 I made just for arbitraging various conventions and the difference in how bond investors think and how lenders generally think. Would you have been better off to take the 10.05% loan from the insurance company, quoted on a 30/360 basis? Yep. But the rate was lower … and all bonds are spheres.

————————–

The voodoo behind the 9.80% monthly equivalent coupon is easy. The first insight is to recognize that a yield is essentially a discount rate. To find a monthly equivalent to a semi-annual yield one needs only to find the interest rate that, when compounded twelve times a year, equals the yield that assumes compounding twice a year (the semi-annual yield).

We start by saying that an annualized yield, assuming compounding x times a year is

     (1 + i/x)^(x) – 1 = annualized yield       Formula that codifies the above intuition.

For our example of a 10% semi-annual yield, we get the following:

ann. yield (12 pmts.) = ann. yield (2 pmts)
(1 + (r/12))^12 – 1 = (1 + (10%/2))^2 – 1 
1+ (r/12)) = (1+5%)^(2/12)                       Algebra… 😦
r/12 = (1.05)^(2/12) – 1
r = 12 * ((1.05)^(2/12) – 1)
r =  9.79781526%                                       Our answer!

And that’s how I arrived at that solution. I’m sure I’m missing something minor that excel would do for me, but you get the idea.

Who Still Credits the Suisse with being Neutral? Anybody? Anybody at all?

A story that has been a focus for the debt markets, specifically as it relates to (corporate) credit debt markets, is the fire sales by C.S. of its stake in Harrah’s without coordinating with other banks. Indeed there is evidence that this wasn’t the first time C.S. got creative. The interesting thing about this turn of events is that these syndicates are put together to share risk and broaden distribution channels (some banks talk to accounts that others do not). Well, with the C.S. shenanigans creating a fire sale, leaving Harrah’s new bonds 7-10 points (cents on the dollar) lower and the loans being offered 5-6 points lower (estimates, market participants are rather cagey, but low 90s dollar price for the loans and 88 cents on the dollar for the bonds was widely noted in the marketplace) it seems like they made a good sale. Complicating the situation, of course, is the fact that they seemed to have caused the panic that led to the downdraft. Add to this technical overhang the lack of help from C.S. in distributing the remaining debt, and the fact that a sizable buyer was taken out of the market. It’s plain to see that C.S. worked against the syndicate and hurt the distribution power of the group.

Further, here’s an interesting datapoint: C.S. was reported to have around $30 billion in LBO debt on its books, around 10% of the estimate of $300 billion total LBO debt out there. Let’s assume all of this is too high by half (although why would journalists stress an extreme figure in a headline, hmm?). That leaves C.S. with around $15 billion. If, including Harrah’s, they sold $5 billion (rounding up all numbers in the previous Deal Journal post) but caused a 5 point decline in the market (assume it’s all loans they hold, no bonds, which suffered a more severe price movement), they lost $500 million. The figure includes $250 million that was saved on the loans they had already sold (overestimating their savings, since they only really “saved” that loss on Harrah’s, other sales occurred earlier). Ouch. But the remaining unsold LBO debt shed $7.5 billion in value (5 points on $150 billion) due to the sale, and ensuing panic. It seems that letting C.S. into the syndicate did anything but mitigate risk.

Because this situation has wreaked such havoc, perhaps other shops will actually take a stand and block C.S. from future syndicated deals. Their actions seem to show they can be relied upon neither to mitigate risk nor aid in distributing any.