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By Neil Hara by jennyyingdi


									                            By Neil O’Hara

Patching up battered
mortgage bonds was a
brisk business last year.
But a combination of a
market rally, uncertain
house prices, tougher

ratings criteria and
changing accounting
rules have prevented
the first-aid kit from      Not such a straightforward path after all                                               i-stock

being more widely                   urely the re-REMIC ought to be the hottest product on the market. That might
                                    sound odd. After all, it has become a popular method of providing battlefield tri-

utilized. But even if               age to battered real estate mortgage investment conduits (REMICs) —some $40
                            billion-worth of reported deals were completed in the first nine months of last year, more
it’s more limited, the      than double the amount undertaken in the whole of 2008, according to Bloomberg data.
                                 But there are many more commercial and residential mortgage bonds (CMBS and
re-REMIC still has a        RMBS) that, on paper at least, could benefit from some tender loving resecuritization. In

                            a report last June, for example, analysts at Barclays Capital estimated up to $580 billion of
purpose to serve.           mortgage bonds could be re-REMICable.

                The advantages for many buyers are pretty clear, at least on will pay back 70% or less.
           paper: building some extra protection into an underperforming                          That carries expensive consequences. If a bank owns a mort-
           triple-A mortgage bond by carving out and selling part of the gage bond that is downgraded from triple-A to single-B, for ex-
           tranche into a new junior security allows its owner to benefit ample, it has to set aside around 20 times more capital. Insur-
           from either capital relief or improved liquidity for the senior ance company holders would, under similar circumstances, have
           bonds it retains at better prices — or both.                                       to quadruple their reserves against losses on such paper. And
                That’s what sparked the market back to life. Many of the if these institutions’ investment guidelines forbid them from
           biggest holders of MBS — insurance companies, banks and holding anything but investment-grade paper — or indeed just
           money manag-                                                                                                                     triple-A-rated pa-
           ers — face con-                                                                                                                  per — they would
           straints on their                                                                                                                be forced to sell
           ability to hold                                                                                                                  the instruments at
           bonds rated below                                                                                                                what would likely
           investment grade.                                                                                                                be far less than
           So once the first                                                                                                                the recovery value
           wave of ratings                                                                                                                  of the bonds.
           downgrades on                                                                                                                       The re-REMIC
           mortgage bonds                                                                                                                   structure is de-
           hit in 2007, some                                                                                                                signed to offer a
           of them turned to                                                                                                                relatively simple
           re-REMICS.                                                                                                                       do-over for bonds
                Of course, it’s                                                                                                             that have taken
           the way the rat-                                                                                                                 bigger hits than
           ings agencies craft                                                                                                              their      original
           their methodolo-                                                                                                                 structure allowed
           gies that make re-                                                                                                               but that should
           REMICS both                                                                                                                      still recoup much
           necessary        and                                                                                                             of the principal.
           possible. Though                                                                                                          Getty
                                                                                                                                            The unrated ju-
                                  Like battlefield triage, re-REMICs can only achieve so much
           the agencies have                                                                                                                nior bonds pro-
           developed ever more sophisticated models to cope with the in- vide enough additional credit support for the ratings agencies
           creasing complexity of securitized debt, they have never altered to confer a triple-A rating on the new senior bonds, which typi-
           the fundamental premise that a bond must be downgraded if it cally represent the majority of the capital. The new triple-A se-
           is expected to suffer any loss of principal, no matter how small. nior bonds will then trade at a premium to the depressed price
                The consequences of default for corporate bonds are usual- of the original tranche.
           ly dire: a loss of principal seldom less than 30% and potentially                      In essence, then, the re-REMIC is a form of ratings
           much higher. Default has a more nuanced effect on a diversified arbitrage — and thus for bank holders also a form of regulatory
           structured debt pool, however. While the junior parts of the capital arbitrage. So it’s no surprise that many have explored it

           capital may be wiped out, the senior bonds often have much as a means of getting relief on chunks of their non-agency RMBS
           higher recovery rates. This                                                                                          portfolios. Scott Buchta,
           nuance is not reflected in                                                                                           head of investment strategy
           the rating process.                          The re-REMIC structure is designed to                                   at Guggenheim Securities,

                Take, for example, a                                                                                            a financial services boutique
           prime RMBS securitization
                                                       offer a relatively simple do-over for bonds                              in Chicago, says his firm has
           where as much as 95% of                         that have taken bigger hits than their                               underwritten $2.4 billion in
           the capital structure is usu-                                                                                        re-REMIC for banks and
           ally rated triple-A. If losses              original structure allowed but that should                               insurance companies in
           in the pool amount to just                          still recoup much of the principal.                              2009. “We can take assets

           $1 more than that 5% cush-                                                                                           that already exist on a cli-
           ion, the entire senior tranche                                                                                       ent’s balance sheet and re-
           will no longer qualify as investment grade even if the underlying structure them to improve their capital standing,” he says.
           mortgage collateral pool suffers no additional losses. Rating to                       But re-REMICSs are not just blind ratings arbitrage like
           the first dollar of loss can leave structured bonds that are still the now infamous subprime mortgage collateralized debt obli-
           expected to return better than 95% of principal rated double-B gations. Re-REMICs, many argue, serve a useful purpose and

           or lower — the same rating applied to a corporate bond that don’t deserve to be tarred with the same brush. Scott Eichel,

co-head of asset-backed and mortgage trading at RBS Ameri- ple-B to triple-C and if losses come in at the top end of the
cas in Greenwich, points out that re-REMICs are less an expected range they will all end up rated no better than triple-
arbitrage play than a way to overcome investor reluctance C. With about 15% of the average Alt-A deal in some stage of
to buy the underlying MBS bonds. The banks and insurers delinquency, she says the ratings agencies will demand an addi-
that buy the senior tranche can’t, or won’t, hold paper rated tional 35% credit enhancement to support a triple-A rating on
below investment grade while the hedge funds and other ju- re-REMIC bonds that represent 65% of the original triple-A
nior bond buyers are looking for higher yields. A re-REMIC tranche. The senior bond then has credit enhancement equal to
puts the two camps together in a way that satisfies both their 35% of the original triple-A layer plus the original 10% cushion
needs.                                                           below that — about 40% in total.
     Regulators would have cause for concern if the transactions     The case for using re-REMICs, then, seems strong. So why
turned one plus one into three, but not if they just improve li- haven’t there been more of them? One reason is the overall rally
quidity in a battered asset class.                                                             in the markets since last spring.
In fact, one industry source finds     “Rating a re-REMIC is essentially                       In mid-November 2009, the se-
a sympathetic hearing among                                                                    nior re-REMIC bonds in Crow-
regulators once they understand          like carving out a portion that we                    ley’s examples traded at yields of
that rating agencies may cut the                                                               6% or less, while the junior bonds
rating on a former AAA bond all
                                                 think is principal safe.”                     were at 12%–14%. That followed
the way to CCC even though it                         Quincy Tang, DBRS                        a huge rally over the preceding
will repay 95% of principal.                                                                   three months in which junior
     Some investors will do re-REMICs even if they can’t get bond prices ran from about 18 cents on the dollar to 30 cents
capital relief. Denise Crowley, who manages $1.3 billion in ABS or more. “A few months ago, money managers like Pimco were
and MBS for Zais Group, a money management firm in Red buying the senior re-REMIC bonds for their funds that track
Bank, New Jersey, says many institutions that bought triple-A the Barclays Aggregate Index and putting the junior bonds in
MBS tranches may not be able to hold them if the rating falls their distressed funds,” says Crowley. “That was a pretty good
below investment grade. “They have to either get rid of them or deal when the junior bonds were cheaper.”
use re-REMIC technology to be able to hold these assets, or at       The rally squeezed the profits out of re-REMICs for the
least a portion of them,” she says.                              highest quality paper, says Sandeep Bordia, head of U.S. resi-
     Crowley explains that in a typical Alt-A RMBS 90% of dential credit strategy at Barclays Capital in New York, but is-
the capital was rated triple-A, but losses in that category are suance volume held up as arrangers turned their attention to
expected to be 25%–30% rather than the original estimate of lower quality paper. The bonds are still triple-A, but the under-
less than 10%. The former triple-A bonds are now rated tri- lying collateral shifted toward Alt-A mortgages or prime and

       	   Some	 mortgage	 buyers	 are	        pected	 in	 defaulted	 MBS	 bonds.	         anyway.	 Regulators	 have	 ex-
       trying	to	come	up	with	other	ways	      “NAIC	is	looking	for	a	way	to	write	        pressed	 concern	 that	 insurers	
       of	dealing	with	the	shortcomings	       to	severity	of	loss	as	opposed	to	          should	 not	 derive	 a	 capital	 ben-

       of the first dollar loss model: the     first dollar,” says Michael Monah-          efit because the cash flows don’t
       National	 Association	 of	 Insur-       an, director of accounting policy           change, but a re-REMIC adds
       ance	Commissioners	(NAIC)	was	          at	 the	 American	 Counsel	 of	 Life	       liquidity to MBS portfolios, too.
       scrambling	to	implement	before	         Insurers.	“It	will	be	mandatory	for	        “Each bond has its own rating,           Obstacle
       the	 end	 of	 2009	 a	 regulatory	      all RMBS and also re-REMICs.”               and an updated rating,” says Mo-
       capital	 scheme	 to	 replace	 tradi-    	    The	 NAIC	 proposal	 could	            nahan.	 “Some	 companies	 may	
       tional	ratings-based	calculations	      eviscerate	 insurance	 company	             sell	the	junior	bond	and	keep	the	
       with	a	framework	in	which	a	third	      demand for portfolio re-REMICs,             highly	 rated	 piece	 while	 others	

       party	—	Pimco	Advisors	—	would	         although	 Monahan	 points	 out	             may	go	the	other	way.	It	depends	
       evaluate	 affected	 residential	        that	 capital	 relief	 is	 not	 the	 pri-   on	 the	 need	 of	 management	 at	
       mortgage-backed	 securities	 and	       mary	reason	insurance	company	              the	time	and	gives	companies	a	
       assess	 the	 recovery	 rates	 ex-       bondholders	 use	 the	 structure	           lot more flexibility.”

               jumbo loans with subpar delinquency performance. Bordia says         coming up from the bottom.” Even within the triple-A tranches,
               investment banks and more sophisticated investors were quicker       “front pay” bonds have a clear advantage over “back pay” bonds
               to change their models than the ratings agencies as the market       that receive no principal until the front pay bonds have been
               deteriorated and expects many vintage 2008 re-REMIC bonds            paid down in full — by which time losses may have reached up
               to be downgraded in time. “Some of the rating model changes          to the triple-A capital.
               only happened in the second quarter,” he says. “It is more likely         Timing of losses plays an important part in the rating pro-
               that recent re-REMICs will not get downgraded.”                      cess as well. Up to now, foreclosure moratoria and loan modifi-
                    That may be so. But with the housing market still in in-        cations have delayed the day of reckoning for some bonds. Tang
               tensive care, the ratings agencies are left with a dilemma: how      says that could change if servicers see a pickup in prices and
               much credit enhancement is enough in a market that continues         decide to accelerate the processing of delinquent loans; in that
               to soften? Quincy Tang, senior vice president, U.S. RMBS, at         case, losses would come through much more quickly. On the
               ratings agency DBRS in New York, notes that deals done in late       other hand, it is also possible that continuous pressure on fore-
               2007 and early 2008 that added just 10%–20% credit enhance-          closure moratorium and loan modification may further push
               ment to the new senior bonds have already faced downgrades.          out loss occurrence. In order to capture all likely circumstances,
               “Re-REMICs these days typically need about 40% or 50%                DBRS runs multiple scenarios that apply different prepayment
               credit support due to continued performance deterioration,”          speeds, loss timing and changes in interest rates; it will only as-
               she says.                                                            sign a triple-A rating if there are no interest shortfalls or princi-
                    And the fundamentals of the housing market have not yet         pal write downs even under the worst case. “Rating a re-REMIC
               improved: despite the recent uptick in the S&P Case-Shiller          is essentially like carving out a portion that we think is principal
               Index, she still expects another 10%–15% drop before house           safe,” says Tang.
               prices hit bottom. Even prime borrowers now have negative eq-             The ratings agencies aren’t all on the same page, though.
               uity in their homes on an unprecedented scale, which makes it        Moody’s takes a skeptical view of portfolio re-REMICs in par-
               hard to predict how they will behave. “In a deteriorating market,    ticular. In some cases, an insurance company or bank has cre-
               you have to evaluate the non-delinquent population to ensure         ated a re-REMIC structure and retained both the new triple-
               that enough defaults are forced through,” she says. “The position    A and the new junior tranche, only later selling enough risk to
               in the capital structure is critical. It’s a race between how fast   qualify as a legal true sale, a procedure known as a springing true
AmSecuritization_ad 121909_Layout 1 12/21/09 12:45 PM Page 1
               bonds are paying down from the top versus how fast losses are        sale. Navneet Agarwal, a senior vice president at Moody’s, says
that although some law firms have blessed the concept, the rat- route, many will simply retain the triple-A bonds. “The sponsors
ings agency does not accept that interpretation and insists that are not necessarily buying any new securities,” Guggenheim’s
a true sale must be established when the re-REMIC is set up. Buchta says. “They are retaining credits they already under-
“If the product is not a true sale on that date, anything you do stand.” But others have created a super senior sliver with, say,
after the close of the transac-                                                                          an 85% credit enhancement
tion may not cure that defect,”            “We can take assets that already                              that fetches a premium, which
says Agarwal.                                                                                            sometimes helped mitigate the
      Moody’s rating method
                                         exist on a client’s balance sheet and                           loss under the old rules.
recognizes the re-REMIC                    restructure them to improve their                                   A slice off the top will
structure does not diminish the                                                                          not work now that the new ac-
expected losses in a portfolio.                           capital standing.”                             counting rules have kicked in,
If a bond rated B1 is divided                 Scott Buchta, Guggenheim Securities                        however. Selling the best cash
into two pieces and one attracts                                                                         flows debases the quality of
a triple-A rating, Moody’s will almost always rate the junior what is left and cuts the value to the point where there is no net
bonds lower than B1. Some agencies assign ratings based on the benefit. “The portion you keep has the worst cash flows,” Rosen-
probability of default, an alternative approach that may permit blatt says. “It would have to go on the balance sheet at such a
the new junior bonds to retain a B1 rating.                            deep discount that you still have the loss.”
      Accounting rules are also proving to be more of a sticking           Throw in the accounting rule changes with greater scrutiny
point than many                                                                                                         of loss assump-
expected. Marty                                                                                                         tions from the rat-
Rosenblatt, a part-                                                                                                     ings agencies and
ner in Deloitte &                                                                                                       improving mort-
Touche’ securiti-                                                                                                       gage bond prices
zation group, says                                                                                                      now that the worst
a bank generally                                                                                                       of the credit crunch
has to sell at least                                                                                                   has passed, and re-
15% of the value                                                                                                       REMICs have a
of the re-REMIC                                                                                                        number of obsta-
transaction       to                                                                                                   cles to overcome.
third parties for                                                                                                      So it’s little wonder
the deal to qualify                                                                                                    that they have not
as a bona fide sale                                                                                                    managed to live
— a prerequisite                                                                                                      up to early expec-
to getting capital                                                                                                    tations of being a
relief. The sale                                                                                                      tool that could have
also triggers a                                                                                                       widespread appeal
book loss if the                                                                                                      among mortgage

original asset had                                                                                                    bondholders look-
not been written                                                                                                      ing for ways to
down to the value Updating the accounting rules can complicate matters                                                manage regulatory
realized when the deal was done, as is often the case.                 capital in a tough environment — not least banks.
      That in turn holds little appeal to those banks that have            Despite al the challenges, though, re-REMICs do still have
been trying to avoid taking losses for as long as possible. Since appeal — not least as a means of creating some liquidity for own-            Obstacle
the start of this year they’ll have an even harder time talking ers of mortgage securities battered by the financial crisis. And
themselves into using re-REMICs. That’s because of the new despite recent improvements in prices in the secondary markets,
accounting rules, FAS 166 and 167. Under the old rules, if a that advantage isn’t going to disappear overnight. Until the
bank created a new junior tranche using 30% of the original spate of bond downgrades comes to a close, or the housing mar-
deal and sold half of that, it would only be required to book a ket recovers — or both — re-REMICs will still have a place at

loss on the portion it offloaded. The new regime stipulates that the operating table.
all tranches must be marked to the sale price, regardless of how
much is sold. That is bound to be off-putting for a number of             Neil O’Hara is a freelance writer based in Lincoln, Mass.
banks, regardless of whether they have enough capital or earn-            He is a contributing editor to FTSE Global Markets and
ings to absorb the loss.                                                  writes for a variety of other publications including On Wall
                                                                          Street, Wealth Manager and Alpha.

      The implications of the new accounting rules don’t stop
there. For those banks that do decide to go the re-REMIC


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