Parts is parts: Part 1, assemble the respective parts
Twenty years back, when Wendy’s was making a name for itself in hamburgers, its advertising agency hit upon a brilliant ad campaign to contrast real hamburger (Where’s the beef?) with mystery meat.
“Where’s the beef?”
Entering an antiseptic fast-food eatery (echoes of Colonel Sanders) with red-and-white checkerboard floor tiles and counter help decked out in orange peaked caps, our customer reads a menu comprised of nothing but chicken – in fact, chicken parts. He asks, “Excuse me, but what was that in there?“ “It’s chicken!” [go to YouTube and search for Wendy’s parts.” – ED.]
“That’s when they take a lot of chickens and assemble the respective parts,” chirps the clerk.
“What parts?”
“Different parts!” chirps his co-worker.
“Parts is parts,” chants the clerk’s sidekick in a serious tone.
“Different parts!”
If chicken parts sound scrumptious to you, then you’ll really want to dig in to GSAMP Trust 2006-03, a tasty concoction whipped up by the good people of Goldman Sachs, and then simply whipped in a lengthy Fortune article, using the chicken-parts metaphor, and reprinted in CNN Money:
(Fortune Magazine) — It’s getting hard to wrap your brain around subprime mortgages, Wall Street’s fancy name for junk home loans. There’s so much subprime stuff floating around - more than $1.5 trillion of loans, maybe $200 billion of losses, thousands of families facing foreclosure, umpteen politicians yapping - that it’s like the federal budget: It’s just too big to be understandable.
Too big to wrap your head around
So let’s reduce this macro story to human scale. Meet GSAMP Trust 2006-S3, a $494 million drop in the junk-mortgage bucket, part of the more than half-a-trillion dollars of mortgage-backed securities issued last year. We found this issue by asking mortgage mavens to pick the worst deal they knew of that had been floated by a top-tier firm - and this one’s pretty bad.
It was sold by Goldman Sachs (Charts, Fortune 500) - GSAMP originally stood for Goldman Sachs Alternative Mortgage Products but now has become a name itself, like AT&T and 3M.
This issue, which is backed by ultra-risky second-mortgage loans, contains all the elements that facilitated the housing bubble and bust.
The story had quite a cast of characters
Feed us! Feed us!
Alas, almost everyone involved in this duck-feeding deal has had a foul experience. Less than 18 months after the issue was floated, a sixth of the borrowers had already defaulted on their loans. Investors who paid face value for these securities - they were looking for slightly more interest than they’d get on equivalent bonds - have suffered heavy losses.
That’s because their securities have either defaulted (for a 100% loss) or been downgraded by credit-rating agencies, which has depressed the securities’ market prices.
If you can do workouts, defaults aren’t a 100% loss – unless you’re junior to enough people that the recovery is below the amount owed those in front of you.
(Check out one of these jewels on a Bloomberg machine, and the price chart looks like something falling off a cliff.)
There goes my tranche
In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players.
Spring, 2006 was after AHI called the market top (December, 2005), but a year before the subprime mess hit the newspapers with the collapse of New Century Financial.
More than a third of the loans were in
The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that’s not a misprint - the average loan-to-value of the issue’s borrowers was 99.29%.)
Fortune is right, 99%+ leverage is frightening to begin with.
99% leverage?
It gets even hinkier.
Hinky?
Some 58% of the loans were no-documentation or low-documentation.
Double yikes.
Double your documentation
This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - “owner-occupied” loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers’ incomes or assets bore any serious relationship to what they told the mortgage lenders.
You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80% first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you’d have a profit. If house prices fell and you couldn’t make your mortgage payments, you’d get to walk away with nothing (or almost nothing) out of pocket.
As we’ve seen in various posts, real live homeowners are human beings who do not simply ‘walk away’. The loans are recourse – borrower still liable for the shortfall even after a foreclosure – and in addition, and for many people, the trauma and ruination of their credit is as bad as the recourse.
It was go-go finance, very 21st century.
Goldman acquired these second-mortgage loans and put them together as GSAMP Trust 2006-S3. To transform them into securities it could sell to investors, it divided them into tranches - which is French for “slices,” in case you’re interested.
Enter the chicken parts.
There are trillions of dollars of mortgage-backed securities in the world for the same reason that Tyson Foods offers you chicken pieces rather than insisting you buy an entire bird. Tyson can slice a chicken into breasts, legs, thighs, giblets - and Lord knows what else - and get more for the pieces than it gets for a whole chicken.
It comes in parts – different parts!
Customers are happy, because they get only the pieces they want.
Similarly, Wall Street carves mortgages into tranches because it can get more for the pieces than it would get for whole mortgages.
Yes, slicing – securitization – normally adds value. Yet it also creates risk moonshine.
Mortgages have maturities that are unpredictable, and they require all that messy maintenance like collecting the monthly payments, making sure real estate taxes are paid, chasing slow-pay and no-pay borrowers, and sending out annual statements of interest and taxes paid.
In other words, loan servicing.
Securities are simpler to deal with and can be customized.
Someone wants a safe, relatively low-interest, short-term security? Fine, we’ll give him a nice AAA-rated slice that gets repaid quickly and is very unlikely to default. Someone wants a risky piece with a potentially very rich yield, an indefinite maturity, and no credit rating at all? One unrated X tranche coming right up. Interested in legs, thighs, giblets, the heart? The butcher - excuse us, the investment banker - gives customers what they want.
In this case, Goldman sliced the $494 million of second mortgages into 13 separate tranches. The $336 million of top tranches - named cleverly A-1, A-2, and A-3 - carried the lowest interest rates and the least risk. The $123 million of intermediate tranches - M (for mezzanine) 1 through 7 - are next in line to get paid and carry progressively higher interest rates.
Thirteen slices? These are probably divided both by security (the vertical axis in a financing quilt) and maturity (the horizontal axis). The more patches in a quilt, the more risk it can come apart at the seams.
Finally, Goldman sold two non-investment-grade tranches. The first, B-1 ($13 million), went to the Luxembourg-based UBS (Charts) Absolute Return fund, which is aimed at non-U.S. investors and thus spread GSAMP’s problems beyond our borders. The second, B-2 ($8 million), went to the Morgan Keegan Select High Income fund. (Like most of this article, this information is based on our reading of various public filings; UBS and Morgan Keegan both declined to comment.)
Goldman wouldn’t say, but it appears to have kept the 13th piece, the X tranche, which had a face value of $14 million (and would have been worth much more had things gone as projected), as its fee for putting the deal together. Goldman may have had money at risk in some of the other tranches, but there’s no way to know without Goldman’s cooperation, which wasn’t forthcoming.
How is a buyer of securities like these supposed to know how safe they are? There are two options. The first is to do what we did: Read the 315-page prospectus, related documents, and other public records with a jaundiced eye and try to see how things can go wrong.
I think things may be looking up soon
The thing is, even reading all 315 pages may not help you as much as it should, because the recitation of seemingly endless risks, unsorted by probability or severity, deadens the mind.
From the solid-caps mandated paragraphs to the small-font expositions, it’s a rare bird who can interpret what he reads. I’m competent to read most real estate prospectuses, but little else.
The second is to rely on the underwriter and the credit-rating agencies - Moody’s and Standard & Poor’s. That, of course, is what nearly everyone does.
It’s stories like these that make a symbiote’s life not a happy one. I’ve already posted that it seems inescapable the agencies will be sued, and I’ve speculated that one of them may not survive.
Even though the individual loans in GSAMP looked like financial toxic waste, 68% of the issue, or $336 million, was rated AAA by both agencies - as secure as U.S. Treasury bonds. Another $123 million, 25% of the issue, was rated investment grade, at levels from AA to BBB-.
Blend ‘em together and they’ll be investment grade?
‘Toxic waste’ is pretty judgmental and unsupported of Fortune, but the larger paradox is relevant. If the individual object is high risk, can an accumulation of similar objects be lower risk? Yes, if the risks that make them volatile are entirely independent. (This is the old coin-flip issue. The more times you flip a coin, the less its standard deviation percentage.) When the risks are not independent, however, the ‘fat tail’ comes into effect, and it becomes much harder to argue that aggregation can transmute junk into gold.
Thus, a total of 93% was rated investment grade. That’s despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren’t vetted by anyone) had less than 1% equity and on which GSAMP couldn’t effectively foreclose.
It’s not implausible to be a rating agency, is it?
How does toxic waste get distilled into spring water? Watch. It’s all in the math - and the assumptions about how borrowers will behave.
“Notice how my fingers never leave my hands …”
[Continued tomorrow in Part 2.]
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