Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

 

Yesterday’s post started with chicken parts (subprime residential second mortgages) and saw how Goldman Sachs chopped, pressed, and sliced them into thirteen different types of chicken parts. 

 

“As I hear tell all the parts are crammed into one big part.”

“Fused.”

“Then the one big part is cut up into little pieces parts.”

 

Now comes the real added value.

 

Don’t cut yourself slicing the tranches

 

How can we turn a pile of BBB’s into a subpile of AAA’s?

 

These loans, which are fixed-rate, carried an average interest rate of 10.51%.

 

Think about that – in April, 2006, these borrowers were signing up for loans at 10.5%.  This is a major red flag since anyone willing to pay that much has been unable to find anyone to lend more cheaply. 

 

After paying the people who collected the payments and handled all the other paperwork, the GSAMP Trust had ten percentage points left. However, the interest on the securities that GSAMP issued ran to only about 7%. (We say “about” because some of the tranches are floating-rate rather than fixed-rate.)

 

The difference between GSAMP’s interest income and interest expense was projected at 2.85% a year. That spread was supposed to provide a cushion to offset defaults by borrowers.

 

Normally this would be a huge spread: it says, more or less, that 25% of the borrowers [2.85% / 10.51%] could default, losing all our principal, and we could still make a 7.0% net yield.

 

Make yield with the right spread

 

In addition, the aforementioned X piece didn’t get fixed monthly payments and thus provided another bit of protection for the 12 tranches ranked above it.

 

Remember that we’re dealing with securities, not actual loans. Thus losses aren’t shared equally by all of GSAMP’s investors. Any loan losses would first hit the X tranche.

 

Basic principle: issuer takes first loss exposure.

 

Then, if X were wiped out, the losses would work their way up the food chain tranche by tranche: B-2, B-1, M-7, and so on.

 

The $241 million A-1 tranche, 60% of which has already been repaid, was designed to be supersafe and quick-paying. It gets first dibs on principal paydowns from regular monthly payments, refinancings, and borrowers paying off their loans because they’re selling their homes.

 

Sounds as if the A-1 tranche is in fact safe.

 

Safety is an AAA rating?

 

Then, after A-1 is paid in full, it’s the turn of A-2 and A-3, and so on down the line.

Moody’s projected in a public analysis of the issue that less than 10% of the loans would ultimately default. S&P, which gave the securities the same ratings that Moody’s did, almost certainly reached a similar conclusion but hasn’t filed a public analysis and wouldn’t share its numbers with us. As long as housing prices kept rising, it all looked copasetic.

 

Goldman peddled the securities in late April 2006. In a matter of months the mathematical models used to assemble and market this issue – and the models that Moody’s and S&P used to rate it – proved to be horribly flawed. That’s because the models were based on recent performances of junk-mortgage borrowers, who hadn’t defaulted much until last year thanks to the housing bubble.

 

Is our model horribly flawed?

 

Through the end of 2005, if you couldn’t make your mortgage payments, you could generally get out from under by selling the house at a profit or refinancing it.  

 

In most markets, during most times, for most borrowers, this is still true, which is why hard equity is so prized.  As I put it more than two years ago:

 

It places the sponsor in first loss position.  Following the control principle, in almost every well-designed program — this includes loan-origination models as well as ownership models — the lead operator takes 100% of the first loss.  Since you can lose only what you have contributed, hard equity makes that first-loss exposure meaningful.

 

Hard equity is the miner’s canary.

 

“It’s rung down the curtain and joined the bleeding choir invisibule!  This — is an ex-parrot!”

 

It shows the borrower has some financial wherewithal.  As a general principle, people part with cash only when they have truly earned it.  Demonstrating financial wherewithal commensurate with the scale of the enterprise (that is, one’s equity contribution as a percentage of the total capitalization) is a great predictor of whether a sponsor is up to the challenge.

 

“No, really, I can handle it!”

 

It gets the borrower’s undivided attention.  “When you’ve got them by the wallets, their hearts and minds will follow.” — with apologies to John Wayne.

 

“Who you apologizin’ to, pilgrim?”

 

When hard equity is absent, you need the property to carry all the debt.  Which works most of the time, but not all of the time.

 

But in 2006 we hit an inflection point. House prices began stagnating or falling in many markets. Instead of HPA – industry shorthand for house-price appreciation – we had HPD: house-price depreciation.

 

Interest rates on mortgages stopped falling. Way too late, as usual, regulators and lenders began imposing higher credit standards. If you had borrowed 99%-plus of the purchase price (as the average GSAMP borrower did) and couldn’t make your payments, couldn’t refinance, and couldn’t sell at a profit, it was over. Lights out.

 

I can’t get out of the position

 

As a second-mortgage holder, GSAMP couldn’t foreclose on deadbeats unless the first-mortgage holder also foreclosed. That’s because to foreclose on a second mortgage, you have to repay the first mortgage in full, and there was no money set aside to do that. So if a borrower decided to keep on paying the first mortgage but not the second, the holder of the second would get bagged.

 

A novel strategy for borrowers: pay the first, default on the second!

 

If the holder of the first mortgage foreclosed, there was likely to be little or nothing left for GSAMP, the second-mortgage holder. Indeed, the monthly reports issued by Deutsche Bank (Charts), the issue’s trustee, indicate that GSAMP has recovered almost nothing on its foreclosed loans.

 

Twenty years ago, one of my then-partners started his own firm, as a specialized investor, making second mortgage loans.  Some of them did well; some did very badly, and for precisely the reasons listed here.  When the borrower goes into default, the second mortgagee is shackled to the first mortgagee but lacks the first’s control. 

 

By February 2007, Moody’s and S&P began downgrading the issue. Both agencies dropped the top-rated tranches all the way to BBB from their original AAA, depressing the securities’ market price substantially.

 

As I’ve previously posted, the rating agencies played a principal role in shaping and legitimizing this market.  Perhaps everything they did was on the up-and-up; perhaps we’ve had a perfect-storm-type reversal of circumstances.  But securities bundles like this one, if the story is accurate and representative, would discourage even the most loyal rating agency supporter.

 

In March, less than a year after the issue was sold, GSAMP began defaulting on its obligations. By the end of September, 18% of the loans had defaulted, according to Deutsche Bank.

As a result, the X tranche, both B tranches, and the four bottom M tranches have been wiped out, and M-3 is being chewed up like a frame house with termites. At this point, there’s no way to know whether any of the A tranches will ultimately be impaired.

 

What of the rating agencies?  Fortune suggested that they were the investors’ principal comfort.  What do they think now?

 

“[In hindsight,] I think we would not have rated it” had Moody’s realized what was going on in the junk-mortgage market, says Nicolas Weill, the firm’s chief credit officer for structured finance. Low credit scores and high loan-to-value ratios were taken into account in Moody’s original analysis, of course, but the firm now thinks there were things it didn’t know about.

 

You could write a book about it, couldn’t you?

 

Weill doesn’t lay blame on any particular party, although in a Sept. 25 special report posted on Moody’s website, he called for “additional third-party oversight that reviews the accuracy of the information provided by borrowers, appraisers, and brokers to originators” when it comes to junk issues. Or, as he calls them, “non-prime.”

 

S&P, by contrast, says that it considers both its original rating and subsequent downward revisions correct. “We used the best information available at the time,” says Vickie Tillman, S&P’s chief rating officer.

 

It seemed like a good idea at the time

 

That has to be the legal defense – “we did our level best, and as it turned out, our estimate was wildly wrong.”  Beyond the legalities, as I posted before, is the issue of brand value.  It takes a long time to recover from a wrecked reputation, and clinging doggedly to a legal defense may be prudent in litigation, but costly in brand value and market position.

 

If you read documents that Goldman filed with the SEC in connection with this offering, you discover that they warn about pretty much everything we’ve discussed so far and some things we haven’t: the impact of falling house prices, the difficulty of foreclosing, the possible changes in credit ratings, the fact that more than half the mortgages were in California, Florida, and New York, all of which were overheated markets.

 

It’s all disclosed. In capital letters. So no buyer – and this is aimed at sophisticated investors – can say he wasn’t warned.

 

What is there to take away from our course in Junk Mortgages 101? Two things. First, you have to pay at least some attention to all those “risk factors” that issuers forever warn you about – especially when you’re dealing with a whole new thing like junk mortgages issued en masse instead of by specialists.

 

Related to risk factors are control responses.  It’s one thing to take risks where, if things go bad, you or your partners are in a position to act.  It’s quite another to buy a position where you’re both helpless (unable to act effectively) and blind (unable to see what’s going on at the properties). 

 

Second, when you rely on the underwriter and the rating agencies to do all your homework for you, you don’t have safety. You have only the illusion of safety.

 

“I feel completely safe riding along here”

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