Remixing REMICS, or shake your booty
By: David A. Smith
If no one wants your pile of booty, perhaps you should try shaking things up At first blush, that appears to be the strategy behind the proposed remixing of Real Estate Mortgage Investment Conduits (REMICs), as presented in a recent Wall Street Journal article:
I’m gonna shake it up
Once upon a time, Wall Street invented a nifty means of centrifuging, separating, refining off, then packaging and selling the resulting slices. It was called ‘securitization‘ and everyone everywhere lived happily ever after again.
I’ve invested all our money with Bernie Madoff, honey
Or something like that ….
Debacle, period
Certainly the Journal, which is always skeptical of money-making that doesn’t involve a smokestack industry producing manly products, brings appropriate skepticism to this one:
Some day, son, you too can read the Wall Street Journal.
Wall Street Wizardry Reworks Mortgages
Wizards, as we all know, are not manly men.
Oh no? I can make your security that big
A new wave of financial alchemy is emerging on Wall Street as banks and insurers seek to make soured securities look better.
That’s full metal alchemy, you know
Regulators are pushing back, saying the transactions don’t have enough substance and stand to benefit bankers and ratings firms.
The popular deals are known as “re-remic,” which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.
The Journal provides a handy graphic:
REMICs REMIX: How a bad bond is rebundled.
Doesn’t sound bad in the abstract; but we’ve seen this movie before, haven’t we?
And the picture gets no better the second time
A hypothetical example cited in research by Barclays Capital said that a $100 million asset that required $2 million in capital at a triple-A rating may require $35 million if downgraded to double-B-minus. At triple-C, the capital requirement might rise to 100%, or $100 million.
Key to your understanding is that downgrades are not changes in the thing itself, but changes in the observation of the thing. This is a Schrodinger’s Cat moment: the act of observing changes the thing’s value even if its essence remains unchanged.
You observing me? You think that changes me?
Though the essence is unchanged, the value is increased.
In a re-remic, three-fourths of the same asset may regain a triple-A rating, requiring just $1.5 million in capital, Barclays said. The remaining one-quarter may require 100% capital, but the total capital requirement would fall to $26.5 million.
Shake up your booty, and it becomes more tasty
The net result is financial firms’ books look better and they need to hold less capital against those assets, even though they are the same assets they held before the transaction.
Put simply, if value is added through the remixing, there are three possibilities:
1. The restructuring changed the risk profile.
2. The old assessment was too pessimistic.
3. The new assessment is too optimistic.
Better when it’s green, isn’t it?
Of these three, Theory 1 is positive change, Theory 2 has positive impact, and Theory 3 will only make things worse. So we’d really like Theory 3 to be false, but as we saw some months back, it’s all too easy for people to believe what they desperately hope should be true.
Hope is not good enough – we need expertise and integrity. Where will we seek it? Why, the supposedly independent rating agencies. (I say supposedly because in a five-part series – Part 1, Part 2, Part 3, Part 4, and Part 5 – we saw the rating agencies cozily symbiotic with their ratees.)
I can be disinterested if you pay me enough
Meanwhile, let’s examine the parol evidence:
American Equity Investment Life Holding Co. has told analysts that it is considering a re-remic. Recent downgrades of its mortgage bonds overstate their risk by a wide margin, its executives said.
That’s Theory 2 expressed in its quintessence. And it might well be right – many folks, including me, have suggested that the capital markets’ liquidity shortage had led to a massive over-reserving on these assets.
Some state insurance regulators worry that current ratings are flawed – perhaps even too harsh – for determining the capital that should back up residential-mortgage securities.
Arr, yer too low-rated, matey!
Another anonymous expression of Theory 2.
But they are chafing at the re-remic strategy. That’s partly because of the fees and partly because re-remics rely on ratings firms – faulted for failing early on to identify problems with mortgage-backed bonds – to rate the new securities.
We do know that a symbiote’s life is not a happy one.
At hearings Wednesday on Capitol Hill focused on the ratings firms, U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, “The credit-rating agencies could be setting us up for problems all over again.”
And I know about being set up for problems
Regulators would like “a lot fewer dollars” paid to Wall Street, as well as “less reliance on the ratings agencies,” said Kermitt Brooks, first deputy insurance superintendent in
Fewer dollars paid is fine if the quality doesn’t suffer, and if you’re not going to rely on the discredited rating agencies, what not-yet-discredited referee are you going to rely on?
The alternative solution, proposed by trade group American Council of Life Insurers, calls for hiring an analytical firm with expertise in residential mortgage-backed securities to help regulators determine the value of deteriorated holdings on insurers’ books, bypassing the ratings providers.
There’s a place for experts who value complex interests. What will make these postulated new ones any better than the current rating agencies?
It is unclear how big a concern this is for banking regulators. Alabama Deputy Banking Superintendent Trabo Reed said he has seen only a few examples of re-remics.
Is $11 billion ‘only a few examples’?
Wall Street bankers and analysts said a minority of re-remics, perhaps as little as 10% to 30%, are aimed at helping firms like insurers manage capital requirements. The general goal, as one banker put it, is to help “create buyers for orphan securities that otherwise would have languished.”
The issue isn’t why the booty’s being remixed; rather, the issue is whether the remixing is sound or unsound.
“There is $350 billion to $400 billion in market value of securities with no natural buyer due to their rating,” Barclays said in a June report. “The re-remic market provides a way out of this gridlock by creating new AAA securities, which are likely to be viewed as attractively priced.”
We’re only in it for the money
Remixing the booty has a valid regulatory purpose. Institutions have capital requirements; low-rated securities consume very high capital reserves.
And Protective Life Corp. said in August that its re-remics, totaling about $1.4 billion, improve the company’s capital standing “in the ballpark” of $75 million.
Getting the securities re-rated, or even re-rating a portion of the securities, adds meaningful value via Theory 1.
Insurance executives estimate that insurers pay 0.35% or so of a deal’s size in investment banking, ratings firm, legal and other costs.
Expressed as a percentage, that’s only 35 beeps. Doesn’t sound like much, until you multiply it out and its $35 million in fees.
Thirty-five mil!
Pay $35 million, free up $75 million. Worth it but not by a huge amount.
At an NAIC hearing last week, ratings firms described changes over the past year to improve their analytical, compliance and corporate-governance processes. But they also generally agreed that their ratings weren’t ideal as a sole basis for determining insurers’ capital levels.
In other words, discredited though the rating agencies be, nobody’s offered real competition.
The alternative is to go overseas and get your money from Sheik Yerbouti
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