Why You Should Hate the Treasury Bailout Proposal
Its obvious that there are problems getting foreign investment into the country - that is exactly why the dollar has weakened this decade.
But that doesn't explain, imo, a crisis requiring a $1 trillion+ bailout.
JE, I get an email newsletter from this fellow John Mauldin, usually 2-3 times per week. He doesn't have a website, to my knowledge, but this last newsletter was very interesting, going into detail about the mortgage business, how the traunches are created and securitized. Imo, the only way to really understand why we're in such a mess, is to understand how the mortgages are sliced up and sold, and Mauldin's letter does an outstanding job of doing this. Because he sends this information in a newsletter format and doesn't post it on a website, the only way I can provide this information is to cut and paste it into my website and provide the link. I've never done this before (linked to my website) because I don't want to come across as pimping my own little business, that's definitely not the intent as I cannot do business in Louisianna. It's simply the only way I can link this information, so forgive me in advance.
For anyone who wants the original email, pm me an email address and I'll forward it along.
Here's the link.
http://www.waterfrontmtgdirect.com/John_20_Mauldin_20_Financial_20_Armageddon_20_Sep_20_19.html
Inside a RMBS
Let's look at a RMBS. As Berg points out, when you are buying a mortgage backed security, there are really only three questions you need to know the answers to:
How many mortgages will default?
How much will I get back on a defaulted loan?
How much credit enhancement is there in the security?
Let's set the table by looking at a few terms and definitions. Using his example, let's take a mortgage where the home was originally appraised for $400,000 and there is a $300,000 mortgage on the home. Let's assume a default and the bank takes back the home. If they sell the home and recover $240,000 that means they lose $60,000. This is called a 20% severity. If they sold and recovered $150,000 it would be said to have a 50% severity.
Next, let's look at how the rating agencies come up with the AAA rating. First they model the expected losses, with emphasis on the word model. If they figure that worst case that 8% of the loans default at a severity of 50%, then the security would lose 4% of its value. To get an AAA rating you have to have at least two times the coverage of the "modeled" loss. In this illustration, that means that 92% of the loans would be put into the AAA tranche. An A rating assumes a coverage of more than 1 times but less than 2. B means you expect to get your money back and if they model that you will get below 100% back then the rating would be at junk levels.
Now, this next fact is important. All ratings assume a par value of 100. The rating of these bonds has nothing to do with price. After the presentation, Rich sat down with me and pulled up an actual mortgage backed security that was being offered that day on his screen. It was once a AAA rated Alt-A security. If I remember correctly it was a 2006 vintage security.
As of the latest reporting, a little over 5% of the mortgages were over 60 days past due or in foreclosure. In this security, there are no toxic option ARMS. The numbers of mortgages in this security that are in trouble are rising. S&P has downgraded that AAA tranche to BBB, which of course means its value is going down.
And sure enough, the offered price of the security is 70 cents on the dollar, or 70% of the original par value. Now remember, this particular AAA bond will only start to lose money after the lower tranches take up the first 8% of losses. Thus, this bond can be said to have an 8% credit enhancement.
Pricing in Financial Armageddon
Now, let's stress test that loan. For the AAA portion of the loan to lose money, that would mean that 16% of the loans would have to default with a severity of 50% losses. Could that happen? Sure.
But let's look at what buying that loan at 70 cents on the dollar does for the new owner. First, you are getting a much higher yield (interest rate) because you are buying the security at a lower valuation. But something else even more interesting happens.
Even though the security sold at 70 cents, it still gets all of the first of the proceeds of the home owners who pay their mortgages, up to 92% of the original value in the security. How many loans would have to default in order to make the buyer at 70 cents lose money? Remember, we already had credit enhancement of 8%. But at 70 cents, we just "bought" or priced in another 30%. Let's think Armageddon and that 50% of the mortgages default and they only recover 50% of the loans. That would only be a total loss of 25% to the entire collateral of the deal, but it would mean that the new investor still get all of my 70 cents plus another 13% back! The proud new owner could get up to 92% of the monies paid. Even in a pretty bad scenario, you get more than you paid for the security.
Let's walk through the math. Let's say the original security was $100 million (which would be a very small RMBS). The AAA tranche would have cost $92 billion. If you have it at 70 cents on the dollar you paid approximately $64 billion. In my Armageddon scenario above, the security loses 25% or $250 million. The lower rated tranches are completely wiped out losing $8 billion. Your tranche loses the remaining $17 billion which means you get $75 billion and you only paid $64 billion.
So, how bad would things have to get to lose money on this security? If I am doing the math right, 72% of the loans would have to default with a severity of 50% before your investment of $64 billion was impaired by even so much as 1 dollar. If that happened, it would be Armageddon.
So, why is it rated BBB? Because the rating is over the entire tranche and it is made at a par price of 100. The rating is not affected by the current price. As of today, assuming that even double the number of mortgages currently delinquent default with a 50% severity, your returns over the life of the security would be well over 12%. You would get back $92 million for your $64 billion dollar investment along with interest payments.
The reason this presentation was being made to banks and institutions? Because if you are a bank, you can generally only get prime plus 2% on a loan you make. But if you buy this security with your capital, you can make prime plus 6%. That is a large difference to a bank. Performance Trust has sold billions of this type of paper to banks and institutions.
If this is such a good deal, then why isn't everyone hitting the bid? Because these securities are very difficult to analyze. It is time consuming. You need to analyze every loan and develop your own valuations. You simply can't trust the ratings, as they are measuring something completely different.
And the real truth is that many of the various RMBS securities will in fact be totally wiped out or lose a great deal. Many are seeing default rates of 30% or more. You have to be very careful when you walk through this minefield. And in a time of crisis, it is not clear what the new rules will be. What if the government forces lenders to re-set mortgages at some loss level? What if the housing crisis gets worse? On the other hand, what if the government comes in and buys up all the bad mortgages in an attempt to stop the erosion in the home markets. The level of uncertainty in these times makes people a lot more cautious.