MBS & Real Time Information

September 21, 2009

Rob Wosnitzer conceived of the argument in this post and wrote it together with Martha Poon. It responds to the discussion of how real time information could contribute to MBS evaluation at the end of the previous post.

A.    MBSs have always been structured with an awareness of ‘real time’ shifts in the status of the individual loans/mortgages. Any loan pool – whether these are actual pools of loans or the derivative CMO/CDOs – is built around a set of assumptions about its likely prepayment rate, or even re-payment rate. A 30 year mortgage is scheduled to have a 30 year life.  However, homeowners can disrupt this schedule by paying more in principal at opportunistic moments, as well as by deploying refinancing strategies in various interest rate environments.

B.     Back in the day, the person whose job it was to interpret  ‘real-time’ information on mortgages was called a ‘tape-cracker’. This person would await the periodic release of a ‘data tape’ from the agencies – Fannie & Freddie – with reports on prepayment rates on pools of mortgages.  Tape crackers operated with a time-critical posture – the quicker the agency information was gleaned and input to re-price the MBS universe, the greater the advantage conferred to the trading desk which moved to reposition their book. (Rob: I always liked the name of that job: tape cracker — it was like possessing special, secret skills, like a safe-cracker or code-breaker spy.)

C.     The oscillating rate of prepayments has the potential to wreak havoc on portfolios.  For example, take a Portfolio Manager (PM) who purchases a CMO with an average life of 14 years. Let’s make the overall interest rate 8% (which translates into mortgage rates of roughly 8.75% or 9.00%). Now let’s say interest rates decrease and mortgage rates fall, by say, 1% to 7.75%.  In the new conditions, homeowners are more likely to refinance, paying off their mortgages early.  The PM, therefore, would get stuck with a pool of money that needed to be reinvested — but in a much lower interest rate environment overall.  So the only way the PM could ‘match’ his original 8% was to take on more risk.

D.    One of the consequences of this intrinsic instability in CMO’s was to create IO’s and PO’s – ‘interest only and ‘principal only’ streams – in which the mortgages would literally be stripped in half.  Here’s how it would work: if a PM thought interest rates would be stable or rise over time they would purchase the IO portion. Conversely, if the PM felt that interest rates were expected to drop, which would incite a wave of refinancing, they would buy the PO portion at a very deep discount to par (say, 80 cents on the dollar). If this second bet was correct the profit margin could be very handsome since prepayments pay 100 cents on the dollar.  (Rob: Over time, traders devised ways to create synthetic securities from these segregated streams. They combined IO’s with high-interest paying pools of mortgages and PO’s with low-interest mortgages.  Another strategy was to engineer a security from Treasury strips and IO’s from a CMO.)

E.     In the world of MBS, defaults are anticipated.  What ‘subprime’ means is that the security is structured to anticipate that a greater percentage of the pool may default.  This is why CMO deals are over-collateralized. The ‘residual’ holder of a CMO structure puts up pure equity in exchange for a percentage of the ‘residual’ mortgages which remain.  These residuals are rated below investment grade.  This means that if the pool pays off as expected – default rates remain under a certain threshold – the residual owner is compensated at an above-average spread and vice-versa.

F.      The debacle from sub-prime escalated because the residual holders were the banks themselves, or the loan originators (i.e. Countrywide).  As increasing defaults accrued, the protection provided by over-collateralization was exhausted.  So the problem was, indeed, sparked by declining credit quality, but what created systemic shock was the highly concentrated ownership of these residual tranches. Tett’s observation in ‘Fool’s Gold’ is that the problem of BISTRO structures was finding an outside party to assume the ‘residual’ risk. Enter AIG. As Tett showed, the issue became pronounced when an increasing number of banks started keeping the ‘residuals’ on their balance sheet (i.e. in SIV’s), and a few dominant players, such as AIG, stepped in to insure the associated risk.

G.    Given that defaults are already being anticipated in MBS’s – hence over-collateralization – how would real time information significantly alter the valuation process?  It was a known fact that (sub-prime) pools deteriorate.  The subprime problem wasn’t really related to time sensitive information.  It was the unusually sensitive structure of the loans (risk layering through exotic features in addition to weakly positioned consumers made subprime loans vulnerable to external shocks); and it was also a liquidity issue — buyers became unwilling to commit capital to these products.

H.    Consumer credit information in the form of FICO scores are only used at the time of MBS structuring.  As Martha’s work suggests, FICO scores helped MBS become liquid by enabling the credit quality of the borrower to be represented in a capturable and comparable fashion.  That FICOs change as credit behavior changes over time, might add real time element to MBS valuation. But it would also make the variability of FICO visible.  FICO becomes particularly volatile in economic conditions where unemployment and credit line retractions [see previous post] can dramatically affect consumer performance.  Visible variation would potentially erode FICO’s robustness as a secondary market facilitator.

I.       The assumption that real-time information would create some degree of stability anchors itself in the very idea of a self-regulating, self-policing market.  Given the history of CMO’s, it would be inevitable that traders and financial modelers would devise strategies to isolate those portions of the pools experiencing distortions, and create new vehicles to even out risk, just like IO’s and PO’s.  Rather than ‘regulate’ themselves, market participants would simply modify production to capitalize on the the newly traceable volatility implied by enhanced real-time information.

This elaboration of Nassim Taleb’s co-authored FT op-ed yesterday through the work of Andrew Caplin was submitted by Rob Wosnitzer.

Interesting article by Taleb.  While I am not sure who gets credit for the idea, I have heard Andrew Caplin make this proposal.  Caplin has made the argument that banks can swap interest for equity, thereby not so much making them landlords, but partners in the “business” of homeowning; that is to say, similar to when a corporate restructuring occurs: rather than pay bondholders 100 cents on the dollar, corporations will offer bondholders some form of equity ownership (typically senior to common equity, as in warrants or preferred stock) and new bonds, with lower interest rates and different maturities.  So, if that framework is translated, homeowners (the corporation) would putatively offer the bank a deal to take an ownership share (say, 20%) and reduce the interest rate and/or term of the mortgage.  The logic is that if enough homeowners are able to effect this restructuring (or banks are mandated to adopt this), an ostensible recovery will occur in home prices, thereby raising the value of the equity where both bank and homeowner gain value.

Of course, there are other fine details that would have to be clarified — such as triggers (e.g. corporate debt restructurings offer have a trigger to swap back to new debt securities if the company’s equity reaches a set target — so, in order for banks to monetize their ownership of the equity in these homes, they would have to offer some form of refinancing in toto, taking out their equity and reverting back to traditional mortgages; this seems to me to be both the problem and potential of the idea — that is, it solves the short-term problem of foreclosures, while setting up an apparatus that will produce new forms of securitization, default insurance, refinancing packages, and so on that will not so much disrupt the form of home ownership, but refashion it in newer forms of capital distributions).

Here is an excerpt from Caplin’s proposal and here is the link to several other pieces by Caplin addressing the issue.

The form of the renegotiation of under water mortgages that we propose involves debt for equity swaps. Such swaps are common in the corporate sector: for example the recent recapitalization of GMAC and many other lending institutions is based on debt holders agreeing to swap debt for equity in the newly re-organized firm. The rationalization of such a swap is that it replaces the fixed obligation of the debt contract with the more flexible obligation of the equity contract, in which the amount of the ultimate repayment depends on how well the business does. Economic logic dictates that similar forms of debt for equity swap be made available for households that find themselves thrust into problems by forces largely beyond their control. Unfortunately, the institutional realities have hitherto prevented such swaps from being undertaken.

We present a five part plan of action to overcome barriers to rational equity-based renegotiation of existing mortgage contracts. The first stage involves regulators and legislators specifying terms of debt for equity swaps. The second involves their creating an appropriate fiscal and accounting framework. The third involves their setting up projects to demonstrate the economic viability of debt for equity swaps. The fourth involves addressing legal obstacles posed by securitization. The fifth involves the simplification of secondary default for borrowers who swap debt for equity.

Some critical advantages of the plan are:

* It aligns the interests of lenders and borrowers, in that they share costs associated with the fall in house prices, and potential gains associated with their recovery.
* It avoids creating incentives for default or delinquency.
* It respects borrowers’ ability to pay in the short run and the long run to avoid secondary default.
* It bridges the contractual divide that separate borrowers from investors in securitized mortgages. This cannot be left to the household.
* It provides a contractual form that is useful in the long run.
* It encourages owners of mortgages and mortgage backed securities to renegotiate at an earlier stage in the default cycle than they do at present.
* It relies to the maximum extent possible on creative use of regulations to provide incentives for restructuring, greatly reducing costs to taxpayer.

Overall, our plan would greatly speed market normalization, reduce default and foreclosure, increase asset values of holders of mortgage backed securities, all the while costing taxpayers far less now than they will be due later. Moreover it works simultaneously to resolve short run problems and to rectify longer term structural problems of mortgage markets.