Delaware Investments Holds Housing Mortgages

[powayseller]

We’ve wondered here who holds the mortgage backed asset backed securities, and why they are so desireable. As foreclosures are rising, I expected investor appetite for this debt is decline, yet the opposite is occuring. Investors are gobbling up this debt as fast as they can, giving lenders more reason to reduce their underwriting guidelines further. After all, if you have a ready customer, why would you stop manufacturing your product?

This reminds me of cigarette manufacturers: it’s legal, people want it and pay for it, so what difference does it make if it kills you? So until the government cracks down, both cigarettes and option loans will be sold and kill your physical and financial health in the future.

One mutual fund company buying this debt, rated AAA, is Delaware Investments Fixed Income Fund. Packaged into tranches, believe it or not, rated AAA, they take up about 1/4 of this fund’s portfolio.

Check out your parents’ and grandparents’ fixed income fund holdings. Look for the words asset backed security, mortgage backed security, or collateralized mortgage obligations, or their acronyms: ABS, MBS, or CMO. We don’t want grandma and grandpa to lose part of their principal in a fund like Delaware.

Although the MBS is paying a high yield, or so I thought, the fund is already down 5% YTD. Why would anyone be in a fund like this, when they can 5.5% in a CD? I thought at least a fund like this offers a high yield.

Here is the Reuters story.
Option ARMS Still Favored By Lenders Amid Scrutiny

“Residential loans that have raised eyebrows at the Federal Reserve and other regulators are increasing in popularity with lenders as a way to buoy profits in a shrinking market.

So-called payment-option adjustable-rate mortgages have become popular in the $10 trillion U.S. home-loan market as borrowers facing high prices try to lower early payments at the risk of later payment shocks. The demand has delighted lenders, who have found the loans are coveted assets on Wall Street, where their prices top those on many other kinds of loans…..

In AAA and AA-rated portions of pay-option ARM securities, “you will be compensated enough, especially in comparison with alternate investment opportunities,” said Alex Wei, who manages asset- and mortgage-backed bonds at Delaware Investments in Philadelphia.”
UNQUOTE

Does it seem possible that these loans which we’ve discussed as so risky, are actually rated AAA and AA? How is this remotely possible? Either I don’t understand financial risk layering, or something is totally amiss.

Just so we all know how widely held and traded this debt is, let PIMCO’s website explain:

“MBS are the Largest Segment of the U.S. Bond Market
With $5.6 trillion in mortgage-related debt outstanding as of June 30, 2005, mortgages are the largest segment of the U.S. bond market, accounting for 22.9% of all bond market debt outstanding, according to estimates by the Bond Market Association. For comparison, corporate bonds account for 20.4% of the market, and Treasury debt accounts for another 16.3%.

Mortgages are also among the most actively traded securities in the U.S. bond market. Primary dealers-the large banks authorized to deal directly with the Federal Reserve-traded on average more than $260 billion per day of agency MBS in 2005, according to data from the Bond Market Association and New York Federal Reserve Bank. For comparison, primary dealers traded about $20 billion per day of corporate bonds with maturities of more than one year in 2005.”

[Daniel]

Powayseller,

A lot of the MBS paper is of pretty good quality. I know, there are a lot of risky mortgages around, with “foreclosure” written all over, but that’s the exception, not the rule. Let’s put things in perspective: if 5 out of 100 outstanding mortgages default, that would be the equivalent of “blood in the streets”. Complete crash and panic. Imagine 1 out of 20 houses in foreclosure. Really bad. But for the MBS holders, it may be not pretty, but not a disaster. They still get paid interest on 95% of their holdings, and the 5% that default won’t be a total loss (they unload the REOs, and still get something for them). If the interest rate they are paid is high enough, they might turn a profit even with 5% of hodings in default. Also, keep in mind that when these things are packaged into MBSs, they spred the risk not only over many borrowers, but over many markets, too.

Now for the bond ratings, yes, a lot of them can be AAA. Why not? Move-up buyers usually have both good credit and substantial equity from the sale of their home. Even in the worst of crashes, the rate of default in many segments of the market will be very low.

Now, there’s also subprime paper, where there is a large concentration of risky loand made to first-time buyers. That is likely to get hit much harder. Obviously, that is not rated anywhere near AAA.

As a final disclaimer, I don’t own any MBS paper (neither high-rated nor sub-prime), and I don’t recommend it either. Chances are, the returns on both will be lousy going forward, although I don’t think anybody will be losing their shirts on high-rated MBSs.

[technovelist]

One point that seems to be overlooked here is that at least some “AAA” rated securities are rated that highly only because of the “insurance” that is sold by insurance companies such as MBIA and MGIC. Those insurance companies have “guaranteed” debt amounting to more than 100 times their capital, so if they have even a few big losses, they will be insolvent. This will immediately lower the ratings on the “guaranteed” bonds they have “insured” to their underlying ratings, which are usually much worse. This will in turn cause a cascade of selling by mutual funds that can’t hold low-rated debt.

I don’t know if this applies to the specific funds you are referring to here, but the very possibility of such a disaster is enough for me to have already made sure that my mother doesn’t have any “asset-backed” securities in her portfolio.

[sdrebear]

Just a thought, and I could be completely missing something, but before the past two years, these Option-ARM’s had an excellent performance history. Primarily, because they were only used by financially secure “investor types” who were only using them to increase the leverage of their cash. These types of people NEVER went into default as they did have the money to cover the loan and resets never truly affected them.

So, the track record on these loans don’t look scary at all. These loans have NEVER been tested on the general public like they have lately. I’m quite sure those ratings will change when the new numbers start to filter in.

[powayseller]

daniel and technovelist, you guys know a lot more about this than I do. Can you write more about how these products are packaged and insured, why investors are gobbing them up without demanding a risk premium, and how a possible financial sytemic crisis (FDIC and Greenspan’s words) is related to issuance of this debt?

sdrebear, I think you are right. GoldenWest was a big seller of OptionARMS in the last RE cycle, and they made money through the entire downturn. This cycle, they started lending heavily to subprime borrowers, but said, “We manage our risk well. Look, we didn’t lose anything in the last downturn”. They forgot to complete the sentence, “because at that time we made option loans only to high FICO borrowers, but we are scared to death of our portfolio at this time, so we are selling out entire bank to Wachovia. Wish you good luck with that, Wachovia,hahahahahahahahahahahah”. The Sandlers got the last laugh, and Earnest Rady was the bigger fool.

By the way, Rady was a sponsor of the UCLA Anderson Forecast conference in San Diego, you know, the one where Thornerbg is not allowed to mention exotic lending in their forecasts. A connection, or coincidence?

[tickets]

The article says these are AAA and AA TRANCHES. It doesn’t say they are holding the whole mortgage, just the safest tranche.

[Anonymous]

I haven’t followed Golden West (World Savings) very closely over the years but I would imagine that the Sandlers are/were looking to the sale as part of their exit strategy in anticipation of retirement. World has, as far as I know, always had a great reputation and has been known as more of a “property lender” than so much a “credit lender.” That is, they have placed more importance on the value of the property and the loan-to-value than the credit history of the borrower(s). It seems like a strategy that has worked well for them.

Who is to say, perhaps the Sandlers are also looking forward and believe property values are precarious and now would be a good time to “hit the silk.”

[powayseller]

tickets, how do you turn one mortgage into layers of various credit ratings? How can a $400K mortgage be broken into a $100K AAA MBS, a $100K AA MBS, a $100K C MBS and a $100K D rated MBS? These are just numbers I’m making up. Who buys the C and D tranches? Who insures them, who pays for the insurance, and who will be left holding the back when the mortgage isn’t paid? If the owner is upside down, who pays off the MBS? I suppose the upper levels get paid off first.

[Anonymous]

powayseller, I will also be interested in tickets’ response. I know there are infinite ways to construct derivatives to underlying securities, including ones that act like mortgage insurance. What I can’t understand is how there would be sufficient return from the security to allow returns from all the tranches from some of these mortgage products, unless the risk is (to me) being underpriced. I’d also like a referral to a site that talks about rating factors for mbs. Does no-doc originating status affect the rating? What’s the differential for a (junior) purchase second? Do recourse and non-recourse loans carry different risk factors, and when this is a legal issue did it affect the price of mortages in the relevant jurisdictions? What kind of bundling is being allowed in AAA and AA mortgages? Does this mean that low-risk borrowers are subsidizing higher risk borrowers?

In addition to questions of personal investment: if the reversal becomes as severe as pessimists believe, where the money is lost (and by whom) will dictate the shape of the government bailout, if any, and it would be useful to anticipate that.

[tickets]

Take 10 mortgages, each with a balance of $200,000. Put them together into a $2 million MBS. Turn the MBS into 3 tranches, a senior tranche that gets paid the first $1 million, a mezzanine tranche that gets paid the next $500,000, and a Z-tranche (often known in the business as toxic waste). So long as less than half of those 10 mortgages go bad, the senior tranche collects everything. The mezzanine tranche then starts to collect, and is OK so long as at least 8 of the 10 mortgages are good. The Z tranche is risky as hell.

To get a AAA rating on a mezzanine tranche is almost impossible, and on a Z tranche literally impossible. To get a AAA on a senior tranche the rating agencies look at how much of the MBS has been subordinated (50% is VERY good, 10% is not so good), on the loan-to-value distributions and credit scores of the underlying loans, and on the insurance. Insurance is of 2 types – the standard private mortage insurance that comes from PMI, GE, Radian, etc., and pool insurance that comes from bond market isurers. A pool of all 80% or less LTV fixed rate mortgages with FICO scores over 680 may require very little subordination to get a AAA (it will require some), a pool of 95% subprimes with option arms may require 50% subordination and pool insurance to get a AAA.

[tickets]

standard and poors, moodys, and fitch all have newsletters on their websites that discuss MBS ratings. No doc definitely changes the risk status. I don’t know about recourse status. But my guess is that that shows up in servicing prices. One thing I didn’t’ go into, in part because I’m a little hazy on it myself, is recoveries from defaulted loans. Not sure what you mean about “bundling” but I don’t see any obvious reason for subsidies to flow between low and high risk borrowers.

MBS is sliced and diced into tranches in thousands of different ways. I don’t know if this is still true, but at one time the Z tranche in the subprime world was fairly small and usually held by the originator, who treated it as more or less a lottery ticket (it probably will pay next to nothing, but if times are really good ….). Don’t know if this is still the case, or if Z tranches are getting sold now. The big loser if things go south in the way of a usual cycle is the mezzanine tranche holder, and the insurer. If things go way south, then the holders of the senior tranches get hit. The $64 Billion question is “who holds all these mezzanine tranches?” No one seems to know for sure, but everyone seems to think it’s hedge funds. Probably only the hedge funds and the investment banks know for sure.

Just like no one seems to know who owns this stuff, no one seems to know what kind of return they are getting. But people have made a lot of money for decades on junk bonds. If you get a big enough interest rate you can suck up a lot of losses.

[Anonymous]

Tickets –

Thank you. That was excellent info – will cruise the rating sites you mention to see what else can be gleaned from there. Am still curious what the actual spreads are on the tranches and suspect somebody may be underpricing risk. Appreciate your multiplying the proverbial 64,000 dollar question by a million, but believe we’re still off by more than an order of magnitude.

[powayseller]

tickets, how did you learn about MBS structuring? Why is this topic so shrouded in mystery?

“If you get a big enough interest rate you can suck up a lot of losses”. – Are they demanding a risk premium large enough for the exposure they are taking on?

Overall, the bundling sounds really safe for the AAA paper. You’d need more than half to go into foreclosure to have a hit to the principal. That seems unlikely even to a bear like me. So I was wrong about the Delware Investment Fund’s Fixed Income fund being risky.

[tickets]

powayseller

I’m a jack of all trades, and master of none. Worked for a few years doing mortgage insurance modeling, a couple of years doing secondary market stuff, a couple of years doing commercial stuff. That’s why I have a pretty good feel for how subprime MBS was structured before the current boom, but don’t claim to have more than a hazy guess about how it’s structured currently. Does mean I keep up with the industry rags, National Mortgage News, Inside Mortgage Finance, etc.

The numbers I posted were for illustration only. Don’t make your financial decisions off of those – do the research. But when I was playing with Standard and Poors Levels software a few years ago I know that a portfolio of loans with even a few blemishes needed a lot of support to get AAA. A normal sort of prime pool, with FICOs in the high 600s and above and 70%-90% LTV (over 80% with insurance) started as a BBB, or maybe a single A if the scores were really good, until you added enhancements like subordination and pool insurance.

MBS structure is no great mystery. The rating agencies talk about it on their websites. Any good university library will have a copy of Fabozzi’s (one b or two in Fabozzi, I don’t remember) Handbook of Mortgage Backed Securities. It’s the reference, but like any other book in a market that moves this fast, it’s a couple of years out of date by the time the latest edition hits the shelves. But in a country where most college students have a hard time calculating percentages, a book focused on probability and integral calculus will not be a big seller.

[tickets]

Gotta say I’m not happy with how the previous reply was Titled!

[Author]

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