Why don't people buy AAA strips at 80c in the dollar? Top five reasons by request

Peter - whoever he may be - but I would like an email - made the following comment:

John,

Do a post of the top five reasons why people aren't buying this stuff. I don't fully believe the we-can't-get-financing argument, or at least I question how important it is here. What are the actual yields at 80 cents on the dollar? The i-banks are financing sales of this stuff, too.

I think there is also fear about fraud, chaos (the servicers can't compile the true delinquency data) and political/legal fears connected to loan-mods etc.

What think you?

Peter is right of course. There are several bits of paper which can't be trusted because the servicing sucks. I once had a big short on MTG - and part of the reason was that they owned C-Bass and its terrible Litton loan servicing business. Litton simply could not keep records of who owed them what.

In the days before Litton blew up I used to speak to consumer lawyers/bankruptcy lawyers about Litton. They would tell me that clients could prove Litton had their money - they had banked checks (cheques if you are an Australian) and Litton would be asserting it was still owed money. Litton was as nasty and reprehensible as they come. You can find out plenty here. And here is a not-atypical story.

Yes Litton/CBass paper - which was "scratch-and-dent" in the first place - could - and probably will default to a 50c in the dollar range.

So yes - some due diligence is required buying the non-standard paper.

But take a look at some companies who are not bankrupt and whose paper is very bad (such as Washington Mutual). Does anyone really believe that WaMus systems are as bad as Litton? How about Countrywide?

Long Beach Mortgage (ie WaMu) sucked as a credit originator - but I suspect they can collect the loans quite effectively.

So reason 1 why people don't buy this paper: the servicing sucks. But not in all instances. You need to be selective. Maybe that is beyond the skill of most people. This should not apply to banks who have to mark their books to market because quite often they control the servicing anyway.

Reason 2 is that there might be legislative change to let people out of their mortgages if sold to them at a predatory level. That is a pretty big statement - and it seems to me unlikely. If it happened then pretty well every bank in America would also go bust. Making the paper accross the board worth less than say 68c in the dollar (12 % credit protection and a 20% discount) just does not seem likely. So I will dismiss that.

Reason 3 is more subtle. Some of these loans will fail now - but at the moment the BBB strips and others are receiving coupons. The money that really should be for the AAA strips is being used to support BBB strips. A legislative change which forces interest holidays or forbearance will keep loans technically current for longer and increase the payments to the BBB strips at the expense of the AAA strips. Given you can buy BBB strips for pennies at the moment if you believed that you should be doing the trade. Its a real possibility and its one I can't discount. I mentioned it obliquely in the original post.

Reason 4 that people are not buying this stuff is that those people with the expertise burnt their wallet out eight months ago at worse prices. I know some people who were very good at assessing scratch-and-dint loans. They still are. But they spent all their money at 85c in the dollar where if they waited they could have purchased the merchandise at 65c in the dollar. They will make a profit - but a small one - and they could have made a motza. They were precisely the sort of people who should be buying now - but can't. I think this is in fact one of the major reasons why this stuff is hard to move. There is so much of it - and the people who do this are either full-up or have problems of their own.

Reason 5: This is the main reason. Its just not that attractive. If you take a AAA strip that originally yielded treasuries plus 30bps. You buy it at 80c in the dollar you will get treasuries plus 30bps times 1.25 for it. Oh, your yield goes from 5 to 6 and a bit. That is not much fun. You will however make back say another 10% over time because the loans will repay at 90c in the dollar and you purchased them for 80c in the dollar. Oh - so you get 8-9% if the loans last five years. And they could last much longer.

That is just not attractive for an unlevered player. I am a sophisticated sort of guy and I want returns above that. Those returns are fine if you can lever them 5 times and borrow at 50bps over treasuries. But try and buy a bunch of distresses mortgage securitisations and lever them 5 times. Can't be done. It used to be easy - but it can't be done now. Leverage is absolutely required at these prices to make the investment attractive.

The prices fall until the yields are attractive enough for an unlevered buyer. That is not me at these prices. It is however me at the right price.

I really think that is the end of the story.

In praise of fraudulent accounts

I wound up having a chat about Barclays with the head banking analyst from a major European broking house. He hit me with the “how is it possible” line about the assets being as miss-marked as I privately think. He talked about auditors and regulators and the like.

I thought that was shockingly naïve – because I am not even sure that miss marking is now the point.

Go back to my first substantive post on this blog. It was about scoping the US mortgage crisis. Seeking Alpha – who I originally sent the column to – changed the heading of this post to imply that the mortgage crisis is not as bad as it seems. (Did they read it?)

Anyway – in that post I note that it is quite common to be able to buy AAA strips of diversified non-standard (but not intentionally subprime) mortgage securitisations for 80c or less on the dollar.

This implies a shocking level of system losses.

In the old days a typical mortgage securitisation had 12 percent “protection” before you got to the AAA strip. For the AAA strip to default you needed something like 30 percent of the loans to default with a loss-given-default (or severity) of 40 percent. This was unthinkable – and so it was considered reasonable that the AAA strips covered 88 percent of the pool. I noted in the first post that for many Alt-A issuers I could not have ex-ante faulted that logic.

Well the unthinkable has happened. There are numerous pools where the defaults will be greater than 30 percent or the severity greater than 40 percent. But it is not obvious that the average non-GSE mortgage will look that bad.

However the market is trading quite a bit worse than that. It is very common to find the AAA strips trading at 80c in the dollar. To lose money on a strip trading at 80c in the dollar you need the losses to be fully 20 percent worse than the above 30 percent of 40 percent scenario.

If 50 percent of the pool defaults and you have a loss given default of 50 percent then you STILL make a profit buying the AAA strip at 80c in the dollar. [Ok – the technically minded will tell you that some of your loot could go to junior strips. But offsetting that you get a high yield in the early periods.]

The meaning of an 80c AAA strip is clear. The market is implying an absolute debacle – something beyond the scope of the really bearish (including me) to contemplate.

I do not think it will happen. I don’t know anyone else who does.

So why does the market keep pricing the AAA strips at 80c? Well I explain in the first post – but it really comes down to “you can’t borrow to buy this paper any more”. The deleveraging will stop when the assets are patently attractive to unlevered buyers – and they are not there yet.

Meanwhile the market seems to imply something that looks insane to me. The market is implying that more than 50 percent of diversified mortgages (not originally deliberately subprime – but not GSE suitable) will default at a severity greater than 50 percent.

So what is the implication of mark-to-market accounting?

Above I argue that the market is insane. It’s a dangerous thing to argue – but I argued the market was insane when subprime mortgages were trading at 101c in the dollar because they had high yields. And I will argue it now when securitisation paper is trading as if losses across the whole US will be greater than 50 percent of 50 percent.

It was insane (but technically correct) for investment banks to mark their book to market when the price of a subprime mortgage was 101. If you believed those accounts you would take on lots of risk and declare immediate profits. Anyone who managed their business as if that was a permanent state is now bankrupt.

It is similarly insane (but technically correct) for anyone subject to fair value accounting to mark a levered book to the current implied market default rate for mortgages.

The market was wrong then and it is wrong now. But fair value accounting required mark to insanity then and similarly requires it now.

If you do mark to the current insanity and you have a lot of mortgages your accounts will show you as breathtakingly insolvent.

So what do you do? Reclassify the assets as level three and mark them to model. It is technically fraud to do this when the assets can be priced – but no more wrong in my opinion than valuing the subprime mortgage at 101 in the first place.

The most obvious such example is Freddie Mac putting over 150 billion of its assets in the level three bucket. Almost all of those assets have a market. It is just that Freddie Mac (justifiably) doesn’t like the price and so marks-to-something-other-than-fair-value.

But it is not just Freddie Mac who is in this position. Everybody with a substantial list of stressed financial assets is. And everybody marks to model. And the models bear little resemblance to fair value as defined in accounting standards.

But if the model makes reasonable probability weighted estimates of the present value of what you will receive in cash on the asset then I can live with the mark-to-model (fraudulent as it is). In fact I will defend it – hence the title of this post.

Unfortunately there is a problem. Once you have decided to commit fraud (as I believe almost every financial institution has) then you might find yourself “in for a penny, in for a pound”. Having decided that you do not want to mark to “fair value” it is not far to decide that you want to mark to total myth. For instance you might (rationally) decide that it is not sensible to mark the mortgage to a 50 percent default and 50 percent severity. But that is no excuse to marking it to a 3 percent default and 15 percent severity. In for a penny…

The level three decision made by Freddie Mac is fraud. They can find a fair arms length value and they chose not to do so. But it is a reasonable fraud – and it is in the interests of Freddie Mac, its shareholders, probably its creditors and certainly its regulators. The accountants are happy to sign off on it too. I wish I knew what reality was and how far from reality Freddie’s models are. I don’t – and so I will not be buying Freddie Mac stock.

Freddie’s fraud is the same fraud committed by everyone who has a substantial amount of financial assets to mark to models.

So how to assess a financial institution?

Having decided that almost all financial institutions are fraudulent the question for a long or a short-seller is not is there fraud or not (as per my European banking analyst). The question is “how much fraud – and just how bad is the book really”.

This is a real problem. Whilst I do not think that the mortgages will have a worse than 50 of 50 outcome – I do believe that it will be worse than 30 of 40 in a wide range of circumstances.

Every one (reasonably) decided to ignore the illiquid markets. Here are a couple of places where they have degenerated into unreasonable myth:

• Barclays manages to produce almost no losing trading days.

• Royal Bank of Scotland has 10 billion dollars of second lien mortgages in the Midwest on which their provisions imply an almost zero loss rate and where the secondary market is way less than 40c in the dollar and where the house prices have fallen to zero.

• Barclays had some private equity loans that they originally intended to originate-and-sell. They are stuck with them. They are stretched. The model prices remain in the high 90s where the companies are cash-stretched right now.

I could go on. These are by no means the atypical myths.

• I crossed the bridge ages ago when I decided that financial institutions mark to things that don’t look like reality at all. (My UK banking analyst friend has not got there yet. That seems to me to be a willing suspension of disbelief.)

• I crossed the bridge this year when I decided that the fraud was OK. I know my morals have slipped. But I will say it again. Some fraud is fair and reasonable.

• I have also decided that you need to grade the fraud from “white lie” to “mark to hope” to “mark a myth so far from obvious reality it is comic”.

David Einhorn in his latest book demonstrates Allied Capital does a lot of marking to a myth so far from reality it is comic. Reading his book is great fun (though living it would have been somewhat rougher).

Unfortunately I think that mark to comic myth is becoming the norm for UK banks as well. The main problem is that the UK banks are much more levered than Allied Capital. Mark-to-myth at 40-50 times leverage is a recipe for tragedy.

Post note: In this post I say a few things that are dangerous - and which I do not believe except within the narrow context of other financial institutions (not me). For instance I say "some fraud is fair and reasoable". I wish never to be quoted out of context.