Category / ABS

Conditional pass through covered bonds October 28, 2013 at 7:08 pm

NIBC has launched a variant on the covered bond which has an interesting structure. This conditional pass through changes what happens if the issuer defaults. Then, if liquidity in the asset pool is insufficient to redeem the bond, and the pools fails an am test (i.e. the pool would not be sufficient to redeem the bond if sold), and creditors agree, then cash flows from the pool pass straight to bond holders, with maturity extension if need be. This avoids forced sale risk on the collateral pool, and is rather neat.

The student debt bubble September 6, 2013 at 11:42 am

An interesting fact courtesy of the American Enterprise Institute (HT FT Alphaville): total US student debt has now exceeded a trillion dollars, and is larger than both US credit card debt and auto loan debt. The usual rules about things going up apply.

A few interesting links July 22, 2013 at 10:55 am

  • Izzy on the impact of the Basel leverage proposals on US repo, here.
  • Matt Levine on double standards in treasury losses, here.
  • Red Jahncke on size vs. complexity in TBTF breakups, here.
  • A timely reminder from the bond vigilantes on the impact of interest diversion triggers in RMBS, here.

Happy reading.

The ECB attempts to revive the European ABS market July 18, 2013 at 12:26 pm

The ECB is reducing the haircut on ABS to 10 percent from 16 percent. At the same time, it is tightening rules for retained covered bonds so the total effect on eligible collateral will be “overall neutral,” it claims. In particular they are targeting SME-backed ABS:

The ECB will continue to investigate how to catalyse recent initiatives by European institutions to improve funding conditions for Small and Medium-sized Enterprises (SMEs), in particular as regards the possible acceptance of SME linked ABS guaranteed mezzanine tranches as Eurosystem collateral in line with established guarantee policies.

This is deeply unfair, but given the quality of the song, I can’t resist ending with:

People cause crises (incentive structure edition) April 30, 2012 at 2:19 pm

Lisa Pollack has an interesting, if rather too fair minded post on Alphaville about the dubious claim that the Black-Scholes formula somehow caused the crisis.

Let’s be clear. Black-Scholes is about options pricing, and hedging in particular. It has nothing to do with securitization, and little with tranching. So the claim that Black-Scholes caused the crisis is BS.

There is a boarder claim that somehow mathematical finance in general – and risk models in particular – were to blame. Certainly many VAR models under-estimated risk before the crisis, while some models of tranches were response for assigning great ratings to assets that didn’t perform well. But no model went out on a wet Wednesday about bought fifty billion of sub-prime ABS. A trader did that. Blame them, and the incentive structure in their firm that encouraged them.

In praise of things that are always what you think they are January 8, 2012 at 7:26 am

A major cause of systemic risk in the financial system is things that are mostly one thing, but occasionally another. Unlike Gremlins – where you are safe provided you don’t get them wet* – these things change without your intervention. Euro-periphery government bonds are one example; AAA RMBS during the crisis are another.

These things are dangerous precisely because you are lulled into thinking that they are always safe, when in fact they mostly are. A shortage of things that are always safe, plus perhaps a touch of greed, causes folks to buy the almost-safes. And we all know how that ends: a flight to (genuine) quality and contagion as investors exit all assets that might even possibly be risky.

There are two reactions to this. FT alphaville nicely sets out the positions in relation to uninsured bank deposits. You can say folks should grow up, and understand the risk; or you can say the risk ought to be removed. For me, the ‘grow up’ position is naïve. Just saying people should not be mistaken solves nothing. At least the ‘do something’ school (represented by Amar Bhidé) recognises the risk that investors will fail to recognise the risk, then flee when bad things happen. If those same investors are forced to pay now for the protection they will need later, maybe stability is enhanced.

Now, of course, there are lots of issues with this, and lots of potential to get the design of the solution wrong. But just throwing your hands up in the air and saying people should be smarter – well, that’s as dumb as a fish trying to swim up Kingston Falls.

(For a further discussion of the importance of genuinely safe assets, see here.)

* Or feed them after midnight, or expose them to sunlight.

Do we need informationally insensitive debt? April 17, 2011 at 5:22 pm

Yes we do. Felix Salmon is wrong. Let me explain.

First, what is informationally insensitive debt?

financial assets which (normally) don’t change in price when new information about them emerges

That’s not a good definition, actually, as there are no assets (apart from cash) which satisfy it. But it hints at a more useful definition, namely an asset whose credit spread does not change when more information about its issuer becomes available. A good example is a government bond from a genuinely AAA issuer. (See here for a longer discussion from Gary Gorton where he mentions the content of a CDS spread and conjectures that the universe of informationally insensitive assets has declined thanks to CDS trading.)

Now, Felix thinks assets like this are a bad idea because “bankers and other financial innovators the world over have every incentive to structure products which turn risky assets into informationally-insensitive debt“. These then “cause crises“.

I see it entirely the other way. The absence of enough genuinely informationally insensitive assets caused a demand which was met by the creation of almost, but not quite informationally insensitive ones, namely AAA-rated ABS. There is a massive demand for informationally insensitive assets, notably from those with low risk tolerance. We need more of them, as I suggested in my posts on policy on the asset side. Indeed, as Matt Yglesias says:

we need to do something—like maintain the existence of a large pool of federal debt—to make sure that the world has the quantity of information-insensitive debt it needs to continue routine operation.

More on the CDO of ABS possible Ponzi May 11, 2010 at 6:06 am

A little while ago I speculated on a possible Ponzi scheme (in fact if not in intention) in pre Crunch CDOs of ABS. The basic idea is that there was a false market in subprime RMBS tranches if there were no real bids, or few real bids, for mezz tranches other than other CDOs.

Bloomberg now leaps into the debate with an article How Wing Chau Helped Neo Default in Merrill CDOs Under SEC View. The key part:

“People on the outside thought the market was going gangbusters because of all the deals getting done,” said Gene Phillips, director of PF2 Securities Evaluations, a New York- based company that helps banks and funds evaluate CDOs. “People on the inside knew this [i.e. the CDO-squared and managed CDO business] was a last-gasp attempt to clear out the warehouses”…

Interactions across the industry among bankers, asset managers, ratings firms and lawyers contributed to what Lang Gibson, head of CDO research at Merrill until early 2008, called a “Ponzi scheme” of CDOs buying other CDOs.

Who is liable if neither of you understand the trade? January 26, 2010 at 8:59 am

Broken

At Jack on tap we find:

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle… Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does.

(Hat tip FT alphaville.)

This all seems reasonable (and comes with the usual I-am-not-a-lawyer-indeed-I-don’t-even-know-how-to-cook-one disclaimer). And undoubtedly there are many instances of devious, scheming bankers selling products they knew (or strongly suspected) were toxic to naive investors, including naive professional investors. The industry short hand in some quarters used to be `Belgian pension fund’, meaning any sleepy, ill-informed party who had the authority to enter into transactions they could not price and might well not have understood the risks of. If some people had something they really couldn’t sell to the cognoscenti, they found a Belgian pension fund.

CDOs of ABS, however, are a slightly different story, at least in some cases. These were products that neither buyer nor seller understood. In many cases both parties used the same flawed model to analyse the product; both parties failed to dig deeply into the underlying collateral; both parties did not think through the consequences of the forms of credit enhancement present*. It suits the current mood to blame the industry – or just Goldman Sachs if you prefer – for knowingly blowing investors up. But the truth is rather more complex. I doubt that this will ever come out. The `we didn’t understand it either’ defence might work against a claim of fraud or misrepresentation, but it does rather open the door to a case of failure of due diligence…

* A good example is the use of excess spread accounts. These work as credit enhancement providing defaults happen late enough in the life of the structure. If they happen early, however, as in most of the 2006 and 2007 vintage CDOs of ABS, they are useless.

How Ponzi were CDOs of ABS? January 19, 2010 at 9:58 am

There has been much incendiary and ill-informed comment on the ‘shadow banking system’ and Wall Street as ‘a giant Ponzi scheme’. As always in the aftermath of a crisis, hyperbole is not in short supply. Still, there is one sense in which a limited version of this claim might be true: the business of making CDOs of ABS could have been a form of Ponzi scheme. Here’s how.

Note that there are three types of tranche in a CDO: senior, mezz, and junior. One main reason for making a CDO in the pre Crunch period was to create AAA-rated senior securities. Lots of people wanted to buy these, so distributing them was not a problem. (Of course, these securities turned out to much more dangerous than many people thought, but that is not the point: in 2003-07 selling AAA ABS tranches was not a problem.)

The junior was typically retained by the originator; if it wasn’t, there were plenty of (mostly hedge fund) buyers. So that was not a problem either.

In order to have a real transfer, and to convince their risk managers that they really had sold the CDO, the makers of CDOs of ABS had to sell the mezz too. This was a lot more problematic. The ratings were not AAA; the yields were not that attractive (often high tens or low hundreds of bps for risk in the low investment grade or high junk area); and buyers knew that there was risk in these tranches.

So what might some banks have done? One answer could have been to set up (or find) friendly asset managers to buy the mezz. Remember, in managed CDOs the asset manager has considerable discretion about which collateral to buy. If you could find a supposedly independent third party who you could somehow persuade to buy your mezz – perhaps because you had provided them with support somehow – then you could claim that you had sold the whole CDO, and you would be allowed to make another one.

This would be a kind of Ponzi scheme if the originator was covertly financing the mezz purchaser, or otherwise providing sufficient support that the mezz purchase was not a free market transaction. It would mean that CDO tranches prices were not the result of willing buyers interacting with willing sellers, but rather connected buyers taking subsidies for being seen to buy known rubbish. These prices in turn would then support the AAA pricing: after all if the As were seen to be trading at 80 over, it made 15bps for the AAAs seem reasonable.

What do we learn from this hypothetical? Simply that if you want to understand what happened in the CDO of ABS market in the run up to the Crunch, the question ‘who bought the mezz and why?’ is particularly relevant.

Monoline sues bank: home owners wonder if they can boo both sides December 17, 2009 at 6:59 am

MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Tranche discount factors October 7, 2009 at 9:40 am

In the bad mad days of 2005 and 2006, some people valued ABS by estimating the future cashflows and then discounting them back at Libor flat. In situations with significant prepayment risk, they might well have option adjusted this value to account for interest rate convexity based on some prepayment model.

That process does not produce values that are market consistent these days. The reason is there is compensation in the spread of an ABS for features other than default and interest rate optionality. These other factors include current liquidity risk, potential future liquidity risk, funding cost (remember you cannot necessarily repo an ABS), and the volatility of both the mark to market of the asset and its capital requirements. (The last two can just be thought of as a convexity adjustment for the volatility of EL and UL.)

The market handles this ‘problem’ rather crudely. The convention is to discount tranche cashflows at a rate higher than Libor. Thus for instance one might recover the market price of a AAA tranche by discounting at Libor plus sixty, while a BB tranche might have to be discounted at Libor plus six hundred to get the right price.

These higher rates solve the problem at the expense of introducing an arbitrary step much like the use of implied volatility to recover market prices for options using the Black-Scholes formula. Just as options dealers think in terms of implied vol without for a moment believing that the underlying follows a diffusion, so ABS traders think in terms of these discount factors without believing that they are anything more than an ad hoc market adjustment. Clearly we still have a long way to go in being able to price ABS based on fundamental factors.

Well that went well I think July 18, 2009 at 7:07 pm

From Wells Fargo via Creditflux:

In their latest research report, Wells Fargo (formerly Wachovia) analysts calculate that 360 CDO of ABS have now triggered an event of default – up from 343 last month. At $351.6 billion, the notional value of these deals accounts for just over half of all CDOs of ABS.

Understanding ABS July 10, 2009 at 9:10 am

The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:

It’s important for people to realize that the credit crunch was not caused by securitization — it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.

It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.

Another key issue is that people didn’t – and to some extent still don’t – understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.

AAA to A3 check, 2/3 A3 to AAA mate July 9, 2009 at 6:14 am

Sorry, I couldn’t resist the bastard cross of chess and bond ratings. Let me explain. Once upon a time there was a leveraged loan CDO arranged by Goldman called Greywolf. Greywolf, which sounds like a monster who wants to gobble up your money, was in fact a monster who wanted to gobble up your money. In the fullness of time, the AAA tranche was downgraded to A-, or A3 in Moody’s speak. Now, according to Bloomberg, Morgan Stanley is doing the Re-REMIC (aka CDO-squared) trick on the Greywolf AAAs. That is, they are buying the AAAs into a SPV and issuing two tranches of notes on the other side, a CDO-squared structure. Bloomberg suggests the tranching is roughly two of AAA to one of Baa2.

My only question, really, is if these new bonds are downgraded too, will someone else step in and ReRe-Remic them?

20% June 30, 2009 at 5:55 am

No, not my standard broker’s commission, but the average level of credit enhancement in CMBS before 2003. FT alphaville, commenting on the forthcoming tsunami of CMBS downgrades, reprints this enlightening table from S&P:

US Credit Enhancement by Vintage

This very clearly shows how investors let their standards slip in the hurt for yield during the Boom years. Not everyone was convinced though: from 2004 the practice of splitting the AAA into two or more tranches became commonplace. The top tranche, amusingly, is called super duper AAA.

S&P want at least 19% credit enhancement for AAA going forward. At least this is generating a nice repack business as banks take junior AAAs and resecuritise to keep most of the notional at AAA. The Americans call this a Re-Remic* — which isn’t nearly as cool sounding as super duper AAA.

* Real estate mortgage investment conduit, or CDO-squared to its friends.

The Amherst Trade June 16, 2009 at 6:15 am

This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a ‘daring’ CDS trade by Amherst Holdings. I didn’t comment on it at first as I didn’t understand the trade from the initial news items, but I now think it is possible to work out what’s going on.

Let’s start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let’s say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let’s suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst’s trade work*.

Now, here’s the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds – $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It’s just that this time, that party wasn’t an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection — and in particular naked shorts — should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst’s long vs. the cash would have been obvious thanks to trade reporting. Personally I don’t particularly feel the need to help the CDS trading desks of investment banks, mind you.

Wot no TALF? June 5, 2009 at 10:00 am

I have been surprised at the slow takeup of the TALF. It looked to me like a license to print money. As Zero Hedge points out, less than $30B has been allocated to a program with a trillion dollar capacity.

Part of my surprise is that to be eligible for the TALF (at the moment at least – this will probably change) a security needs to be AAA rated. And S&P are on the downgrade war path. As Calculated Risk reports, quoting S&P, approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages [of CMBS}, respectively, may be downgraded. So you would have thought that people would have rushed to throw things into the TALF before they became ineligible.

Bloomberg suggests that the TALF, and its brother the PPIP, is stalling. They seem to have a point.

The pain in Spain… May 17, 2009 at 10:04 pm

Spanish RMBS delinquencies

…as the FT says, will be felt mostly by the banksWhat is interesting about this is how vintage insensitive it is. In the US, there is a world of difference between the 2005s and the 2007s: in Spain, not so much.

Update. Downgrades loom for the Spanish banks as an interest diversion test is tripped on a Caja Madrid RMBS.

When you want to come bottom of the list May 13, 2009 at 7:58 pm

Brick Lane Ruin

Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages… In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman — but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.