The study out of Harvard and Princeton arguing against the official story line about firesales underpricing toxic assets is now coming under fire from those who think the authors are too pessimistic about asset values.
Megan McArdle at the Atlantic’s Business blog raises two objections.
- If toxic assets aren’t underpriced, we’re all in “big, big, BIG trouble.”
- The market prices for toxic assets don’t reflect reasonable expectations of cash flows.
Her first objection isn’t really so much an argument as a lament. The correct response is simply: Yes. We are in big trouble. Some of our big money centre banks are insolvent. But just because something is very bad news doesn’t mean it isn’t true.
The second objection is more substantive. We hear a different version of it all the time: real estate isn’t going to zero, so therefore securities backed by real estate can’t go to zero. This makes sense only if you don’t really understand how complex the collateralized debt market got during the boom years. Because once you understand this, it’s pretty obvious that even though most mortgages will continue to perform, lots of real-estate based assets held by banks can go to zero.
How To Make An Asset Backed Security
Let’s ilustrate this with an example of an asset backed security built on home loans. (We’re borrowing the example from the excellent Acrued Interest blog.) These weren’t exotic credit products. In fact, for most of the years building up to the crash, HEL ABS (as they were known in the business) was the dominant credit product. In 2005, something like $400 billion were issued. At the time, JP Morgan Chase was urging clients to buy this stuff by saying the pricing was “cheap” because of “irrational fears” over a housing bubble.
So let’s say our imaginary bank, CitiMorganAmerica, decides it wants to sell HEL ABS built from mortgages with $100 million face value. One of the first things it does is cut this up into tranches to reflect the risk and price points of various customers. For simplicities sake, we’ll just pretend that there are only three tranches. (In reality, there could be dozens of tranches).
- Senior: 5.75% coupon, $80 million
- Mezzanine: 6.50% coupon, $15 million
- Subordinate: 8.00% coupon, $5 million
The reason the lower tranches get bigger coupons is that they are riskier. They only receive interest payments after the tranche above them have received all interst payments they are due. Each tranche below senior receives principal payments only when the tranche above them has been full paid off. Any short fall hits the lowest level first.
Here’s where things start to get scary. If just 5% of the mortgages in that HEL ABS default, the subordinate tranche is worth zero. We’re just about at 5% national default rate for all mortgages right now. Default rates on more recent mortgages are even higher. Fortunately, the ratings agencies were pretty good about this level of stuff so the Mezz and Sub investors knew they were getting riskier products, and only the senior deal would be rated AAA.
How To Make A CDO
Now lets see what happens when we build a CDO on these types of deals. CitiMorgan America takes $1 billion and buys the Mezz and Sub tranches of 50 HEL ABS deals that are built just like this. It slices up the CDO just like it did the earlier deal.
- Senior: 5.45% coupon, $800 million
- Mezz: 6.00% coupon, $120 million
- Sub: 8.00% coupon, $40 million
- Equity: $40 million
These pay out just like the ABS, a waterfall filling up each bucket before anything gets paid to the next level down. The top tranche of this CDO can be rated AAA even though it is built out of already subordinated debt. You see, even though it is technically subordinated debt, there are so many underlying mortgages spread out across the country that the odds of systemic defaults materially affecting the cash flow would have been viewed very remote. After all, what are the odds that defaults will suddenly tick up all around the country?
How To Lose Your Shirt
See the problem? Here you have $1 billion of assets that can be devastated by a small increase in the default rate. If defaults climb to just 5% for the underlying mortgages, the cash flows will drop 25% as the portion of the CDO built from the Sub HEL ABS stops paying. Everything but the senior portion of the CDO gets wiped out.
If the losses on the mortgages rise to just 10%–high defaults from those bubble years from 2005, lower than expected recovery rates from foreclosures on houses with falling values, cram downs–even the most senior piece will lose 30% of its value.
In short, structured debt can rapidly decline in value even though the underlying assets don’t decline as much. The benchmark index of the market for securities backed by home loans shows that the AAA tranches for deals made in 2007 are valued at about 23% of their original value. The lower tranches show losses greater than 97%. Some of this may no doubt reflect a bit of irrational fear and illiquidity. But claiming the overwhelming majority of these losses aren’t real is just wishful thinking.
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