Sunday, October 21, 2007 0 comments ++[ CLICK TO COMMENT ]++

Potential Loss of Interest Payments on ABS Securities

One of the huge risks with any ABS investment is the potential loss of interest payments. It's one thing to take some capital loss but if you lose the interest payment then it's just a piece of paper. Here is a good article by Vikas Bajaj of New York Times talking about the potential for the cut-off of interest payments on CDOs. The article gives a good overview of the risks that haven't materialized yet.

For all the pain in the mortgage market, investors who hold bonds backed by risky home loans have continued to receive their monthly interest payments — until now.

Collateralized debt obligations — made up of bonds backed by thousands of subprime home loans — are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own, according to analysts and industry executives.

Cutting off the cash flow, which is governed by rules and mathematical formulas that vary by security, is expected to accelerate in the months ahead.

As the article points out, mortage-backed bonds, CDO instruments, and others, haven't really cut distributions yet. That's why some of them have annualized yields of like 20% right now (The Canadian trust I was looking at, GII.UN, is not paying anything due to the lockup in the ABCP market, but if it were paying distributions, the annualized yield is around 50%(!) right now.) Chasing yields with these things is a risky business. I remember reading Jason Zweig's comment in The Intelligent Investor that investing for yield is like marrying someone for sex. When sex dries up, it's all downhill. If you invest based on yield, and if the yield dries up, it's all downhill.

Some bonds, for example, may go from being valued at, say, 70 cents on the dollar to becoming largely worthless overnight, bankers and analysts say.

Talk about a scary scenario. Going to zero overnight is not something any investor looks forward to...

A majority of the bonds have high credit ratings, and the trustees of the debt obligations typically shut off lower-rated bonds first to accelerate payments to investors holding higher-rated debt.

This is what is confusing about these trusts and open-ended funds that hold CDOs. The ones I have looked at hold a lot of securities, generally 100+, and some are rated AA or better while others are lower quality. It's not clear what the impact on interest payments for those trusts will be. Even if lower quality interest payments are lost, is it worth investing just to get the interest payments on the higher quality holdings? Since none of this is transparent, not to mention the fact that the ratings are unreliable and being revised down on a regular basis, it's difficult to gauge what a realistic yield on these instruments will be.

Yet for all the damage that has already been done, the real stress for investors in these securities lies ahead, industry officials say.

Most mortgage securities have not yet had significant losses, which are only recorded when homes are foreclosed and sold. Up to two years can pass between a borrower’s falling behind on payments and an auction. Each mortgage security has a reservoir of excess cash to draw upon to pay bondholders when borrowers do not make monthly payments.

“As far as the security is concerned, it’s only once the property is effectively sold that a loss is recorded,” said Nicholas Weill, chief credit officer at Moody’s. “The process of foreclosure is a long process. It doesn’t just happen overnight.”

The comments above are not reassuring to me. If I were to invest in these ABS funds or trusts, it would be because I am sure that the worst is behind me or is happening right now. If, as the article suggests, there is a lot of uncertainty for up to two years, I will not find these attractive. There is nothing worse than investing in these things and then waiting two years to see what the value is based on foreclosure rates.


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