Subprime Mortgage Debt Investing 101

I ran across an excellent article by Allan Sloan of Fortune (Oct 16 2007) on the workings of a subprime mortgage debt instrument. Anyone contemplating investing in closed-end funds and trusts that hold mortgage debt of any sort should read the article. What I quote below does not do justice to the article. John Mauldin and others have written articles on ABSes, CDOs, and mortgage debt, but this article presents a case study examining the details of why--and how--these things were created.

I have to point out that the authors picked one of the worst ones out there so it may not be entirely representative of the securities that are out there. However, as investors looking to capitalize on these security sell-offs, we should consider a bad case like the one studied in this article.

This issue, which is backed by ultra-risky second-mortgage loans, contains all the elements that facilitated the housing bubble and bust. It's got speculators searching for quick gains in hot housing markets; it's got loans that seem to have been made with little or no serious analysis by lenders; and finally, it's got Wall Street, which churned out mortgage "product" because buyers wanted it. As they say on the Street, "When the ducks quack, feed them."

LOL Can't stop laughing at the ducks comment because it's so true. If there is a demand, Wall Street will satisfy it. It's a characteristic of a free market after all.

In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players. More than a third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential mortgage-backed issues totaling $592 billion that were sold last year.

The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)

It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.

Think about the amount an average person put into their home in this case: 0.71%! Unbelievably low number. Homeowners have practically no downside and massive upside (sort of sounds like stop options for executives).

The article goes into how mortgages are sliced and diced into different tranches. The tranches, from least risky to the most risky, are: A-1, A-2, A-3, M-1 to M-7 (called mezzanine), B-1, B-2, and X. The lower tranches get blown up first due to adverse changes. In this case, four of the lower rated tranches lost their full value, while the AAA-rated tranches were lowered to BBB.

How is a buyer of securities like these supposed to know how safe they are? There are two options. The first is to do what we did: Read the 315-page prospectus, related documents, and other public records with a jaundiced eye and try to see how things can go wrong.

The second is to rely on the underwriter and the credit-rating agencies - Moody's and Standard & Poor's. That, of course, is what nearly everyone does.

In any event, it's impossible for investors to conduct an independent analysis of the borrowers' credit quality even if they choose to invest the time, money, and effort to do so. That's because Goldman, like other assemblers of mortgage-backed deals, doesn't tell investors who the borrowers are.

One Goldman filing lists more than 1,000 pages of individual loans - but they're by code number and zip code, not name and address.

Even though the individual loans in GSAMP looked like financial toxic waste, 68% of the issue, or $336 million, was rated AAA by both agencies - as secure as U.S. Treasury bonds. Another $123 million, 25% of the issue, was rated investment grade, at levels from AA to BBB--.

Thus, a total of 93% was rated investment grade. That's despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren't vetted by anyone) had less than 1% equity and on which GSAMP couldn't effectively foreclose.

The problem with these securities in the first place was that there was no way to figure out the true risk of any of these things. As Fortune points out above, even if we were to read through all the documentation, it is quite difficult to pin the risk.

How does toxic waste get distilled into spring water? Watch. It's all in the math - and the assumptions about how borrowers will behave.

These loans, which are fixed-rate, carried an average interest rate of 10.51%. After paying the people who collected the payments and handled all the other paperwork, the GSAMP Trust had ten percentage points left. However, the interest on the securities that GSAMP issued ran to only about 7%. (We say "about" because some of the tranches are floating-rate rather than fixed-rate.)

The difference between GSAMP's interest income and interest expense was projected at 2.85% a year. That spread was supposed to provide a cushion to offset defaults by borrowers. In addition, the aforementioned X piece didn't get fixed monthly payments and thus provided another bit of protection for the 12 tranches ranked above it.

Remember that we're dealing with securities, not actual loans. Thus losses aren't shared equally by all of GSAMP's investors. Any loan losses would first hit the X tranche. Then, if X were wiped out, the losses would work their way up the food chain tranche by tranche: B-2, B-1, M-7, and so on.

The real culprit behind all the mispricing of risk lay with the assumptions that went into default rates. The credit rating agencies never really had a true understanding of who the borrowers were, what they were doing, and the risk that it all entailed.

If you had borrowed 99%-plus of the purchase price (as the average GSAMP borrower did) and couldn't make your payments, couldn't refinance, and couldn't sell at a profit, it was over. Lights out.

As a second-mortgage holder, GSAMP couldn't foreclose on deadbeats unless the first-mortgage holder also foreclosed. That's because to foreclose on a second mortgage, you have to repay the first mortgage in full, and there was no money set aside to do that. So if a borrower decided to keep on paying the first mortgage but not the second, the holder of the second would get bagged.

If the holder of the first mortgage foreclosed, there was likely to be little or nothing left for GSAMP, the second-mortgage holder. Indeed, the monthly reports issued by Deutsche Bank (Charts), the issue's trustee, indicate that GSAMP has recovered almost nothing on its foreclosed loans.

Reading the above makes one think why anyone would even consider these things in the first place. But that's the nature of investing. People do a lot of crazy things. Investing in second mortgages where the homeowner put down less than 1% seems like the dumbest thing ever.

Through all this, Goldman Sachs actually somehow made money:

Goldman said it made money in the third quarter by shorting an index of mortgage-backed securities. That prompted Fortune to ask the firm to explain to us how it had managed to come out ahead while so many of its mortgage-backed customers were getting stomped.

Goldman's profits came from hedging the mortgage securities it keeps in inventory in order to make trading markets. It said in a recent SEC filing, "Although we recognized significant losses on our non-prime mortgage loans and securities, those losses were more than offset by gains on short mortgage positions."

As we interpret this - the firm declined to elaborate - Goldman made more on its hedges than it lost on its inventory because junk mortgages fell even more sharply than Goldman thought they would.

The graphic below illustrates what actually happened to the mortgage security that was studied:

You can see from the graphic how the lower tranches ended up losing everything, while the higher ones were downgraded.

If we are to invest in these things, the thing we need to realize is that it is highly likely that the tranches will not recover their rating in the near future--if ever. If I were to invest, it will be solely on the view that the price is much lower than what the true risk is. I don't think anyone should invest in BBB and expect it to go back to AAA. However, if the security truly deserves a BBB rating, and the price implies, say, a CCC rating, then it is worth checking out. It is still a statistical game (you are investing in a black box where you don't know what's in the mortgages) but at a low enough price it may be profitable.


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