Securitization is 'designed to fail'

[JebediahSpringfield]

JonCris, you have your facts wrong. It's not that securitisation was "designed to fail". The SEC alleges these synthetic securities were designed to fail. But that's not even the basis of the SEC complaint. They are really alleging that there was a failure to disclose the involvement of John Paulson in the deal. I could rattle on about this case, but I'll leave it at that. Securitisation does have a valid purpose and central banks including the Bank of England have bought enormous amounts of mortgage backed securities (the BoE bought over £200 billion in mortgage backed securities last year) to maintain a minimum level of liquidity and lending in the market. I grant you the fact that many mortgages should never have been made, and banks were irresponsible in making them. This doesn't negate the value of securitisation. "The fact that these derivatives are meant to default means the 'investment' (your property) has to be realized within 5 years hence if the derivative/bond becomes unsaleable, (as they have) your 25 year mortgage is a sham";. Again, you are wrong. I'm not sure where you are coming up "realized within 5 years". I worked in sales/trading at a major bank selling mortgage backed securities, so I do have a very good guess as to where you derived that erroneous information. The prospectus of a transaction often refers to the 'weighted average life' of the notes. And often you will see that this weighted average life is around 4 to 5 years. Key word there AVERAGE. There's no guarantee the notes will pay off in 5 years. It's based on a prepayment rate assumption that may or may not be true. The LEGAL FINAL maturity of the bonds is usually after 2040 in most cases. An investor assumes the risk that the loans prepay more slowly than any prepayment assumption dictates and in worst case, at the legal final maturity date. An investor can't demand his money back if he hasn't received his money back within 5 years. That's nonsense.

Edited May 5, 2010 by JebediahSpringfield

[JebediahSpringfield]

If you believe that investors did not know what they were buying, you don't understand the market.

 

Here's an example:

 

Unassociated Document

 

From the Risk Factors section...

 

The securities will be directly or indirectly backed by mortgage loans or by conditional or installment sales contracts or installment loan agreements, referred to as contracts, secured by manufactured homes. The types of mortgage loans or contracts included in a trust fund may include loans made to borrowers who do not qualify for loans conforming to underwriting standards of more traditional lenders and as a result of the credit quality of such borrowers, such mortgage loans may have a greater likelihood of delinquency and foreclosure, and a greater likelihood of loss in the event of delinquency and foreclosure. You should be aware that if the mortgaged properties or manufactured homes fail to provide adequate security for the mortgage loans or contracts, as applicable, included in a trust fund, any resulting losses, to the extent not covered by credit support, will be allocated to the related securities in the manner described in the related prospectus supplement and consequently would adversely affect the yield to maturity on those securities. The depositor cannot assure you that the values of the mortgaged properties or manufactured homes have remained or will remain at the appraised values on the dates of origination of the related mortgage loans or contracts. Manufactured homes, unlike mortgaged properties, generally depreciate in value. Consequently, at any time after origination it is possible, especially in the case of contracts with high loan-to-value ratios, that the market value of the manufactured home or home may be lower than the principal amount outstanding under the related contract. The prospectus supplement for each series of securities will describe the mortgage loans and contracts which are to be included in the trust fund related to your security and risks associated with those mortgage loans which you should carefully consider in connection with the purchase of your security.

 

Non-conforming Loans. Non-conforming mortgage loans are mortgage loans that do not qualify for purchase by government sponsored agencies such as the Fannie Mae and the Freddie Mac due to credit characteristics that to not satisfy the Fannie Mae and Freddie Mac guidelines, including mortgagors whose creditworthiness and repayment ability do not satisfy the Fannie Mae and Freddie Mac underwriting guidelines and mortgagors who may have a record of credit write-offs, outstanding judgments, prior bankruptcies and other derogatory credit items. Accordingly, non-conforming mortgage loans are likely to experience rates of delinquency, foreclosure and loss that are higher, and that may be substantially higher, than mortgage loans originated in accordance with Fannie Mae or Freddie Mac underwriting guidelines. The principal differences between conforming mortgage loans and non-conforming mortgage loans include:

 

●the applicable loan-to-value ratios,

 

●the credit and income histories of the related mortgagors,

 

●the documentation required for approval of the related mortgage loans,

 

●the types of properties securing the mortgage loans, the loan sizes, and

 

●the mortgagors' occupancy status with respect to the mortgaged properties.

 

As a result of these and other factors, the interest rates charged on non-conforming mortgage loans are often higher than those charged for conforming mortgage loans. The combination of different underwriting criteria and higher rates of interest may also lead to higher delinquency, foreclosure and losses on non-conforming mortgage loans as compared to conforming mortgage loans.

 

And here in another transaction, you find this paragraph in the risk factors section of a preliminary prospectus (from early 2007):

 

If this document is a Prospectus Supplement, do not delete this paragraph

 

Recent Developments in the Residential Mortgage Market May Adversely Affect the Performance and Market Value of Your Securities

 

Recently, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions that may adversely affect the performance and market value of your securities. Delinquencies and losses with respect to residential mortgage loans generally have increased in recent months, and may continue to increase, particularly in the subprime sector. In addition, in recent months housing prices and appraisal values in many states have declined or stopped appreciating, after extended periods of significant appreciation. A continued decline or an extended flattening of those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, particularly with respect to second homes and investor properties and with respect to any residential mortgage loans whose aggregate loan amounts (including any subordinate liens) are close to or greater than the related property values.

 

Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Borrowers with adjustable payment mortgage loans are being exposed to increased monthly payments when the related mortgage interest rate adjusts upward from the initial fixed rate or a low introductory rate, as applicable, to the rate computed in accordance with the applicable index and margin. This increase in borrowers’ monthly payments, together with any increase in prevailing market interest rates, may result in significantly increased monthly payments for borrowers with adjustable rate mortgage loans.

Borrowers seeking to avoid these increased monthly payments by refinancing their mortgage loans may no longer be able to find available replacement loans at comparably low interest rates. A decline in housing prices may also leave borrowers with insufficient equity in their homes to permit them to refinance, and in addition, many mortgage loans have prepayment premiums that inhibit refinancing. Furthermore, borrowers who intend to sell their homes on or before the expiration of the fixed rate periods on their mortgage loans may find that they cannot sell their properties for an amount equal to or greater than the unpaid principal balance of their loans. These events, alone or in combination, may contribute to higher delinquency rates.

 

In addition, numerous residential mortgage loan originators that originate subprime mortgage loans have recently experienced serious financial difficulties and, in some cases, bankruptcy. Those difficulties have resulted in part from declining markets for mortgage loans as well as from claims for repurchases of mortgage loans previously sold under provisions that require repurchase in the event of early payment defaults, or for material breaches of representations and warranties made on the mortgage loans, such as fraud claims. The inability to repurchase these loans in the event of early payment defaults or breaches of representations and warranties may also affect the performance and market value of your securities.

The mortgage loans in the trust fund include subprime mortgage loans, and it is possible that an originator, due to substantial economic exposure to the subprime mortgage market, for financial or other reasons may not be capable of repurchasing or substituting for any defective mortgage loans in the trust fund. You should consider that the general market conditions discussed above may adversely affect the performance and market value of your securities.

 

Guess what? Investors still bought the deal, which punches a hole in your argument that investors did not know what they were getting themselves into. Maybe they didn't appreciate the severity of the downturn/market collapse, but they certainly knew what they were buying. Investors were drawn to higher risk mortgages because the securitised bonds carried a higher yield than standard mortgage securitisations. Additionally, they overly relied on rating agency opinions to give them comfort notwithstanding the higher risk. In essence, they didn't do the appropriate credit analysis and outsourced it to a third party in exchange for higher returns.

 

You keep harping on this '5 year' point. Please provide a source, because that is not correct. The mortgage backed securities market was traditionally a buy and hold market, it was not a market where these instruments were traded freely (except until AFTER the financial crisis when investors were trying to sell everything they owned). Investors traditionally held these instruments till the deal paid down on its own. So this idea you have that these were sold as 5 year investments is incorrect. If you're erroneously referring to the weighted average life section of a prospectus, see below from the Citi prospectus.

 

The prepayment experience on the mortgage loans and contracts underlying or comprising the trust fund assets in a trust fund will affect the weighted average life of the related series of securities. Weighted average life refers to the average amount of time that will elapse from the date of issuance of a security until each dollar of principal of such security will be repaid to the investor. The weighted average life of the securities of a series will be influenced by the rate at which principal on the mortgage loans underlying or comprising the trust fund assets included in the related trust fund is paid, which payments may be in the form of scheduled amortization or prepayments, for this purpose, the term “prepayment” includes prepayments, in whole or in part, and liquidations due to default and hazard or condemnation losses. The rate of prepayment with respect to fixed rate mortgage loans has fluctuated significantly in recent years. In general, if interest rates fall below the interest rates on the mortgage loans underlying or comprising the trust fund assets, the rate of prepayment would be expected to increase. There can be no assurance as to the rate of prepayment of the mortgage loans underlying or comprising the trust fund assets in any trust fund. The depositor is not aware of any publicly available statistics relating to the principal prepayment experience of diverse portfolios of mortgage loans over an extended period of time. All statistics known to the depositor that have been compiled with respect to prepayment experience on mortgage loans indicates that while some mortgage loans may remain outstanding until their stated maturities, a substantial number will be paid prior to their respective stated maturities.

 

The above can't be clearer that the weighted average life of the notes is UNCERTAIN.

[JebediahSpringfield]

And thanks to the posters above.

[JebediahSpringfield]

Hi Suetonius,

 

It's puzzling that you are troubled with regard to the five year argument. You see, even the CML admit that RMBS (residential mortgage backed securities - i.e. securitised mortgaged) are designed to have less than a 6 year life. It was YOU who posted up evidence of the very short-term nature of a securitised mortgage.

 

Andrew Heywood who is Deputy Head of Policy at the Council of Mortgage Lenders, accepts (and knows) that 90% of securitised mortgages (RMBS) reach their call up date within 6 years. Just in case you didn't fully read the Andrew Heywood CML document that you posted up, it's attached here again. See slide 10.

 

Consequently, there is a breach of contract with the borrower. The borrower contracts to borrow the money for 25 years whereas, the lender KNOWS from the outset that it has NO INTENTION of honouring its obligation to lend for 25 years. Hence, remortgage or be repossessed within 5 years.

 

You are incorrect re: this 5 year sham mortgage you are suggesting. Securitisations have historically had a weighted average life of a few years largely due to prepayment rates. Non-conforming mortgages just a few years ago had exceptionally high prepayment rates 30% to 50% (peak). Prepayment rates now are around 5%. Anyone owning subprime paper now is prepared to hold for a significantly longer period because these types of mortgage products no longer exist and prepayment rates cannot justifiably be expected to reach levels of a few years ago.

 

You’re also failing to take into account that the reason these deals pay down in a relatively short time period is also due to the fact that the deals are called by the originator. An originator can call a transaction once the collateral balance is 10% of the original balance (known as a clean-up call option) and that means the originator owns the mortgages once again. Why do they do this? Because as the portfolio amortises to, it becomes more and more expensive to service the transaction and the economics tilt in favour of calling the deal versus paying out the high fixed costs of servicing the bonds. The mortgages that are called at the clean up call date are usually recycled and resecuritised.

 

You also fail to realise that repossessions are not in the interest of an investor. Loss severities on repossessions can easily be 40-50%. In the U.S., loss severities reached as high as 70%. Who takes that loss? It’s the investor, assuming the loss is not covered by excess margin on the collateral and credit enhancement. Also, an originator is not going to have a particularly easy time selling new securitised bonds to investors if they had a historically high repossession rate on previous deals as it’s evidence of either poor lending criteria, servicing, and significantly higher risk.

 

So your theory, frankly, does not hold water.

[JebediahSpringfield]

Theory? What theory? It is a fact that the borrowers will not have their loans for 25 years, and it is a fact that "lenders" intention that RMBS have a life "less than 6 years" as verified by non-other than Mr Heywood at the Council of Mortgage Lenders. Do you argue against Mr Heywood of the CML?

 

So you spout a load of drivel displaying that you're aware of certain securitisation soundbites, which, to most CAGGers is probably no more than pure gobbledegook. So perhaps you'd like to explain your soundbites gobbledegook in plain english so that other gaggers may understand and debate the point you have tried to make.

 

Also, perhaps you might also be mindful that you seem to be under the impression that it is the investors that are in the driving seat on all this. You are mistaken. The investors are passive just waiting for their payout (or not as the case may be). It is the Issuer/SPV that is in control of the events that befall the borrowers - not the investors.

 

Plus, be mindful that the "investors" and the "issuers" have very different ideas about what is commercially beneficial to them - they may have (and probably do have) conflicting interests. What the investor wants, may not be what the issuer wants. After all, it is the issuer/SPV that is in control of the assets - not the investor. So whilst you may spout off about the investors, remember that it is the Issuer/SPV that is the devil driving the borrowers to hell. So my dear, it seems that it is you who has failed to realise and understand what is going on.

 

Let me simplify for your simple brain.

 

I’m fully aware that the average life of an RMBS WAS 5-6 years. The question is WHY that it is. You seem to suggest some baseless insidious plot that if a borrower has not refinanced in 5 years the lender will seek to repossess a borrower to ensure a five year paydown in the RMBS and thus, a sham mortgage contract exists. That is patently ridiculous and shows you have a very crude and ill-informed understanding of how securitisation works.

 

Notice I said WAS. Now the weighted average lives of RMBS will be significantly longer if lending doesn’t return to previous levels. The weighted average life was driven by largely by prepayment rates i.e., what proportion of borrowers voluntarily prepay. Up until the start of the financial crisis, default rates were almost insignificant. Given average prepayment rates that we saw during the housing boom of 30-50% a pool of mortgages amortised very quickly in size which meant that 4 or 5 years in, the pool of mortgages was small enough to trigger the originator’s ability to call the transaction. And they did call those transactions. So what about that 10% of the pool that was left after 4 or 5 years? What happened to them? Did they get repossessed? See how nonsensical your argument is The deals were CALLED, which means those borrowers that did not refinance still had their mortgage, and not only that, but the originator sold that mortgage into a new securitisation. By your warped logic, there is no one that has been with the same lender for 15 years whose loan has been previously been securitised.

 

And what would happen if an originator did not call the transaction? Instead of being paid in 5 years, the bonds would probably not be paid for 10 years or longer, so it is by definition the fact that an originator called a deal that a deal paid off in 5 years, not because of some absurd conspiratorial repossession strategy for borrowers who did not refinance.

 

As far as the SPV, you clearly do not know what you are talking about here. The SPV is a braindead entity. It is purely a passive vehicle and it has to be structured that way because if it is an actively managed entity, it may jeopardise its status as a bankruptcy remote entity and it also may not qualify for the appropriate accounting treatment.

 

You should really do more homework before you start spouting misinformation.