"Re-mimicking the crisis
Commercial mortgage-backed bonds have been flying higher this week. As Reuters reported on Thursday:
June 18 (Bloomberg) — Yields on bonds backed by commercial mortgages fell relative to benchmark interest rates for the third day to the lowest this month as new offerings boosted investor interest. The yield gap, or spread, relative to the benchmark swap rate on top-rated bonds backed by commercial real estate fell 68 basis points to 6.83 percentage points today, the lowest since June 2, according to Bank of America Corp. data. On June 15, the spread was 8.39 percentage points.
What’s all this down to? The trick is dubbed the re-Remic. As Reuters explains:
Banks are turning to so-called re-REMICs for commercial mortgage debt to create securities that offer protection from rating cuts and losses. Investors are buying commercial mortgage bonds that may be repackaged into securities similar to re-REMIC deals being sold by Bank of America and Morgan Stanley, assuming they will be able to sell them at a higher price, according to Chris Sullivan, chief investment officer at United Nations Federal Credit Union in New York.
Why hasnt, then, the re-remic been used more extensively before?
Perhaps because, all a re-remic is, is basically a re-use of CDO structuring technology.
Barclays Capital offers a little more insight on the slicing and dicing practises that makes all this wonderfulness possible (our emphasis):
Re-remics involve the restructuring of one or more existing remic securities to create new remic securities. It is typically done with the purpose of creating a true AAA-rated super senior security that is protected from potential downgrades and losses. The restructuring primarily involves distributing the cash flows of a bond that was originally rated AAA into multiple bonds with different risk profiles.
Even a year ago, several market participants expected a large share of bonds rated AAA to eventually take some writedowns. However, the significant worsening in performance over past 6-12 months helped build greater consensus around this expectation. Further, a slew of rating downgrades in 1Q09 also led to a number of ratings-related fire sales and pushed prices to levels where even the best quality super senior bonds could earn 12-15%. While these yields were high enough to attract traditional non-agency investors, many of them had rating constraints, either in form of explicit mandates or due to regulatory capital concerns. That essentially left only distressed buyers in the market for these securities.
We estimate that 73% of 2005-07 original AAAs outstanding have already been downgraded by at least one of the three rating agencies (Moody’s, S&P and Fitch), and 12% of remainder will get downgraded eventually. Figure 1 shows that of about the $1.4trn of securities originally rated AAA that are still outstanding in the non-agency space, about $1.0trn have already been downgraded. Of these, we estimate about 55% (or $580bn) are re-remicable securities. Assuming a conservative price of $65, there is $350-400bn in market value of securities with no natural buyer due to their rating. The re-remic market provides a way out of this gridlock by creating new AAA securities, which are likely to be viewed as attractively priced by traditional real money accounts.
The key point being:
It is possible to create new AAAs because a large majority of super senior non-agency bonds that have been downgraded are not expected to take substantial writedowns. This means that while a bond may be pricing in the $60-65 dollar price range, it may only be expected to take 15-20 points of writedowns — the rest of the discount is a result of investors demanding higher yields than the coupon on the bonds.
Since most rating agencies rate according to expected principal writedowns (first dollar of loss), the entire bond gets downgraded even for a small expected loss.
But having the entire bond get downgraded just because the rating agencies grade according to principal writedown is soooo unfair! Accordingly:
However, since the expected levels of loss are much lower than the price discount, it is possible to re-enhance these securities through the re-remic structure and provide value for the traditional non-agency buyers by creating new AAA securities that yield 7-9%.
So from what we can make out that means you extract the still worthwhile component from the deteriorating asset pool, wave a magic wand, and hey presto it’s a triple A security again. Brilliant.
Okay, not that straightforward. It’s a little more like this:
As we discussed in the first section, the broad purpose of a re-remics structure is to create a new AAA security with much lower risk of writedowns or downgrades. It is achieved primarily by increasing credit support through additional subordination and redirecting principal cash flows to create pro-rata and/or sequential classes. In terms of collateral, we are still looking for securities that will get a substantial portion of their principal back. Re-remics are typically created from the current-pay prime, dented prime or Alt-A type senior bonds. The front cash flows of the sequential structures, pro rata pay super seniors, NAS bonds and sinkers are typically re-remic-able. It is unusual to see a re-remic off very poorly performing Alt-B or subprime as the level of required subordination to reach an AAA credit rating makes the deal uneconomical.
And here’s the science:
Of course, we presume the name reason no one stumbled on this brainchild before is because it’s only now that higher graded mortgage-backed paper has begun to get downgraded. Let’s all hope it works out, nevertheless.
Related links:
The Re-Remic gimmick? - FT Alphaville
Structured finance 101 - FT Alphaville
“Investors are getting ahead of the banks that are beginning to package these deals,” Sullivan said today in a telephone interview. “There will be more of these deals going forward, so it makes sense to pick up the bonds now.”
This sounds very iffy and very speculative.
"Having sales of any type of commercial mortgage-backed debt is cause for some optimism, Sullivan said. "
Here's financial innovation. You're creating a salable product from unsalable products. Of course, you're doing that by changing the credit ratings.
"Morgan Stanley (MS.N) and Bank of America (BAC.N) are the first to take a cue from the residential mortgage bond market where dealers have been actively restructuring securities into parts that protect investors from downgrade risks and also satisfy demand of speculators looking for higher returns."
Yep. There's the speculators.
"The dealers are betting that they can satisfy both more conservative investors who are fearful their portfolios will be downgraded, and hedge funds that want to take more risk amid signs the economic recession is bottoming, investors said. More re-remics will follow if dealers can sell the parts at prices greater than the value of the underlying asset. "
Yep. Worth more split up.
Ok. Some investors are buying bonds that they hope will be tranched in such a way as to attract more investors from a wider spectrum. CDOs live.
"That essentially left only distressed buyers in the market for these securities."
Here's the real problem. The only people willing to buy these bonds are investors who only buy when they get a great deal. The owner's of the bonds don't like this. If they can slice the bonds up, then they won't be at the mercy of these buyers who want a great deal. In essence, this is like the problem addressed by PPIP. The sellers simply don't want to sell at the prices offered. That's been the underlying problem with CDOs in this market from the beginning of this crisis. It is not the inability to price CDOs."
From Bloomberg:
"Commercial Mortgage Debt Rallies on New Securities (Update1)
By Sarah Mulholland
June 18 (Bloomberg) -- Yields on bonds backed by commercial mortgages fell relative to benchmark interest rates for the third day to the lowest this month as new offerings boosted investor interest.
The yield gap, or spread, relative to the benchmark swap rate on top-rated bonds backed by commercial real estate fell 68 basis points to 6.83 percentage points today, the lowest since June 2, according to Bank of America Corp. data. On June 15, the spread was 8.39 percentage points.
Banks are turning to so-called re-REMICs for commercial mortgage debt to create securities that offer protection from rating cuts and losses. Investors are buying commercial mortgage bonds that may be repackaged into securities similar to re-REMIC deals being sold by Bank of America and Morgan Stanley, assuming they will be able to sell them at a higher price, according to Chris Sullivan, chief investment officer at United Nations Federal Credit Union in New York.
“Investors are getting ahead of the banks that are beginning to package these deals,” Sullivan said today in a telephone interview. “There will be more of these deals going forward, so it makes sense to pick up the bonds now.”
Bank of America is selling $368 million of debt backed by nine commercial mortgage bonds, according to a person familiar with the offering. Morgan Stanley plans to sell $210 million in similar securities backed by a single commercial mortgage bond, according to a person familiar with the sale. The people declined to be identified because the terms aren’t public.
Weighing the Yields
The top-ranked portion of the Bank of America debt may price to yield 550 basis points more than the benchmark, the person said. The most senior part of the Morgan Stanley offering may price to yield 500 basis points more than the benchmark swap rate. A basis point is 0.01 percentage point. The swap rate is currently about 4.083 percent.
A re-REMIC may be used to create top-graded debt from securities that have had ratings cuts. Standard & Poor’s said May 26 that it may lower the rankings on as much as 90 percent of the highest-graded commercial mortgage-backed bonds sold in 2007. A record $237 billion of the debt was sold that year, according to JPMorgan Chase & Co. data.
REMICs, or real-estate mortgage investment conduits, are vehicles used to turn loans into bonds by passing payments from the debt to different investors in varying orders of priority or at different times. Re-REMICs repackage those securities into new bonds.
‘Apathy and Avoidance’
About $27 billion of re-REMIC repackagings of home-loan bonds have been issued this year, up from $17 billion for all of 2008, according to a June 12 report from Bank of America Merrill Lynch.
Sales of commercial mortgage bonds have plummeted amid concern about rising defaults. There have been no sales of the debt this year, according to data compiled by Bloomberg.
Having sales of any type of commercial mortgage-backed debt is cause for some optimism, Sullivan said.
“There is a great deal of apathy and avoidance in the sector,” he said. “Having anything at all brought to the market sparks hope.”
To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net"
From Reuters:"Morgan Stanley, BofA ignite CMBS rally with deals
By Al Yoon
NEW YORK, June 17 (Reuters) - Morgan Stanley and Bank of America Corp on Wednesday sparked a sudden rally in commercial mortgage-backed securities by initiating deals that will split existing securities into more valuable parts.
By recasting older issues, the dealers are hoping to awaken the $700 billion CMBS market that has been slumbering for weeks under the weight of downgrade threats and weakening outlooks on underlying office, retail and apartment properties, said investors familiar with the two private deals.
Morgan Stanley (MS.N: Quote, Profile, Research, Stock Buzz) and Bank of America (BAC.N: Quote, Profile, Research, Stock Buzz) are the first to take a cue from the residential mortgage bond market where dealers have been actively restructuring securities into parts that protect investors from downgrade risks and also satisfy demand of speculators looking for higher returns. The "re-remics" are also a way for dealers to adapt to the financial crisis as new issue volumes remain sidelined.
Morgan Stanley's $210 million re-remic -- spawned from its benchmark GSMS 2007-GG10 issue -- includes a $150 million bond with credit protection jacked up to 50 percent, from 30 percent on the underlying asset, investors said. The smaller part offers a higher return, at the expense of credit protection.
The first part is being marketed at a yield 500 basis points over interest rate swaps, marking a huge drop in risk premium from the 875 basis point level where top quality CMBS with 30 percent protection had been trading.
Spreads on top CMBS gapped lower to about 775 basis points amid expectations that success of the re-remics will enhance demand for outstanding issues.
Bank of America has a $368 million commercial bond re-remic in the works, backed by multiple securities, investors said.
The dealers are betting that they can satisfy both more conservative investors who are fearful their portfolios will be downgraded, and hedge funds that want to take more risk amid signs the economic recession is bottoming, investors said. More re-remics will follow if dealers can sell the parts at prices greater than the value of the underlying asset.
"The market is counting heavily on those two deals, and greater volatility could lay ahead should the results not be wholly favorable," said analysts at IFR, a Thomson Reuters market service, in a client note.
The threat of downgrades on AAA rated CMBS from rating company Standard & Poor's has set the market on edge this month since the cuts could sharply reduce demand for the assets under a federal program to unfreeze credit markets. Lower ratings could also force investors who cannot own anything sub AAA to sell their assets at fire-sale prices.
But there are signs that many funds are now willing to take the riskier side of the bet, unlike in 2008 when re-remics of home mortgage bonds stalled, partly due to low risk appetites.
"I see more logical buyers of the mezzanine class than the seniors as hedge funds continue to search for 15 percent to 20 percent levered returns," said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago."
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