NEW YORK, Dec 2 (Reuters) - Amherst Securities Group on Wednesday said it hired veteran analyst Darrell Wheeler from Citigroup Inc. to help expand its business into commercial mortgage-backed securities.
Amherst specializes in residential mortgage-backed securities and has hired aggressively in research, sales and trading over the past two years.
It aims to build a similar business in CMBS, which finance one of the most volatile sectors of the U.S. economy. Many analysts believe a commercial real estate recovery will lag that of residential by at least a year, creating pitfalls for the $700 billion market.
Hedge funds and other investors have amassed billions of dollars for distressed investments in commercial real estate.
Wheeler was a managing director and global head of the Citigroup's securitized strategy unit. His research team held the top rank for six straight years in Institutional Investor magazine's fixed-income research survey, Amherst said.
Wednesday, December 2, 2009
KKR, Fubon among bidders for Morgan Stanley's CICC stake
HONG KONG (Reuters) - Kohlberg Kravis Roberts & Co and Fubon Financial are among the bidders for Morgan Stanley's (MS.N) stake in Chinese investment bank CICC, people familiar with the matter said on Wednesday, in a deal that could be worth more than $1 billion.
Fubon (2881.TW), Taiwan's No. 5 financial conglomerate, has made no secret about its intention to grow into China, especially now that cross-straits relations are thawing.
When CICC was founded around 14 years ago, Morgan Stanley paid just $37 million for a 34.3 percent piece of the Chinese bank. CICC is now one of the biggest and most successful investment banks in China, led by Levin Zhu, the son of China's influential former Premier Zhu Rongji.
While the stake has been profitable for Morgan Stanley, the New York bank lacks control of management decisions at CICC.
In December 2007, Morgan Stanley signed an agreement with China Fortune Securities, in an effort to attain a Chinese joint venture that gave it more control over management.
Beijing bars foreign firms from having more than one investment banking venture and limits their holdings to a third of the total. Morgan Stanley's ability to move ahead with the China Fortune deal has been held up by its failure so far to sell the CICC stake.
Last year, Morgan Stanley tried to sell the stake, but the auction failed. It recently relaunched the sale, seeking between $1.2 billion and $1.5 billion, a separate source previously told Reuters.
Other private equity firms that have joined the bidding include Bain Capital and General Atlantic, sources previously told Reuters. Two other buyout firms, TPG and J.C. Flowers, had also expressed interest in the stake.
Bain Capital's Jonathan Zhu, one of the firm's managing directors in Hong Kong, is a former top banker for Morgan Stanley in Asia.
Morgan Stanley, KKR KKR.UL and Fubon declined to comment. The other private equity firms have declined to comment. The sources have asked not to be identified because they are not allowed to speak on the record about the deal.
Any deal is likely to take several months, as the buyer of the stake in the government-backed bank would have to meet Beijing's approval.
STRATEGIC, FINANCIAL INTEREST
For Fubon, the purchase of a CICC stake would increase its footprint in China. Its subsidiary, Fubon Bank (Hong Kong) (0636.HK), owns a 19.99 percent stake in China's Xiamen Commercial Bank.
Fubon's attempt at CICC comes as Taiwan and China have pledged to open their financial markets to each other, highlighting the improving business ties across the Taiwan strait after the island's President Ma Ying-jeou took office last year.
Though both sides have recently signed a financial MOU (memorandum of understanding), investors are still waiting for the signing of a wider trade agreement that will allow Chinese and Taiwanese banks to buy stakes in each other
Fubon (2881.TW), Taiwan's No. 5 financial conglomerate, has made no secret about its intention to grow into China, especially now that cross-straits relations are thawing.
When CICC was founded around 14 years ago, Morgan Stanley paid just $37 million for a 34.3 percent piece of the Chinese bank. CICC is now one of the biggest and most successful investment banks in China, led by Levin Zhu, the son of China's influential former Premier Zhu Rongji.
While the stake has been profitable for Morgan Stanley, the New York bank lacks control of management decisions at CICC.
In December 2007, Morgan Stanley signed an agreement with China Fortune Securities, in an effort to attain a Chinese joint venture that gave it more control over management.
Beijing bars foreign firms from having more than one investment banking venture and limits their holdings to a third of the total. Morgan Stanley's ability to move ahead with the China Fortune deal has been held up by its failure so far to sell the CICC stake.
Last year, Morgan Stanley tried to sell the stake, but the auction failed. It recently relaunched the sale, seeking between $1.2 billion and $1.5 billion, a separate source previously told Reuters.
Other private equity firms that have joined the bidding include Bain Capital and General Atlantic, sources previously told Reuters. Two other buyout firms, TPG and J.C. Flowers, had also expressed interest in the stake.
Bain Capital's Jonathan Zhu, one of the firm's managing directors in Hong Kong, is a former top banker for Morgan Stanley in Asia.
Morgan Stanley, KKR KKR.UL and Fubon declined to comment. The other private equity firms have declined to comment. The sources have asked not to be identified because they are not allowed to speak on the record about the deal.
Any deal is likely to take several months, as the buyer of the stake in the government-backed bank would have to meet Beijing's approval.
STRATEGIC, FINANCIAL INTEREST
For Fubon, the purchase of a CICC stake would increase its footprint in China. Its subsidiary, Fubon Bank (Hong Kong) (0636.HK), owns a 19.99 percent stake in China's Xiamen Commercial Bank.
Fubon's attempt at CICC comes as Taiwan and China have pledged to open their financial markets to each other, highlighting the improving business ties across the Taiwan strait after the island's President Ma Ying-jeou took office last year.
Though both sides have recently signed a financial MOU (memorandum of understanding), investors are still waiting for the signing of a wider trade agreement that will allow Chinese and Taiwanese banks to buy stakes in each other
Bernanke to defend his record and the Fed's
WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke vowed before taking office to follow in the footsteps of his storied predecessor, Alan Greenspan, but he will likely distance himself from the past as he seeks a second term.
After a devastating financial crisis and deep recession that eliminated 7.3 million U.S. jobs and cost taxpayers hundreds of billions of dollars to bail out banks and financial firms, political friends of the Fed seem few and far between.
While his confirmation does not appear in doubt, that popular discontent is likely to translate into aggressive, even hostile questioning on Thursday when Bernanke testifies before the Senate Banking Committee in a bid to win confirmation to a fresh four-year stint as Fed chairman.
The panel must approve his nomination before sending it to the full Senate for a vote. His term expires on January 31. It is unclear when the panel will act on the nomination.
"My guess is he'll be confirmed, but he'll take a lot of flak," said Allan Meltzer, a professor of economics at Carnegie Mellon's Tupper School of Business in Pittsburgh and an expert on the Fed's history. "We're in a bad period and the public is very unhappy. So that comes out in the Congress."
The tone of the questioning will reflect popular resentment over lavish government aid to some of the most profitable U.S. firms at a time millions of ordinary Americans face job losses and foreclosures.
It will also offer a taste of bitter political battles ahead as Republicans seek to link the country's economic woes to President Barack Obama and his fellow Democrats, with an eye to regaining a majority in one or both houses of Congress in mid-term elections next November.
FED'S ROLE
The confirmation hearing for the soft-spoken former economics professor will be as much about the future of the Fed as it will be about Bernanke himself.
Congress is considering steps that could dramatically curtail the Fed's responsibilities and would subject the Fed to unprecedented oversight from Congress. One measure fiercely opposed by the central bank would allow a congressional watchdog agency to audit the Fed's interest rate decisions.
The central bank's many critics contend it failed to rein in the risky lending practices that fueled the U.S. housing bubble. With the Fed scoring low in polls on trust in public institutions, hitting hard at the central bank may play well among voters of both political parties.
Senate Banking Committee Chairman Christopher Dodd, who is in a tough re-election campaign, may aim to dispel any accusation he is soft on the Fed or financial firms. He has said he is inclined to support Bernanke but has called the central bank's regulatory track record an "abysmal failure."
Dodd is championing a regulatory reform plan that would strip the Fed of its primary bank oversight responsibility, and both Dodd and Democrats in the House want to take away its consumer protection powers.
Bernanke launched a preemptive strike in the debate over the Fed's role in a rare newspaper column, arguing that auditing monetary policy or stripping the Fed of its ability to oversee big banks would impair economic stability.
Fed officials have argued vehemently that subjecting their decisions on monetary policy to congressional second-guessing would undercut the central bank's independence in a way that could unnerve investors and drive interest rates higher.
After a devastating financial crisis and deep recession that eliminated 7.3 million U.S. jobs and cost taxpayers hundreds of billions of dollars to bail out banks and financial firms, political friends of the Fed seem few and far between.
While his confirmation does not appear in doubt, that popular discontent is likely to translate into aggressive, even hostile questioning on Thursday when Bernanke testifies before the Senate Banking Committee in a bid to win confirmation to a fresh four-year stint as Fed chairman.
The panel must approve his nomination before sending it to the full Senate for a vote. His term expires on January 31. It is unclear when the panel will act on the nomination.
"My guess is he'll be confirmed, but he'll take a lot of flak," said Allan Meltzer, a professor of economics at Carnegie Mellon's Tupper School of Business in Pittsburgh and an expert on the Fed's history. "We're in a bad period and the public is very unhappy. So that comes out in the Congress."
The tone of the questioning will reflect popular resentment over lavish government aid to some of the most profitable U.S. firms at a time millions of ordinary Americans face job losses and foreclosures.
It will also offer a taste of bitter political battles ahead as Republicans seek to link the country's economic woes to President Barack Obama and his fellow Democrats, with an eye to regaining a majority in one or both houses of Congress in mid-term elections next November.
FED'S ROLE
The confirmation hearing for the soft-spoken former economics professor will be as much about the future of the Fed as it will be about Bernanke himself.
Congress is considering steps that could dramatically curtail the Fed's responsibilities and would subject the Fed to unprecedented oversight from Congress. One measure fiercely opposed by the central bank would allow a congressional watchdog agency to audit the Fed's interest rate decisions.
The central bank's many critics contend it failed to rein in the risky lending practices that fueled the U.S. housing bubble. With the Fed scoring low in polls on trust in public institutions, hitting hard at the central bank may play well among voters of both political parties.
Senate Banking Committee Chairman Christopher Dodd, who is in a tough re-election campaign, may aim to dispel any accusation he is soft on the Fed or financial firms. He has said he is inclined to support Bernanke but has called the central bank's regulatory track record an "abysmal failure."
Dodd is championing a regulatory reform plan that would strip the Fed of its primary bank oversight responsibility, and both Dodd and Democrats in the House want to take away its consumer protection powers.
Bernanke launched a preemptive strike in the debate over the Fed's role in a rare newspaper column, arguing that auditing monetary policy or stripping the Fed of its ability to oversee big banks would impair economic stability.
Fed officials have argued vehemently that subjecting their decisions on monetary policy to congressional second-guessing would undercut the central bank's independence in a way that could unnerve investors and drive interest rates higher.
Economic research guru and resident skeptic Charles Biderman, the CEO of TrimTabs, says the FORTUNE Recovery Index won't see an uptick until 2010.
NEW YORK (Fortune) -- Few individuals derive quite so much pleasure from digging through data as Charles Biderman. He's the always-opinionated, hyper-watchful numbers hound behind TrimTabs Investment Research, the firm that FORTUNE partnered with to build our Recovery Index.
And though he's a Harvard Business School grad, Biderman's insights about how the market moves are more than purely academic. In order to pay back his school loans, he spent the 1970s and 1980s building a career in real estate development until, in 1988, his bank went broke and his loans were called.
Biderman was forced into personal bankruptcy and emerged with key insight: price is a function of liquidity, it has nothing to do with value.
That notion led him to form TrimTabs, which sells proprietary research about the markets, money flows and the economy to investors (currently one-fourth of the biggest hedge funds in the United States are clients, and Goldman Sachs purchased a minority stake in the company last year).
Candid and colorful in conversation, Biderman's exhaustive research has produced some alarmingly simple findings.
For instance: "When companies are net buyers of stock, the market goes up, when they're net sellers the market goes down," he says. Indeed, one of his favorite metrics to watch is the number of stock buybacks by corporations, which he says start climbing at the trough of every downturn (something, as we note in our Recovery Index, that hasn't happened yet.)
Biderman talked to FORTUNE's Lee Clifford about what the Recovery Index is showing now, the one move Obama needs to make, and when he thinks the stock market will finally hit bottom.
Fortune: Give us your take on the health of the overall economy right now.
Biderman: Things are getting worse. The job market continues to contract. Incomes keep declining, even after adjusting for the latest round of tax credits. We don't see any slowdown in the rate of declines in incomes or job losses. There's no end in sight.
I've been looking at the numbers, comparing the three-week Easter season this year versus last year. Incomes are down 10%. We haven't seen anything like that for decades.
Fortune: How do you view the policy responses from Washington so far?
Biderman: The only thing that's helping anybody right now is the $400 per person [$800 per couple] tax cut. That's helping somewhat. But I'm a little cynical. My feeling is that the divine purpose of the political system is to raise money for politicians so they can get reelected.
The banks that are in trouble have paid Congress a lot of money over the years. You and I don't pay anything to the congressman. What we would recommend is that instead of focusing on getting the banks to lend, you've got to focus on giving wage earners more money.
Fortune: You don't believe any of the recent stock market rallies have been for real. Explain.
Biderman: Well, what you've had recently is $2 billion a week in tax refunds that started to go out during the first in week February and will continue through the third week in May. I suspect that's part of the reason for the stock market rally, but that's only temporary.
In March there was a little revival in refinancing, but again, I think the number of people who are in a position to take advantage of refinancings right now is pretty small. The glimmers of hope were temporary and now we see that things are declining again.
Fortune: Talk about what you're seeing in terms of the housing market.
Biderman: If we look at homes, while the number of foreclosures seems to be dropping somewhat, the notices of default are at record levels and so we expect the foreclosures to spike up again too. If you look at what's really going on, right after the 'peak' in foreclosures in September, there was a moratorium on foreclosures, but that ended in March. Once those pick up again, it's going to be a new down leg in the real estate market.
Fortune: If there's one policy you could implement now to help fix the economy, what would it be?
Biderman: If we cut withholding rates by 15%, and we did it for three years, it would be $300 billion a year in lower taxes, which is less than it costs to bail out some of these institutions. But we're not doing that, so instead you're creating a situation where more and more consumers are going to be defaulting on their debts. Forget new lending, the real problem for banks is going to be collecting on all these loans, and the problems are going to be way beyond sub prime.
Fortune: In your view, what would be the single best sign that we've hit bottom?
Biderman: That foreclosures dry up. That'll be a sign that household wealth has stabilized. Things aren't going to hit bottom until the real estate market bottoms, and we work through all the problem homes, and people can afford the homes they're in. Then we can grow from there.
Fortune: And when do you think that might be?
Biderman: At least another year. We probably won't see a bottom till sometime in 2010. We're still in retreat.
Fortune: You've long taken issue with the way the government collects some economic data. What bothers you most?
Biderman: Just look at how they track income and jobs. When everybody gets paid, the amount of money withheld goes to the government. From that you could tell who had jobs and how much they're making. But instead of tracking this in aggregate and reporting it in real time, the Bureau of Economic Analysis uses historic data that's 5 to 7 months old and based on state unemployment data to come up with estimate of current income and job gains or losses. Then of course they always go back and revise the number. But they never have a press release about the revisions. What's equally annoying is that nobody's taking the time to say, 'this is crazy!'
And though he's a Harvard Business School grad, Biderman's insights about how the market moves are more than purely academic. In order to pay back his school loans, he spent the 1970s and 1980s building a career in real estate development until, in 1988, his bank went broke and his loans were called.
Biderman was forced into personal bankruptcy and emerged with key insight: price is a function of liquidity, it has nothing to do with value.
That notion led him to form TrimTabs, which sells proprietary research about the markets, money flows and the economy to investors (currently one-fourth of the biggest hedge funds in the United States are clients, and Goldman Sachs purchased a minority stake in the company last year).
Candid and colorful in conversation, Biderman's exhaustive research has produced some alarmingly simple findings.
For instance: "When companies are net buyers of stock, the market goes up, when they're net sellers the market goes down," he says. Indeed, one of his favorite metrics to watch is the number of stock buybacks by corporations, which he says start climbing at the trough of every downturn (something, as we note in our Recovery Index, that hasn't happened yet.)
Biderman talked to FORTUNE's Lee Clifford about what the Recovery Index is showing now, the one move Obama needs to make, and when he thinks the stock market will finally hit bottom.
Fortune: Give us your take on the health of the overall economy right now.
Biderman: Things are getting worse. The job market continues to contract. Incomes keep declining, even after adjusting for the latest round of tax credits. We don't see any slowdown in the rate of declines in incomes or job losses. There's no end in sight.
I've been looking at the numbers, comparing the three-week Easter season this year versus last year. Incomes are down 10%. We haven't seen anything like that for decades.
Fortune: How do you view the policy responses from Washington so far?
Biderman: The only thing that's helping anybody right now is the $400 per person [$800 per couple] tax cut. That's helping somewhat. But I'm a little cynical. My feeling is that the divine purpose of the political system is to raise money for politicians so they can get reelected.
The banks that are in trouble have paid Congress a lot of money over the years. You and I don't pay anything to the congressman. What we would recommend is that instead of focusing on getting the banks to lend, you've got to focus on giving wage earners more money.
Fortune: You don't believe any of the recent stock market rallies have been for real. Explain.
Biderman: Well, what you've had recently is $2 billion a week in tax refunds that started to go out during the first in week February and will continue through the third week in May. I suspect that's part of the reason for the stock market rally, but that's only temporary.
In March there was a little revival in refinancing, but again, I think the number of people who are in a position to take advantage of refinancings right now is pretty small. The glimmers of hope were temporary and now we see that things are declining again.
Fortune: Talk about what you're seeing in terms of the housing market.
Biderman: If we look at homes, while the number of foreclosures seems to be dropping somewhat, the notices of default are at record levels and so we expect the foreclosures to spike up again too. If you look at what's really going on, right after the 'peak' in foreclosures in September, there was a moratorium on foreclosures, but that ended in March. Once those pick up again, it's going to be a new down leg in the real estate market.
Fortune: If there's one policy you could implement now to help fix the economy, what would it be?
Biderman: If we cut withholding rates by 15%, and we did it for three years, it would be $300 billion a year in lower taxes, which is less than it costs to bail out some of these institutions. But we're not doing that, so instead you're creating a situation where more and more consumers are going to be defaulting on their debts. Forget new lending, the real problem for banks is going to be collecting on all these loans, and the problems are going to be way beyond sub prime.
Fortune: In your view, what would be the single best sign that we've hit bottom?
Biderman: That foreclosures dry up. That'll be a sign that household wealth has stabilized. Things aren't going to hit bottom until the real estate market bottoms, and we work through all the problem homes, and people can afford the homes they're in. Then we can grow from there.
Fortune: And when do you think that might be?
Biderman: At least another year. We probably won't see a bottom till sometime in 2010. We're still in retreat.
Fortune: You've long taken issue with the way the government collects some economic data. What bothers you most?
Biderman: Just look at how they track income and jobs. When everybody gets paid, the amount of money withheld goes to the government. From that you could tell who had jobs and how much they're making. But instead of tracking this in aggregate and reporting it in real time, the Bureau of Economic Analysis uses historic data that's 5 to 7 months old and based on state unemployment data to come up with estimate of current income and job gains or losses. Then of course they always go back and revise the number. But they never have a press release about the revisions. What's equally annoying is that nobody's taking the time to say, 'this is crazy!'
Junk mortgages: It just gets worse....
NEW YORK (Fortune) -- Back two years ago when the mortgage meltdown was heating up, we wrote an article called "Junk Mortgages Under the Microscope" dissecting a particularly wretched mortgage-backed securities issue peddled by Goldman Sachs.
We wanted to show how these complex securities really worked and how Moody's and S&P, the rating agencies, aided and abetted the process by giving two-thirds of an issue backed by ultra-risky second mortgages the same safety rating they gave to U.S. Treasury securities.
We thought this was a cautionary tale -- but it's turned into a horror story. All the tranches of this issue, GSAMP-2006 S3, that were originally rated below AAA have defaulted. Two of the three original AAA -rated tranches (French for "slices") are facing losses of about 90%, and even the "super senior," safer-than-mere-AAA slice is facing losses of 25%. How could this happen? And what lessons can we take away from it?
Let's revisit the way this security was put together, and how and why it fell apart. And for the first time, we can even estimate the value -- low -- of the mortgages backing it, thanks to a new service called ABSNet Loan HomeVal.
Our tale begins in April 2006, when Goldman Sachs (GS, Fortune 500) sold $494 million of securities to institutional investors seeking yields somewhat above those that were available on U.S. Treasuries or high-rated corporate bonds.
It was an especially hinky offering, because it was backed by second mortgages rather than by traditional first mortgages. A first mortgage rarely becomes completely worthless, because a house is usually worth something.
But often all it takes is a decline of 20% in a home's value to wipe out a second mortgage, which is typically piled on top of an 80% first mortgage. In our case, borrowers' stated equity in their homes averaged less than 1% -- 0.71%, to be precise. Even that was doubtless overstated because a majority of the mortgages were low-documentation and no-documentation.
Despite these problems, the formulas used by Moody's and S&P allowed Goldman to market the top three slices of the security -- cleverly called A-1, A-2 and A- 3 -- as AAA rated. That meant they were supposedly as safe as U.S. Treasury securities.
But of course they weren't. More than a third of the loans were on homes in California, then a superhot market, now a frigid one. Defaults and rating downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted -- it stopped making interest payments. Now every month's report by the issue's trustee, Deutsche Bank, shows that the old AAAs -- now rated D by S&P and Ca by Moody's -- continue to rot out.
As of Oct. 26, date of the most recent available trustee's report, only $79.6 million of mortgages were left, supporting $159.9 million of bonds. In other words, each dollar of bonds had a claim on less than 50¢ of mortgages.
But even worse, those mortgages aren't worth anything like their $79.6 million of face value, according to ABSNet Loan HomeVal. ABSNet, unveiled in October, combines a database from Lewtan Technologies of Waltham, Mass., that has a list of every mortgage underlying every mortgage-backed issue, with data from Collateral Analytics of Honolulu, which tracks individual home values. It gives you a snapshot of the value of the collateral backing a mortgage security.
As of Sept. 26 -- a slightly different date from what we're using above -- ABSNet valued the remaining mortgages in our issue at a tad above 20% their face value. Now, watch this math. If the mortgages are worth 20% of their face value and each dollar of mortgages supports more than $2 of bonds, it means that the remaining bonds are worth maybe 10% of face value.
If all the originally AAA -rated bonds were the same, they'd all be facing losses of 90% or so in value. However, they weren't the same. The A-1 "super senior" tranche was entitled to get all the principal payments from all the borrowers until it was paid off in full. Then A-2 and A-3 would share the repayments, then repayments would move down to the lower-rated issues.
But under the security's rules, once the M-1 tranche -- the highest-rated piece of the issue other than the A tranches -- defaulted in July 2008, all the A's began sharing in the repayments. The result is that only about 28% of the original A-1 "super seniors" are outstanding, compared with more than 98% of A-2 and A-3. If you apply a 90% haircut, the losses work out to about 25% for the "super seniors," and about 90% for A-2 and A-3.
This was an especially bad issue, which we picked (on advice of some bond mavens who aren't competitors of Goldman Sachs) precisely because it was so awful. According to Bloomberg LP, recent trades in the A's were at less than 7% of face value. So the market is saying the losses are even greater than our estimates.
Goldman and Moody's declined to discuss this security. S&P told us that it had toughened its standards in 2005 and had discontinued rating second-mortgage securities in 2008. "Had we anticipated fully the severity of the declines in these markets at the time we issued our original ratings, many of those ratings would have been different," a spokesman said.
Now to the investment lessons: The first is, Don't put your faith in rating agencies, even though some branches of the federal government, including the Federal Reserve, use ratings to determine whether certain securities qualify as collateral under federal loan programs to financial institutions.
Our problem is that if things change for the worse after the original rating comes out, the agencies' response is, "Oops, sorry about that," and they revise the ratings down after you've already taken a hit. When lawsuits arrive, the agencies say all they did was issue an opinion that's protected under the First Amendment, therefore they're not liable.
The second lesson is, No matter how fancy the name is on the offering statement -- Goldman Sachs, the calumny being heaped on it lately notwithstanding, is still Wall Street's alpha outfit -- you're on your own if the issue heads south.
The final lesson is, Beware of the dangers of bottom fishing. It would have been tempting to buy this security when the original AAA paper traded down to the low two-digits -- but any buyer that did that is sitting on big losses.
Just as things often rise further than you think they will and stay there longer, they can also fall further than you think and keep on falling. Remember that when someone tells you that something is so cheap that it has nowhere to go but up.
We wanted to show how these complex securities really worked and how Moody's and S&P, the rating agencies, aided and abetted the process by giving two-thirds of an issue backed by ultra-risky second mortgages the same safety rating they gave to U.S. Treasury securities.
We thought this was a cautionary tale -- but it's turned into a horror story. All the tranches of this issue, GSAMP-2006 S3, that were originally rated below AAA have defaulted. Two of the three original AAA -rated tranches (French for "slices") are facing losses of about 90%, and even the "super senior," safer-than-mere-AAA slice is facing losses of 25%. How could this happen? And what lessons can we take away from it?
Let's revisit the way this security was put together, and how and why it fell apart. And for the first time, we can even estimate the value -- low -- of the mortgages backing it, thanks to a new service called ABSNet Loan HomeVal.
Our tale begins in April 2006, when Goldman Sachs (GS, Fortune 500) sold $494 million of securities to institutional investors seeking yields somewhat above those that were available on U.S. Treasuries or high-rated corporate bonds.
It was an especially hinky offering, because it was backed by second mortgages rather than by traditional first mortgages. A first mortgage rarely becomes completely worthless, because a house is usually worth something.
But often all it takes is a decline of 20% in a home's value to wipe out a second mortgage, which is typically piled on top of an 80% first mortgage. In our case, borrowers' stated equity in their homes averaged less than 1% -- 0.71%, to be precise. Even that was doubtless overstated because a majority of the mortgages were low-documentation and no-documentation.
Despite these problems, the formulas used by Moody's and S&P allowed Goldman to market the top three slices of the security -- cleverly called A-1, A-2 and A- 3 -- as AAA rated. That meant they were supposedly as safe as U.S. Treasury securities.
But of course they weren't. More than a third of the loans were on homes in California, then a superhot market, now a frigid one. Defaults and rating downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted -- it stopped making interest payments. Now every month's report by the issue's trustee, Deutsche Bank, shows that the old AAAs -- now rated D by S&P and Ca by Moody's -- continue to rot out.
As of Oct. 26, date of the most recent available trustee's report, only $79.6 million of mortgages were left, supporting $159.9 million of bonds. In other words, each dollar of bonds had a claim on less than 50¢ of mortgages.
But even worse, those mortgages aren't worth anything like their $79.6 million of face value, according to ABSNet Loan HomeVal. ABSNet, unveiled in October, combines a database from Lewtan Technologies of Waltham, Mass., that has a list of every mortgage underlying every mortgage-backed issue, with data from Collateral Analytics of Honolulu, which tracks individual home values. It gives you a snapshot of the value of the collateral backing a mortgage security.
As of Sept. 26 -- a slightly different date from what we're using above -- ABSNet valued the remaining mortgages in our issue at a tad above 20% their face value. Now, watch this math. If the mortgages are worth 20% of their face value and each dollar of mortgages supports more than $2 of bonds, it means that the remaining bonds are worth maybe 10% of face value.
If all the originally AAA -rated bonds were the same, they'd all be facing losses of 90% or so in value. However, they weren't the same. The A-1 "super senior" tranche was entitled to get all the principal payments from all the borrowers until it was paid off in full. Then A-2 and A-3 would share the repayments, then repayments would move down to the lower-rated issues.
But under the security's rules, once the M-1 tranche -- the highest-rated piece of the issue other than the A tranches -- defaulted in July 2008, all the A's began sharing in the repayments. The result is that only about 28% of the original A-1 "super seniors" are outstanding, compared with more than 98% of A-2 and A-3. If you apply a 90% haircut, the losses work out to about 25% for the "super seniors," and about 90% for A-2 and A-3.
This was an especially bad issue, which we picked (on advice of some bond mavens who aren't competitors of Goldman Sachs) precisely because it was so awful. According to Bloomberg LP, recent trades in the A's were at less than 7% of face value. So the market is saying the losses are even greater than our estimates.
Goldman and Moody's declined to discuss this security. S&P told us that it had toughened its standards in 2005 and had discontinued rating second-mortgage securities in 2008. "Had we anticipated fully the severity of the declines in these markets at the time we issued our original ratings, many of those ratings would have been different," a spokesman said.
Now to the investment lessons: The first is, Don't put your faith in rating agencies, even though some branches of the federal government, including the Federal Reserve, use ratings to determine whether certain securities qualify as collateral under federal loan programs to financial institutions.
Our problem is that if things change for the worse after the original rating comes out, the agencies' response is, "Oops, sorry about that," and they revise the ratings down after you've already taken a hit. When lawsuits arrive, the agencies say all they did was issue an opinion that's protected under the First Amendment, therefore they're not liable.
The second lesson is, No matter how fancy the name is on the offering statement -- Goldman Sachs, the calumny being heaped on it lately notwithstanding, is still Wall Street's alpha outfit -- you're on your own if the issue heads south.
The final lesson is, Beware of the dangers of bottom fishing. It would have been tempting to buy this security when the original AAA paper traded down to the low two-digits -- but any buyer that did that is sitting on big losses.
Just as things often rise further than you think they will and stay there longer, they can also fall further than you think and keep on falling. Remember that when someone tells you that something is so cheap that it has nowhere to go but up.
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