Tuesday, April 21, 2009

My Securitization Misconceptions

I am not a CMBS insider – although I’ve been doing nothing but income property finance for 30 years, it’s almost always been for whole loan lenders. However, a good chunk of that time was spent originating Fannie Mae multifamily loans and competing against CMBS lenders for business, and we lost that competition on many, many deals. I found this surprising – how could pricing be better on a securitized deal than the pricing offered by an institution with an implicit government guarantee? How could CMBS lenders offer better pricing on deals that had screamingly obvious flaws? At the time, I came up with some answers I thought made sense, but it turned out I was wrong.

Simple securitization is not complicated. You take a pool of loans and project the aggregate principal and interest cash flows from the pool. Picture the cash flow as a river with a series of waterfalls. First the cash flow goes to the A piece buyer, and the remainder goes to the B piece buyer. If the cash flow falls a little short because there are losses on some loans, the A piece buyer still gets his return but the B piece buyer gets shorted. If the cash flows are massively short (for example, many loans default as a result of a global financial meltdown), the B piece buyer is wiped out and the A piece buyer will also suffer some losses. If you’re a do-it-yourselfer, I recommend Keith Allman’s book, Modeling Structured Finance Cash Flows with Microsoft Excel; spend an afternoon with it and a laptop and you can do your own securitization model.

My first misconception was how value was created out of this process. The idea was the aggregate value of the allocated cash flow was worth more than the whole, much like the value of the packages of meat in the supermarket cooler are worth more than the whole cow. Some people want sirloin, some want hamburger, and by giving people what they want the parts are worth more than the whole.

Although to some extent value was created in this process, the real problem is the securities were simply mispriced. From The Economics of Structured Finance, A paper by Joshua Coval, Jakub Jurik, and Erik Stafford:

The rapid growth of the market for structured products coincided with fairly strong economic growth and few defaults, which gave market participants little reason to question the robustness of these products. In fact, all parties believed they were getting a good deal. Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives, such as corporate bonds. The “rated” nature of these securities, along with their yield advantage, engendered significant interest from investors.

However, these seemingly attractive yields were in fact too low given the true underlying risks. First, the securities’ credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies’ naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk). The spuriously low yields on senior claims, in turn, allowed the holders of remaining claims to be overcompensated, incentivizing market participants to hold the “toxic” junior tranches. As a result of this mispricing, demand for structured claims of all seniorities grew explosively. The banks were eager to play along, collecting handsome fees for origination and structuring. Ultimately, the growing demand for the underlying collateral assets lead to an unprecedented reduction in the borrowing costs for homeowners and corporations alike, fueling the real estate bubble that is now unwinding.

My second misconception was that the B piece buyers were the canaries in the mine. Rating agencies blessed the cash flow projections, but the real safety valves were the B piece buyers – since they were to take the first loss, they had a strong incentive to make sure the projections were reasonable. If the deals were too risky, B piece buyers would stop buying. This is what happened when CMBS spreads widened in 1998 after Russia defaulted on its bonds, so I thought that B piece buyers were an effective check on the market.

We now know, however, that B piece buyers were repackaging their exposure, obtaining a triple AAA rating of most of it, and selling their pieces as CDOs. Baseline Scenario provides a good explanation of how this worked in this post. Since the B piece buyers weren’t retaining the risk, there was no canary to signal the problem.

For more on securitization, Derivative Dribble is an excellent source. I recommend starting with Tranches and Risk.