The key word here is model. The ratings agencies used data supplied by the investment banks on what the likely default rates would be. It was like taking an open book test where you get to write the questions. And since home values had only gone up, default rates were low. Of course, the data was from an era when bankers lent money expecting to get paid back.

Inside a RMBS

As Berg points out, when you are buying a mortgage backed security, there are really only 3 questions you need to know the answers to:

1. How many mortgages will default?
2. How much will I get back on a defaulted loan?
3. How much credit enhancement is there in the security?
 
Let's take a mortgage where the home was originally appraised for $400,000 and there is a $300,000 mortgage on the home. Let's assume a default and the bank takes back the home. If they sell the home and recover $240,000 then they lose $60,000. This is called a 20% severity. If they sold and recovered $150,000 it would have a 50% severity.

How do the rating agencies come up with the AAA rating? First they model the expected losses. If they figure that 8% of the loans default at a severity of 50%, then the security would lose 4% of its value. To get an AAA rating you have to have at least twice the coverage of the "modeled" loss. An A rating assumes a coverage of more than 1 times but less than 2. B means you expect to get your money back. If they model that you’ll get back below 100% then the rating would be at junk levels.

All ratings assume a par value of 100. The rating of these bonds has nothing to do with price. After the presentation, Rich sat down with me and pulled up an actual mortgage backed security that was being offered that day on his screen. It was once a AAA rated Alt-A security. If I remember correctly it was a 2006 vintage security.

As of the latest reporting, a little over 5% of the mortgages were over 60 days past due or in foreclosure. In this security there are no toxic option ARMS. The number of mortgages in this security that are in trouble are rising. S&P has downgraded that AAA tranche to BBB.

Sure enough, the offered price of the security is 70 cents on the dollar, or 70% of the original par value. Remember, this particular AAA bond will only start to lose money after the lower tranches take up the first 8% of losses. Thus, this bond can be said to have an 8% credit enhancement.

Pricing in Financial Armageddon

Now, let's stress test that loan. For the AAA portion of the loan to lose money, 16% of the loans would have to default with a severity of 50% losses. Could that happen? Sure.

Let's look at what buying that loan at $0.70 on the dollar does for the new owner. First, you are getting a much higher yield (interest rate) because you are buying the security at a lower valuation. But something else even more interesting happens.