Remember, we already had credit enhancement of 8%. But at 70 cents, we just "bought" or priced in another 30%. Let's think Armageddon and that 50% of the mortgages default and they only recover 50% of the loans. That would only be a total loss of 25% to the entire collateral of the deal, but it would mean that the new investor still get all of my 70 cents plus another 13% back! The proud new owner could get up to 92% of the monies paid. Even in a pretty bad scenario you get more than you paid for the security.
Let's say the original security was $100 million. The AAA tranche would have cost $92 billion. If you have it at 70 cents on the dollar you paid approximately $64 billion. In my Armageddon scenario, the security loses 25% or $250 million. The lower rated tranches are completely wiped out losing $8 billion. Your tranche loses the remaining $17 billion which means you get $75 billion when you only paid $64 billion.
How bad would things have to get to lose money on this security? 72% of the loans would have to default with a severity of 50% before your investment of $64 billion was impaired by even so much as 1 dollar. If that happened, it would be Armageddon.
Why is it rated BBB? Because the rating is over the entire tranche and it’s made at a par price of 100. The rating isn’t affected by the current price. Assuming that even double the number of delinquent mortgages default with a 50% severity, your returns over the life of the security would be well over 12%. You would get back $92 million for your $64 billion dollar investment along with interest payments.
Here’s why this presentation was being made to banks: If you’re a bank, you can generally only get prime plus 2% on a loan you make. But if you buy this security with your capital, you can make prime plus 6%. That is a large difference to a bank. Performance Trust has sold billions of this type of paper to banks and institutions.
You might be wondering why everyone isn’t hitting such a good deal. In fact, these securities are very difficult to analyze. It’s time consuming. You need to analyze every loan and develop your own valuations. Because the ratings are measuring something completely different, you simply can't trust them.
The truth is that many of the RMBS securities will be totally wiped out or at least lose a great deal. Many are seeing default rates of 30% or more. You have to be very careful when you walk through this minefield. In a time of crisis, it’s not clear what the new rules will be. What if the government forces lenders to re-set mortgages at some loss level? What if the housing crisis gets worse? On the other hand, what if the government comes in and buys up all the bad mortgages in an attempt to stop the erosion in the home markets. The level of uncertainty in these times makes people a lot more cautious.
There are Alt-A RMBS like the one mentioned above that are probably not worth even 70 cents on the dollar. These things are marked to a frozen market. Everything gets lumped into the same basket that needs to be marked to market by the new accounting rules called FASB 157. The institution selling the above mentioned security is being forced to do so, either because they are in financial trouble or they are not allowed to hold BBB securities in their portfolios and by law are required to sell. In times of crisis, selling prices aren’t normal.
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