Re-mimicking the crisis | FT Alphaville

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 hasn’t, 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:

Remimic mechanics - Barclays Capital

Of course, we presume the main 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, then.

Related links:
The Re-Remic gimmick?
– FT Alphaville
Structured finance 101
– FT Alphaville