Have US Mortgage Defaults Bottomed Out?

For all those securitization watchers that have traditionally looked to the US mortgage market as a bellweather for all structured products, perhaps an analysis coming out of California this week will be viewed as good news.

As the largest among the many asset classes in the securitization market, US residential mortgage-backed securities (RMBS) and the residential mortgages that make-up the collateral pools for thousands of GSE and private MBS structures have always been viewed as the foundation of the structured finance industry; and within the asset class, the California housing market has been viewed as the most important and therefore the most analyzed market in the US.

This week, DataQuick, a San Diego based research firm, published a report which among other nuggets detailed trends for new defaults in the California residential market.  What their research apparently tells us is that, not since the Second Quarter of 2007 has the pace of new mortgage defaults been as low as it was in the First Quarter of 2011.

New California Mortgage Default Notices*

  • Q2 – 2007 : 53,493
  • Q1 – 2009: 135,431
  • Q1 – 2011: 68,239

At minimum, these findings suggest a signficant turning of the corner in the largest US market.  At maximum, the statistics might just pose the question that if California seems to have turned a corner, can the rest of the US market be far behind?  If you subscribe to the theory that Q2 2007 may have been the last “normal” quarter for the mortgage market in the past 5 years, then the drop in new default filings to a level which approaches that last normal period must tell us something about the re-stabilization of the market.

Of course, these days all industry followers can be accused of sifting through the ashes, searching for any good news.  While that is undoubtedly accurate, we have seen bottoms (and recoveries) before.  In the past, it has been statistics such as these that have signaled the turn. 

*(Source: DataQuick)

CLO Strategies Continue to Percolate

If anyone had any doubts about whether the Collateralized Loan Obligation market was nearing full boil, these doubts should have been erased by the cascade of new developments over the past several days in this recovering asset class.

Yesterday’s announcement by Ares Asset Management of their purchase of a US$2.5 Billion portfolio, composed of 6 CLO issues and a separate loan fund from Nomura Holdings, Inc., capped yet another week of signficant announcements for CLO’s.

Although there are continuing concerns about the supply of new product, there are few that can refute the steady recovery of the broadly syndicated loan market which has traditionally provided most of the collateral for these structured programs.  The recent flurry in bank financing to back a surging  M&A market only reinforces the growing momentum in the loan market which should create a strong supply of collateral for new CLO programs.  On the investor side, more and more portfolio managers are being called on to produce better returns, as their clients begin to push for performance.  CLO’s and the strong performance of many of these structures over the past several years, despite the economic turn-down, are turning into an increasingly attractive option.

These trends are generating a wave of activity within the CLO market as managers look for consolidation opportunities such as the Nomura purchase by Ares and the recent completion of the combination of CIFC and Deerfield CapitalCarlyle has also let it be known that they remain on the hunt for new acquisition opportunities and Wells Fargo’s sale of  its US$500mm Foothill CLO I is apparently imminent. 

Other strategies involve the build out of new commercial financing platforms with the intent to issue new CLO’s as their portfolios grow.  Churchill Financial’s announcement of their organization of a business development company (“BDC”) aimed at building a CLO platform is just the latest example of a BDC strategy being utilized in the CLO market.

We would expect that for much of the remainder of 2011, we will find key CLO market participants continuing to retool and reload their businesses to take advantage of expected growth in demand for new CLO product.

Sheila Bair’s Double Standard

Yet another interesting set of pronouncements from the FDIC’s outgoing Chairman, Sheila Bair.  It seems that the Chairman is once again wrapping herself in the blanket of the US taxpayer, taking just a few more final swings at the banking community that her department oversees.

In today’s Financial Times interview, Ms. Bair suggests that the standard of “Too Big to Fail” should have a big stake run through it, so that it is clear once and for all, that taxpayers will not be responsible for bailing out big banks that run into trouble.  She is suggesting that the banks should “ring-fence” their most risky activities, so that taxpayers will be protected from excessive risk.

We almost can’t believe that she said ring-fence.  We read the interview several times to make sure we weren’t somehow mistaken.

Is this coming from the same person that has led an FDIC that has campaigned against the development of a legislative framework for a covered bond market in the US?  Isn’t the notion of a “ring-fence” around assets pledged to the holders of covered bonds issued by banks, exactly what the FDIC is contesting. 

Oh….. we get it!  The FDIC wants to be sure it can control what assets and businesses are valuable and which are not.  They want to control what they are obligated to stand behind and what they are not.  This almost sounds like a private sector insurance company’s business model.

Isn’t putting a ring-fence around certain assets, exactly what the entire securitization industry was built on.  Financial institutions should have the right to sell both good and bad assets from their balance sheet.  The “true sale” standard withstood a test of more than 30 years in the market.  Now the FDIC wants to use a ring-fence to pick and choose what it backs but won’t afford the same freedom of choice to their members.

The problem with wrapping oneself in the blanket of the taxpayer is that it is the taxpayers which are hurt the most when the markets collapse.   The government “loans” that were made to the financial services industry resulted from a very, very complex set of events that transpired over many years and these events demanded that the Federal Government step up in the very same way it does after a major natural disaster.

 Keep in mind that it is the banks themselves that fund the FDIC’s insurance fund and while things were very good during the past 15 years, we are sure that the FDIC was very happy to collect the premiums that supported that fund. 

We think it is easy to forget just how desperate and bleak those days were in late 2007 and 2008 and just how important it was for all taxpayers that the financial system was able to fall back on the same type of safety net that every important part of the “infrastructure ” in this country relies upon.  There will always be some things that are just “too big to fail” or put another way, too big and too important for us to not try to save. 

Ms. Bair’s reference to Lehman in her interview as an example of how she suggests it could have been done differently is rather ironic.  Given the enormous gain that Barclay’s made as a result of the fire sale price it paid for Lehman’s assets, you have to continue to wonder if the US Government should have stepped in sooner and, if they had, would the overall price tag that Ms. Bair is referring to been less; perhaps much less.

The Financial Crisis was/is a natural disaster in every sense of the word.  Quite simply, there were too many people, in too many parts of the economy (including regulators like the FDIC), involved in creating the mess to suggest it was anything different.  On that basis, it was exactly the right thing to step in and prop up the largest US (and Global) financial institutions in this time of disaster.  Without those institutions, there isn’t a U.S. economy to talk about.

If the Chairman and other regulators want to discuss whether a bank should be engaged in one business or another or discuss whether the insurance premiums for institutions engaged in certain activities are high enough, we think that is a different conversation; perhaps one that should be had.

However, we can only hope that both this discussion about “ring-fencing” certain businesses while severely restricting securitization and the beating of the “end too big to fail” drum will also ride off into the sunset in the coming months.

The Financial Crisis: A Victimless Crime?

As any good detective might tell you, in order to catch a criminal, you must have a crime and in order to have a crime, you must have a victim.

This week the US Senate released a 650 page report, “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse”.  Of course the metaphor in the title lies in the reference to “anatomy” and the indirect reference to a “corpse”.  In this tragedy, the role of the corpse is played by the Global Economy (except China and Brazil, we suppose).  The problem with this casting is that the actor (i.e. the Global Economy) is simply too big to get one’s head around it; not unlike standing 6 inches from an aircraft carrier and trying to take in all its subtleties (not an easy thing to do).

Nevertheless, if you cast the Global Economy on one side, you would seem to need an equally large villan in the other leading role.  In comes Wall Street in all its high office tower, private jet flying, five-star resort staying, Gucci wearing best to the rescue. 

We fear that the reality doesn’t live up to the Hollywood casting.

The New York Times had an interesting article today, asking the question “Where are all the prosecutions?”.  The general theme seems to be based on the prevailing conventional wisdom that “Everyone knows that Wall Street bamboozled their customers and stole billions from their innocent clients”.  Has to be true, right? 

If it is true then another popular conventional wisdom is there to support the argument; namely that “This fraud was so sophisticated and so well thought out that it will be next to impossible to pin the blame on the Wall Street bankers”.

On the other hand, we would prefer to have folks consider the following:

No doubt there were bad transactions being put together by Wall Street bankers.  That is simply a fact that cannot be disputed.  However, if they were so smart and if they were so cunning, as to make sure they weren’t caught, what happened to Bear Stearns, Lehman, Merrill Lynch, UBS, etc, etc?  We suppose they didn’t get the memo.

*  Are we really to believe that many, maybe most, of the investors in complex MBS, CDO and other structured programs were not “sophisticated” investors?  Who’s kidding who?  So many of these folks started their careers on the sell side at those very same Wall Street banks.  Many others are simply too smart or capable to have to work for a large public company, like a Wall Street bank, where their ideas and strategies would be too constrained.

We have in the past offered a different analysis of the events and actions that led to the collapse of the global credit markets:

1- The entire market, including everyone from issuers to arrangers, to rating agencies, to law firms, to accounting firms and to investors fell into the same trap that has been a major component of every major market collapse since the dawn of time; namely, too many people became too lazy and relied too heavily on the work and opinions of others.  No matter how sophisticated we might become, we will always be vulnerable to complacency and no Basel III or Dodd-Frank is going to completely solve that problem.

2- If we want to narrow the focus to the US market (since it is the linchpin in the Global Economy), we would prefer to look where the majority of all that extra liquidity and cheap capital wound up from 2000-2007.  Most of it wound up in the pockets of consumers and many plowed their money into the US real estate market.  This “social movement” was engineered by our Government (and we voted for them) in the late 1990’s and rubber stamped by US regulators in the early 2000’s. 

In our view, if you want to find a villan in this tragedy, it will be hard to do so.  That’s because, in addition to all those Wall Street bankers that seem so obvious for the part,  this casting call will need to include the thousands of small time mortgage brokers and bankers who bent the rules, the regulators who turned an eye and even the politicians who thought they knew better.

How about this as an answer to the New York Times question……..  Maybe the reason that there has been a shortage of criminals in this movie is that there really isn’t a victim here…… And as we mentioned above, if you don’t have a corpse then you don’t have a crime.

CLO’s Breaking Out

There is much good news in the markets these last few weeks about the resurgence of the Collateralized Loan Obligation market and it seems that any potentially bad news resulting from the SEC’s recently proposed risk retention rule is not dampening that enthusiasm.

One might conclude that most industry participants are expecting that once the regulators realize the potentially negative and perhaps unintended impact of the newly proposed skin-in-the-game rules on non-mortgage asset structures, they will make the proper adjustments (“clarifications”) to the rule.  We would agree with this assessment.

So, with optimism abounding, we see the results of Citigroup’s survey of attendees at the bank’s recent Structured Credit Conference indicating that a majority of the investors survey expect to increase their holdings of  primary CLO’s and nearly half indicated their intentions to increase their secondary CLO holdings. 

We don’t find this surprising as more and more stories about how well “pre-crisis” CLO’s have performed including a recent story about how some of the “old” Lehman Bros. CLO’s are producing annualized returns exceeding 50%.  The S&P/LSTA Leveraged Loan Index is up by more that 17% since October 2009.

No wonder that Bloomberg reports that  BlackRock, Inc.  is currently working with Citigroup in sourcing $400mm for a new CLO program and many other banks and asset managers are considering the possibilities associated with a strong resurgence in this asset class.

Covered Bonds: UK Regulators Get it Right!

Excellent news coming out of London this week as both the FSA and the UK Treasury have confirmed that investors in the UK Covered Bond market should count on the fact that the collateral backing their bonds issued by UK banks will be protected even if the issuing bank goes under.

The uncertainty in each of the major structured finance markets for how local regulators will treat securitizations and other “collateralized” debt instruments in connection with a bank failure has put a wet blanket  on the global market’s recovery.  Notably, the lack of clarity from the US regulatory bodies, led by the FDIC, has cast a pale over the resurrection of that market.  Add the FDIC’s resistance to recently proposed legislation which would largely “align” a fledgling US Covered Bond Market with what most investors believe is in place in both the European and Canadian markets and this week’s announcement out of the UK would seem to add even greater distance between the US regulators and their counterparts around the world.

We applaud the UK regulators and their “confirmation” of what many investors believed was already the case.  We agree with those that have pointed out that this is exactly the type of “transparency” that the markets need and, quite frankly, deserve.

We remain baffled by how US regulators, who for more than 30 years set the standard for a progressive framework for the global securitization markets, can continue to get it all so wrong.

Proposed Risk Retention Rule Simply Misses the Point

Yesterday, the six major U.S. financial services regulatory agencies announced their joint-proposal for the guidelines that issuers of securitized debt instruments will be expected to follow, as a result of the “risk retention” standards set by the Dodd-Frank legislation.

We suppose it’s really not their fault.  After all, the law is the law.  Nevertheless, something just doesn’t sit right with us as we continue to ask, where are the industry experts when you need them?  The proposal is a slightly modified version of what has been kicked around since 2008 and crowed about from the rooftops by every politician and pundit on the planet…….. the answer to this whole mess is “skin-in-the-game” or shall we say “skininthegame”, since the phrase has been so over-used for so long that it has become one word?

As far as we can tell, this entire discussion has been hijacked by the same type of “faulty assumption theory” that brought the securitization industry to its knees to begin with; namely the over reliance on someone else in the process, based on the assumption that “they are the experts and they should know what they are doing”.

In the case of the securitization industry of the mid-2000’s, otherwise sophisticated investors relied too much on the rating agencies, who relied too much on the underwriters, who relied too much on their models and third-party experts, who relied too much on the originator’s underwriting methods, who relied too much on their “relationship” with their mortgage bankers, etc, etc, etc.

Is it us, or did we read too much latitude into Dodd-Frank, as the legislative end of this whole business (never one to take a position that they couldn’t back off from gracefully) seemed to be giving the regulatory bodies a wide berth to implement the intent of the legislation as those bodies see the legislation best fits their markets?  After all, the regulators are the experts!

On the other hand, maybe we expected too much of the regulators, as the shortage of “political cover” for their own political or private sector aspirations may not have given the leadership of these agencies much choice but to go with the flow of “current conventional wisdom”.

The problem we see is that the basis for all this policy seems to be well rooted in any number of false conclusions and assumptions.

In no particular order, here are some the things that are nagging us…….

1) 5% Retention Level:  We find no real logic behind this level.  As with many rules and regulations devised under duress, this seems to largely an arbitrary figure.  We can’t help but come back to a scenario where an unrepentant issuer, with horribly deficient underwriting standards taps the market for a $500mm securitization of sub-prime mortgages.  Does anyone really think that this issuer is going to think twice about the fact that they must retain $25mm of the pool, when they can unload the other $475mm?

We know, you’re going to say “but wait a minute!  There are other ways to prevent this from happening.” and we would be the first to agree with you.  Stopping the cheat should not be a matter an exercise of trying to put the genie back in the bottle or one which penalizes the frequent or large issuer and that is what we believe the 5% rule does.

2) The Fox and the Fox:  From our little corner of the room, we can’t help but continue to feel that much of this whole process has been one big chess game with both the legislative and the regulatory bodies trying to stay focused on one very mutually beneficial objective; namely to make sure that no one remembers that it was the Government doing all the encouraging to open up the mortgage markets and then turning their back to the abuses in the origination process.  It has always been easier to blame the inmates for conditions in the asylum.  One section of the SEC’s published notice is telling……..

“When properly structured, securitization provides economic benefits that lower the cost of credit to households and businesses.  However, when incentives are not properly aligned and there is a lack of discipline in the origination process, securitization can result in harm to investors, consumers, financial institutions, and the financial system.

 During the financial crisis, securitization displayed significant vulnerabilities to informational and incentive problems among various parties involved in the process.

For example, as noted in the legislative history of section 15G, under the “originate to distribute” model, loans were made expressly to be sold into securitization pools, with lenders often not expecting to bear the credit risk of borrower default.  In addition, participants in the securitization chain may be able to affect the value of the ABS in opaque ways, both before and after the sale of the securities, particularly if those assets are resecuritized into complex instruments such as collateralized debt obligations (CDOs) and CDOs-squared.  Moreover, some lenders using an “originate-to-distribute” business model loosened their underwriting standards knowing that the loans could be sold through a securitization and retained little or no continuing exposure to the quality of those assets.

 The risk retention requirements added by section 15G are intended to help address problems in the securitization markets by requiring that securitizers, as a general matter, retain an economic interest in the credit risk of the assets they securitize. As indicated in the legislative history of section 15G, “When securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interest with those of investors in asset-backed securities.”

By requiring that the securitizer retain a portion of the credit risk of the assets being securitized, section 15G provides securitizers an incentive to monitor and ensure the quality of the assets underlying a securitization transaction, and thereby helps align the interests of the securitizer with the interests of investors. Additionally, in circumstances where the assets collateralizing the ABS meet underwriting and other standards that should ensure the assets pose low credit risk, the statute provides or permits an exemption.

 The credit risk retention requirements of section 15G are an important part of the legislative and regulatory efforts to address weaknesses and failures in the securitization process and the securitization markets. Section 15G complements other parts of the Dodd-Frank Act intended to improve the securitization markets. These include, among others, provisions that strengthen the regulation and supervision of nationally recognized statistical rating agencies (NRSROs) and improve the transparency of credit ratings; provide for issuers of registered ABS offerings to perform a review of the assets underlying the ABS and disclose the nature of the review; and require issuers of ABS to disclose the history of the repurchase requests they received and repurchases they made related to their outstanding ABS.”

We could go on at some length about several “freudian moments” in this passage but the central point is that this proposal and all the arguments that go with it are essentially an attempt to fix problem in the “asset origination” process by restricting the “securitization origination process”.  How about focusing the cure on the source of the problem?  Of course if they did that, it would shed light on just how lax and just how negligent the cops on the beat were throughout the past decade. 

3)  To Praise or to Defile Securitization:  “To be or not to be!  That is the question for securitization.”  On the one hand, regulators have continuously sung the praises of securitization’s significant role in a robust capital market.  Once again, even the above passage describes how securitization represents one of the most efficient methods for ensuring that consumer borrowing costs are affordable.  Why then would the centerpiece of the regulators proposals attempt to artificially increase those costs by a) forcing so many borrowers away from the “Qualifying Residential Mortgage” market and b) imposing an extra cost to the securitization program in the form of the 5% retention rule.  If something is that important to a well operating market, then why would you try to stymie it; particularly when it is not the securitization process itself which is the real problem?

We would probably agree with the many that are now projecting both 1) a more costly consumer market in those markets that have traditionally relied on securitization to fund their operations and 2) a vastly smaller market where it may prove difficult for many borrowers to even find a lender in critical consumer markets such as residential mortgages, autos and credit cards.

Somehow the regulators, the “experts”, seem to have missed the point.