PrefBlog

My quotation from the Bear Stearns Asset Backed Securities Trust prospectus on December 7 was well received, with both Econbrowser and Calculated Risk kind enough to credit me in their posts. My interest was more regarding the investor in the conduits being concerned the cash flows from the pool were being reduced; these two commenters are more interested in Treasury involvement.

It seems that the legal structure for these investments is a REMIC – real estate mortgage investment conduit, which has to be brain-dead in order to qualify for advantageous tax treatment. Without some assurance from the IRS that The Plan would not disqualify the conduit, there would be no plan – however, some such assurance is expected shortly; no great surprise since Paulson runs Treasury and Treasury runs IRS.

Calculated Risk also provides commentary on the involvement of FHA & FHASecure in The Plan.

Meanwhile, reverberations about the entire sub-prime fiasco continue, with UBS, Washington Mutual and MBIA announcing major equity infusions today. Meanwhile, Bank of America is winding up an Enhanced Money Market Fund that broke the buck on SIV paper, SocGen is consolidating a SIV onto its books and good old MLEC/Super-Conduit is being ridiculed as too little, too late.

Accrued Interest thinks we’ll see more of this:

However, my view is that this won’t be the end of MBIA’s need for more capital. MBIA has about $84 billion in residential ABS and “multi-sector” CDOs, vs. about $82 billion with AMBAC. I recently estimated that AMBAC would need $2-3 billion in new capital, so I’d suspect that before this is all said and done, MBIA comes back to the market for more. Note I didn’t say that MBIA would get downgraded. I have a strong suspicion that the bond insurers have been tipped off by Moody’s and Fitch as to how the capital adequacy studies are going. I further suspect that any capital improvements you hear about in the coming days are over and above what Moody’s and Fitch will announce (supposedly next week) is needed.

David Dodge used a speech at the Empire Club to plug the Financial System Review article on the credit rating agencies. He also lends a certain amount of support to calls for repeal of the credit agencies favoured position with respect to material non-public information (in the US, this means exemption from Regulation FD; I don’t know what the legal framework is in Canada):

Let me touch briefly on the role of credit-rating agencies in all of this. There is an article in the current FSR that expands on the issues related to the possible reform of the credit-rating process. One thing that is clear is that in the future, credit-rating agencies will find it to their advantage to explain more clearly the rationale for, and limitations of, their ratings for highly structured products. There are some natural, self-correcting market forces at work that should lead the rating agencies to improve their processes. Indeed, those credit-rating agencies that do not work harder to improve their processes will likely have fewer clients willing to pay for their services. As I understand it, most agencies are working on such improvements.

But credit-rating agencies are not to blame for the lack of information about those highly structured products that were sold to highly-sophisticated investors in the so-called exempt market. In the retail market, securities regulators impose strict requirements about the information that must be provided through a prospectus or term sheet. But there are no such requirements in the exempt market. It seems to me that some very basic disclosure is needed in every market. And since securities designed for the exempt market are usually required to carry a rating from a credit-rating agency, one way to ensure that appropriate information is available could be to require issuers to publicly disclose the same information that they make available to credit-rating agencies. In this way, investors would have access to the information they need in order to make informed decisions.

I’d like to see more discussion of this issue; removal of the special privilege might mean that everybody gets to see the information; it might mean that nobody gets to see the information.

For example, it is my understanding that the guarantee of Principal Protected Notes by international banks has a two-tiered price structure: you can get the guarantee with or without using the name of the guarantor in your advertising. In the current system, the credit rating agency can (I think) look at all the information and rate the notes while taking into account the non-public nature of the guarantee. In the proposed system, not even the credit rating agency would get to see the terms of the notes and the guarantor, unless it was all public and therefore more costly.  

I spent some time today at the David Berry hearing. You know why lawyers get paid so much? It’s because they have to listen to so much mind-numbing detail, that’s why. The part I heard was an assertion by RS staff that RS does indeed have authority to make a finding of misconduct should they wish to do so. This has been challenged by Mr. Berry on a variety of grounds including – as far as I can make out – that the TSE was not timely in changing its rules to reflect the hand-off of regulatory powers to RS and that, while Mr. Berry was employed by a Member of the TSE at the time of the alleged offence, he is not so employed now.

To my great astonishment, the documents presented to the panel hearing the case have not been published on the RS website.

I’ve found a bit more information on the Coleman Stipanovich story:

Stipanovich has worked for the board since 1999. Before that he was president of an investment consulting firm in Gainesville. He has worked for Paine Webber as a consultant and investment executive. He has a master of science degree in Criminal Justice Administration from Michigan State University and a bachelor of science in criminology from Florida State University.

Democrats have questioned why Stipanovich, whose brother is lobbyist and Republican strategist J.M. “Mac” Stipanovich, was hired. “This administration is taking the friends-and-family plan to the extreme,” Democratic Party spokesman Ryan Banfill said. “A $100-billion fund — it seems to me to be a no-brainer that you would do a national search.”

And a report – how accurate I don’t know – on his salary:

After seven years of overseeing Florida’s investment portfolio, Coleman Stipanovich suddenly resigned his $182,000 job moments ago amid upheaval over a massive withdrawal of the local government investment pool.

So let me see if I have this straight … the CEO of a fund with $184-billion in assets is being paid $182,000? And was hired without a national search? Not that a national search would have found anyone well qualified, because you don’t need to be a very well established portfolio manager – not boss of investment firm, I mean portfolio manager – to make more than $182,000 anyway.

I just lost all sympathy for the Florida municipalities – regardless of how much, if any, of the blame for their mess can be laid at Mr. Stipanovich’s door, they deserve exactly what they’re getting.

Another day of good volume and good performance by the perpetuals today.

Dear Santa, I have tried very hard all year to be a good Portfolio Manager. All I want for Christmas is to keep the month-to-date relative returns for the fund. Sincerely, JH. P.S., If you have any relative returns left over, of course, I’ll take them. JH.

There were forty other index-included $25.00-equivalent issues trading over 10,000 shares today.

The Internet is alive with discussion of the sub-prime bail-out announced by George Bush yesterday:

Representatives of HOPE NOW just briefed me on their plan to help homeowners who will not be able to make the higher payments on their sub-prime loan once the interest rates goes up — but who can at least afford the current, starter rate. HOPE NOW members have agreed on a set of industry-wide standards to provide relief to these borrowers in one of three ways: by refinancing an existing loan into a new private mortgage, by moving them into an FHA Secure loan, or by freezing their current interest rate for five years.

Lenders are already refinancing and modifying mortgages on a case-by-case basis. With this systematic approach, HOPE NOW will be able to help large groups of homeowners all at once.

The first question to occur to both Naked Capitalism and Jim Hamilton of Econbrowser was: how is this legal?

The natural question is then, Why did lenders volunteer to receive a lower interest rate than that to which borrowers had previously committed? And why was the announcement coming from the government rather than the creditors themselves?

Joshua Rosner – last mentioned in this blog in connection with an early – if somewhat self-serving – attack on the Credit Rating Agencies was quoted by Bloomberg:

“The modification of existing contracts, without the full and willing agreement of all parties to these contracts, risks significant erosion of 200 years of contract law,” said Joshua Rosner, managing director at Graham-Fisher & Co., an independent research firm in New York.

This got me interested in the actual contract language, so I went back to the security issue that I have been using as an – unscientifically chosen and possibly completely unrepresentative – example of a tranched RMBS CDO : Bear Stearns Asset Backed Securities Trust 2005-1. In order to find out what the contract between the securities holders and the securities issuers says, I’m going to try my hand at reading the contract. Old-fashioned of me, I know, but I’m an old-fashioned guy. The prospectus says by way of warning:

Modifications of mortgage loans agreed to by the master servicer in order to maximize ultimate proceeds of such mortgage loans may extend the period over which principal is received on your certificates, resulting in a longer weighted average life. If such modifications downwardly adjust interest rates, such modifications may lower the applicable interest rate cap, resulting in a lower yield to maturity on your certificates.

Continuing a text search for the word “modification” (finding out that “modification” was the right word to search on to find this stuff took me an hour last night, so I hope this post is greatly appreciated) we find the good part in the section “COLLECTION AND OTHER SERVICING PROCEDURES”:

EMC, as master servicer, will make reasonable efforts to ensure that all payments required under the terms and provisions of the mortgage loans are collected, and shall follow collection procedures comparable to the collection procedures of prudent mortgage servicers servicing mortgage loans for their own account, to the extent such procedures shall be consistent with the pooling and servicing agreement and any insurance policy required to be maintained pursuant to the pooling and servicing agreement. Consistent with the foregoing, the master servicer may in its discretion (i) waive any late payment charge or penalty interest in connection with the prepayment of a mortgage loan and (ii) extend the due dates for payments due on a mortgage note for a period not greater than 125 days. In addition, if (x) a mortgage loan is in default or default is imminent or (y) the master servicer delivers to the trustee a certification that a modification of such mortgage loan will not result in the imposition of taxes on or disqualify any trust REMIC, the master servicer may (A) amend the related mortgage note to reduce the mortgage rate applicable thereto, provided that such reduced mortgage rate shall in no event be lower than 7.5% and (B) amend any mortgage note to extend the maturity thereof, but not beyond the Distribution Date occurring in March 2035.

So – the legality of proposed loan modifications looks clear enough. The servicer has discretion, provided:

• New rate is not lower than 7.5%
• New maturity date is not later than the Distribution Date in 2035
• “procedures comparable to the collection procedures of prudent mortgage servicers servicing mortgage loans for their own account” have been followed

So there you have it. It is the Prudent Man Rule that applies to loan mods, and all that Bush and New Hope Alliance have done is changed the definition of what may be prudently done.

Prof. Nouriel Roubini, as always, writes a very insightful and entertaining commentary:

Also the actual legal challenges to these loans modifications – that a number of authors have expressed concerns about – are also way overstated: leaving aside technical legal issues litigation will be very limited only because investors in these instruments are better off under this plan than the nightmarish alternative of massive defaults and foreclosure; investors are not stupid and will find out on their own that they are better off in a world where mortgage are orderly and massively restructured.

Naked Capitalism has an entire post devoted to what Prudent Men used to do in the old days and claims that in the rough and tumble of corporate law, there might be enough ammunition to inflict damage on the New Hope Alliance. I don’t buy it – at least, not yet, and not as far as the Bear Stearns Asset Backed Trust prospectus is concerned. If you have all these people saying (i) it’s prudent, and (ii) it’s what they do when servicing mortgages they own themselves, I can’t see a judge saying that they’re not prudent according to contemporary standards.

Would I go to court on this? Not in a million years. I’d get the advice of a real lawyer, and that would be AFTER I’d spent a full week reading the entire prospectus extremely carefully myself. But I haven’t seen this explained anywhere else, so I thought I’d take a stab at it. Anyway, it was once explained to me that the first thing you learn as a law student is that a contract is holy. The first thing you learn as a practicing lawyer is that a contract is a reasonably convenient place to start. So let’s not hear any more about contracts, OK?

Accrued Interest asks a much more interesting question: what’s in it for me?:

So my view is that the deal benefits senior tranche holders, and REALLY benefits monoline insurers, who mostly care about the senior holders. If the odds of senior holders remaining whole for a longer period of time goes up, that’s certainly good for AMBAC, MBIA, etc.

Moody’s commented:

Moody’s has cited insufficient use of loan modifications, along with underlying loan defaults and home price depreciation, as a contributing factor to recent subprime RMBS downgrade actions. (See the October 11, 2007 Special Report “Rating Actions Related to 2006 Subprime First-Lien RMBS”.) We believe that judicious use of loan modifications can be beneficial to securitization trusts as a whole.

Based on our recent servicer survey results, the number of modifications to date has been relatively small. The proposed framework seems to provide a reasonable approach for identifying borrowers suitable for streamlined modifications and should expedite the number of modifications going forward. Time will tell how successful servicers are in identifying and modifying the loans most appropriate for modification. The ability of servicers to determine a borrower’s eligibility for FHA Secure or other refinancing options may vary, since a servicer’s expertise generally lies in servicing and not in underwriting. Larger servicers with both servicing and origination arms may be better equipped to manage this process.

Generally speaking, a higher level of interest rate modifications should decrease delinquencies post reset, thereby also potentially contributing to ratings stability for securities backed by subprime collateral.

Fitch has also weighed in:

Fitch Ratings believes that on balance, by mitigating the impact of ARM resets on borrower default rates, the framework can help to reduce the risk of principal loss on senior subprime RMBS. Increased refinancing opportunities via FHA and other programs are also important to stabilizing default rates. The implications for subordinated RMBS classes are unclear, as they may be exposed to a complex interaction of variables that can be difficult to analyze. Implementation of the proposed data reporting will aid analysis of the impact of streamlined modifications, and analysis of loan modifications generally.
…
If substantial number of borrowers prove to be eligible for streamlined modification and accept the five-year fixed rate, this should lead to lower default and loss rates than might be expected, if borrowers incurred a large payment increase at ARM reset. A major concern regarding the large-scale conversion to five-year fixed-rates is that excess interest within RMBS will decrease. Excess interest is an important source of credit enhancement which compensates for loss of cash flow due to mortgage losses. Uncertainty around the benefit of loan modifications is centered on the relative reduction in loss, versus reduction in excess interest that could be incurred. On balance, Fitch believes that stabilization of loss rates can outweigh excess interest reduction when analyzing the impact on senior RMBS. Greater refinancing opportunity can also help senior bond performance, as it will cause those bonds to prepay and reduce the risk of principal loss.

For subordinated RMBS, excess interest is a much greater component of credit enhancement, and in some instances only substantially lower loss rates would offset a reduction in excess interest. Fitch also notes that extensive use of rate ‘freezing’ will lead to lower collateral weighted average coupon (WAC), which in turn could lead to more extensive Available Funds Cap (AFC) interest shortfalls. AFC shortfall risk is not addressed by Fitch’s credit ratings.

and, as far as everything else goes:

“At best, it may stop some of the hemorrhaging of the housing market, but it doesn’t necessarily turn things around,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “The fundamental problem with housing is oversupply.”

Existing home prices may fall as much as 15 percent by 2009 from their peak last year, even if interest rates are frozen on one fifth of 2006 subprime loans resetting next year, said Mark Zandi, chief economist at Moody’s Economy.com, a unit of New York-based Moody’s Corp. About 2.8 million mortgage loan defaults will occur in 2008 and 2009, Zandi said in Dec. 5 testimony before the U.S. Senate Judiciary Committee.

Meanwhile, US ABCP yields are spiking:

Yields on commercial paper backed by assets such as credit cards and mortgages rose at the fastest pace in at least a decade as investors retreated from buying debt that may contain subprime mortgage assets.

Yields on 30-day asset-backed commercial paper rose 91 basis points to 6.06 percent this week, or 82 basis points more than the one-month London interbank offered rate, the largest gap on record, according to data compiled by Bloomberg.

What makes this even more interesting is that outstandings fell another $23.1-billion this week and are now down to $801.2-billion from the July month-end level of $1,186.6-billion. However … the Super-Conduit/MLEC is up and running!

The banks also began marketing the fund to smaller institutions, aiming to raise $75 million to $100 million, including their own undisclosed contributions, said the people, who asked not to be named because details of the SuperSiv haven’t been made public. The banks, the three largest in the U.S., are set to meet with potential contributors on Dec. 10.

Well … up and stumbling, anyway. The three big sponsors are making undisclosed contributions? Perhaps this is just my lack of marketting skills showing up again, but it seems to me that if the sponsors really wanted it to fly, they’d have a big news conference announcing that they’d put $1-billion each into the things capital notes.

But capital notes aren’t looking too good nowadays:

Standard & Poor’s said it lowered credit ratings on capital notes of 13 structured investment vehicles and placed debt of 18 SIVs on negative outlook as the funds struggle to finance themselves.

Orion Finance Corp., managed by asset manager Eiger Capital Ltd., became the fourth SIV to enter “enforcement mode,” requiring the appointment of a trustee to protect senior debt holders. Premier Asset Collateralized Entity Ltd., an SIV sponsored by Societe Generale SA is close to breaching capital tests that would trigger enforcement, S&P said in a statement.

Expectations for a massive easing by the Fed are being reduced:

Futures contracts on the Chicago Board of Trade indicated a 24 percent chance that policy makers will lower the 4.5 percent target rate for overnight lending between banks by a half- percentage point at their meeting Dec. 11, compared with a 36 percent likelihood yesterday. The odds of a quarter-point cut were 76 percent.

… while Prof. Gilles Saint-Paul of Toulouse encourages the Fed to play tough:

To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.
…
the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market.
…
All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

PerpetualDiscounts were up again today. *yawn* Remember the old days, when they sometimes went down? Life was more interesting then.

There were thirty-five other index-included $25.00-equivalent issues trading over 10,000 shares today.

After CIBC’s earnings release this morning, Moody’s announced that it had:

affirmed the ratings of Canadian Imperial Bank of Commerce (CIBC) and rated subsidiaries and changed their rating outlooks to negative from stable. CIBC is rated B- for bank financial strength, Aa2 for long-term deposits, and P-1 for short-term obligations. This rating action follows CIBC’s earnings report for the fourth quarter of 2007 in which it disclosed details of a hedged portfolio of Collateralized Debt Obligations (CDO). 

The change in outlook is based on Moody’s view that this exposure highlights weaknesses in the firm’s strategic risk management. Moody’s concern centers on the concentration of counterparty risks to which it has exposed itself via a rapid and recent build-up of its CDO activities. Though Moody’s believes that any losses related to these particular exposures are manageable for CIBC, risk management weaknesses may expose the firm to further risks. Moody’s is also concerned that it has cited CIBC in the past for risk management weaknesses, and despite expected improvements, it now appears the bank has not fully addressed appropriate risk-taking at a senior, strategic level.

In other words … Moody’s is saying that CIBC got away with it this time, but they’ve been more lucky than smart.

In Super-Conduit/MLEC news, yet another bank is acting immediately:

Rabobank [RABN.UL] is taking the remaining assets of its structured investment vehicle (SIV) Tango Finance onto its balance sheet, the unlisted Dutch bank said on Thursday.

Rabobank, which manages Tango with Citigroup (C.N: Quote, Profile , Research), said the SIV has only 5.2 billion euros ($7.6 billion) in cash assets, down from 9.7 billion in July. Rabobank had warned on Wednesday that Tango’s size had almost halved as it has been selling off assets.

And the Northern Rock auction is running into trouble:

U.S. buyout firm J.C. Flowers’ offer to buy British bank Northern Rock (NRK.L: Quote, Profile , Research) was in doubt late on Thursday as people familiar with the matter said its interest had cooled.

J.C. Flowers remains interested in buying Northern Rock but is finding it increasingly difficult to meet the requirements of shareholders and the government, Bank of England and regulators, all of whom are involved in the auction, a person familiar with the matter said.
…
A consortium led by Virgin Group [VA.UL] has been picked as preferred bidder, but Flowers was considered its nearest challenger.

A consortium led by investment group Olivant is expected to submit a revised offer for the bank by Friday, sources have said.

And that’s all the colour for today! There wasn’t too much of interest anyway, other than the American Sub-Prime Plan, which has attracted considerable comment, not to mention buying.

But how about them PerpetualDiscounts, eh? Holy smokes … if they can keep up this performance every day for a couple of months, it’ll be a good year.

I didn’t understand it on the way down … I don’t understand it on the way up.

I feel reasonably confident when I say “on the way up”, because this looks just as much like a buying frenzy as anything else I’ve seen in the past … um … year, but who knows? Maybe everything will reverse itself tomorrow … and finding out is what makes it interesting to get up in the morning.

There were forty-eight other index-included $25.00-equivalent issues trading over 10,000 shares today.