The U.S. government continues to reinforce its commitment to preserving the securitization market.
Last month it tackled the asset overhang problem by establishing legacy programs through the Public-Private Investment Program (PPIP) and the Term ABS Loan Facility (TALF).
These efforts have improved market sentiment, although industry players said that the nature of the assets at hand ensures a tenuous road ahead. In the absence of any real activity from the Federal Reserve-sponsored programs, the securitization market has found its own solutions.
These moves have supported better pricing and made the market more optimistic.
"The huge difference in TALF is that up to now it has funded only new issues; the legacy concept came under PPIP," an ABS trader said. "No one was expecting that TALF would turn around and introduce legacy assets so soon. The point is that the government is showing that it is flexible in its attempt to deal with legacy assets. It's thrown out support both through the TALF and the PPIP, but what we have is a confusing menu and the truth is that no one knows which program will really work."
TALF has had a positive impact on the ABS world, where some excess of $50 billion has traded. On the CMBS side, success hasn't come as readily. "If you look at what happened in the ABS world, it should give us some indication that the legacy programs will have a positive impact on financing," a market source said.
Around a third of all ABS financing in new issues has occurred through the government's lever. "What is interesting is that the TALF bid was less than $700 million despite the fact that we had $4.5 billion in bid lists over the course of the last five to seven trading days," said Lisa Pendergast, managing director at Jefferies & Co. Pendergast spoke on a Web conference hosted by the Commercial Mortgage Securities Association (CMSA) late last month. She added that it showed that the program will take some time to get up and running properly.
Fluctuating Spreads
The announcement of the PPIP managers and soaring re-remic issuance have moved the technical bid for non-agency RMBS to the forefront, JPMorgan Securities analysts said.
Volume spread over the past 18 months has seen a lot of fluctuation. Back in December 2007, the official month when the U.S. recession started, spreads registered at 85 basis points over swaps and the delinquency rate was below 1%. By June 2008, spreads had widened to 200 basis points over swaps but the market still benefited from benign delinquency rates, according to Pendergast.
It wasn't until November 2008 that the market felt the full effect of the recession. Pendergast said that spreads at that point ballooned to 1550 basis points over swaps.
The market today has come in some to around 900 basis points over swaps. With the spread tightening comes a general optimism, which is further boosted by the government's commitment to dealing with legacy assets. "The good news came in May when the Fed expanded collateral to legacy CMBS, and that halved spreads from 1100 basis points to 550 basis points," Pendergast said.
However, if market players have learned anything in the past 18 months, it is to expect fluctuations with any good news. After the Fed announced its legacy program, Standard & Poor's announced model changes to its CMBS methodology that jeopardized nearly 1500 CMBS bonds and their eligibility as collateral for TALF.
The next step in tightening has come with details on the PPIP. Those who thought PPIP was never going to work might have had a change of heart following the release of further details on the program.
Although it still leaves some questions unanswered, market players said it's a good step toward getting the program off the ground and addressing the legacy MBS problem that has yet to be resolved. If the funds get underway, it will potentially take a significant chunk of supply out of the market and effectively begin to rid it of the securitization overhang.
According to market reports, residential non-agency paper has already rallied 15% to 30% to higher pricing, and PPIP is expected to push pricing even higher. But the new details for PPIP offer no real reference on financing rates or information on the exact haircuts or how it will determine leverage for the different asset classes eligible under the program.
"There is clearly going to be some price discovery in the non-agency space as the market figures out what the rules of the game are going to be," wrote Jefferies analyst Jesse Litvak. "But if you're telling me that a super senior MTA (or even better yet, a senior mezz) is going to get the same terms as a prime hybrid bond, that is very interesting."
TALF has rallied consumer ABS markets from 80 cent dollar prices to near par levels, and the market is likewise expecting a similar propelling of RMBS pricing under the PPIP. According to Litvak, in the week following the legacy securities announcement under PPIP, prices continued to move higher for non-agency paper. There are bonds that were bid/traded anywhere from five to 10 basis points higher than where they traded two weeks before. Litvak added that there are also more accounts that are not even trading bonds at these new levels for fear of not being able to replace them.
"There is a new-found acceptance/willingness of investors (and even more so from the Street) to put capital at risk," explained Litvak. "Stocks continue to rip higher, and the financial space has never looked back in the rearview mirror since the middle of March." He added that with the back drop of all the positive technicals in the market, it is likely that the market will remain in this tight range and possibly even tighter for the next several months.
PPIP Terms
So far, the U.S. Treasury Department has pre-qualified nine firms to participate as fund managers. Each firm will have up to 12 weeks to raise at least $500 million in capital from private investors to be matched by the Fed. The funds can obtain leverage from the Treasury, from participating in the TALF program and from private sources.
"On a systemic basis, we don't find the securities program to be terribly interesting because it is so relatively small," said Rick Jones, a partner at Dechert, who was also part of the CMSA Webcast.
Although it is modestly sized as a Treasury investment of up to $40 billion in equity and debt, the program can be "quickly expanded" if economic and financial conditions deteriorate. The government expects to close the first public-private investment fund (PPIF) in early August.
"This type of private-public collaboration would be difficult to negotiate, so we are impressed that the regulators and the fund managers are moving through this complex process so quickly," said Citigroup Global Markets analysts. "The PPIP managers now have to raise funds for the government to match, so actual market buying support could be several months away. But given the potential of about $40 billion in buying power and a simply estimated low-teens cost of capital, we expect strong demand to operate positively on secondary spreads."
A source at an independent consulting firm - with $200 billion in assets under management - said that over the coming weeks it would be performing due diligence on managers to see if they could move ahead and added that it was clear that some firms don't belong in the program because they simply don't know the assets.
Anecdotal evidence also suggests that a number of likely candidates opted out of participating in PPIP over concerns of partnering with the government. The concern for the buyside is how politically motivated managers might be over the term of the program. For example, if some funds aren't being used as prevalently as others, there could be political pressure to get the fund invested. The problem is that finding the buyers could be a challenge if pricing remains expensive.
"We could see a misalignment of interest if the government wants these assets to sell but not at the price that investors want to buy - who makes the decision?" a buysider asked. "Investors like RMBS and CMBS but at cheaper levels than where they are today. So the question remains do we buy this paper unlevered or through PPIP where it's better structured but carries with it the political baggage?"
Pendergast said that the PPIP will provide supply and encourage insurance companies that are holding these securities to sell into the renewed bid as the nine advisors that were chosen start investing in the program.
Another interesting point is that the PPIP fund could theoretically get lever from both the Treasury and the New York Federal Reserve, but most players have opted out of the Fed lever because they want to buy into the so-called damaged dupers. They are not allowed to buy these securities with Fed money, so they are purchasing them within the confines of the PPIP.
Re-Remic Bid
The re-remic bid has also tightened spread. Pendergast said that July started around 700 basis points over swaps tighter because of the re-remic bid that has started to exert tightening pressure on the non-TALF eligible CMBS. Pendergast said that this tightening that the market has seen has caused a significant amount of selling.
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 triple-A 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 triple-A into multiple bonds with different risk profiles.
"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 write-downs," Barclays Capital analysts said. "This means that while a bond may be pricing in the $60 to $65 price range, it may be expected to take only 15 to 20 points of write-downs - 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 write-downs (first dollar of loss), the entire bond gets downgraded even for a small expected loss."
A short-WAL re-remic yielding 7% to 9% compares favorably with triple-A-rated consumer and CMBS securities and high-grade corporates. "Without TALF leverage, investors are looking at yields below 5% in triple-A rated consumer ABS," Barclays analysts said. "In CMBS, last-cash-flow super-duper yields 9% to 10% on an extension- and loss-adjusted basis, and on the corporate front, the three- to five-year single-A U.S. corporate index yields only 5.2%."
According to market reports, around $24 billion in residential re-remics were completed in 2009 through May, when more than a third of that volume was produced, and it's been propelled by the emergence of the two major investor groups.
On the one hand, banks, money managers and insurance companies find it appealing because they are looking for principal and downgrade protection. This investor base is mostly interested in the super senior portion of the re-remic trade. Hedge funds and private equity investors are interested in the credit-risk-leveraged mezzanine portion of the re-remic, Barclays said, because these investors are looking to express a view on bond performance.
"The re-remic trade has offset the lack of new Jumbo origination in the first half of 2009," Litvak said. "But prices have run up a lot, though, and people are having a hard time getting collateral (i.e., bonds) right now. Sellers are few and far between right now."
Sandeep Bordia, a Barclays analyst, agreed and said that with prices firmer after PPIP, the re-remic arbitrage does not work. "In most cases, it would be better to sell the bond outright if prices remain at current levels," he said.
And while re-remics have provided some issuance in 2009, it doesn't really address the fundamental problems of asset overhang."Some of the new RMBS issuance has been entirely based on seasoned loans, where the average life is six years or more, but as those average lives shift to two years, it means more credit risk being transferred and it may be a leading indicator that investors are ready to purchase newly originated RMBS," Tom Deutsch, deputy executive director of the American Securitization Forum.
Overhang Won't Go Away
Deutsch said that the government programs for legacy assets provide a good stop-gap measure to replicate a normal functioning market.
TALF has provided access to secondary market funding to many issuers who might not otherwise be able to access the capital market at cost-effective levels," he said. "For some investors, it has also provided a valuable investment opportunity."
But its primary intent is not to force the market's recovery. The fundamental problem still remains the mortgage-related asset overhang that has yet to be addressed. For that to be eliminated, Deutsch said that the market could opt to let the existing assets amortize until an equilibrium is reached where demand for those securities meets the supply at prices that are cost-effective for new issuance.
The question is: How long will it take for these assets to amortize? Deutsch said that, on the consumer side, amortization happens quicker because of the shorter duration of the receivables; for longer-dated, 30-year mortgages, it will take longer.
Another option is to introduce new investors, as has been the case for the GSEs. Here, the government acting as an investor bought a chunk of the assets, which helped prop up pricing. Deutsch said he didn't expect that the government would have any political interest in providing similar leverage for consumer ABS or non-agency MBS.
"Our goal should be to keep the securitization system operating at a sustainable level without over-stimulus from naive investors buying questionable products," said Paul Baker, president of WWN Software, who recently authored a white paper on how to sell legacy assets. "The government could do two things. It could alter the regulatory landscape so that investors can accurately assess derivative investments, or it could replace the reluctant private investors by pumping the system up with public money. The first solution leads to a free and vibrant market, but the second is what we have with TALF and PPIP."
What impact PPIP will have is still debatable. Deutsch said the market is in a wait-and-see mode. Until it actually sees some purchases, it will be hard to gauge what sort of dent the program might make on the massive accumulation of mortgage legacy assets. "Mortgages are where we have the most pent-up illiquidity," he said. "To begin to address the problem,policy makers will have to make a very large commitment to make a splash in the pool of outstandings."
Baker believes that the short-term success of TALF and PIPP depends on whether the dollars available from the public can support the overhang from toxic assets. "This I can't say, but suppose they are? Then what? Investors will never buy the same derivative assets at the same price levels again any more than they will again buy overpriced tulip bulbs from Holland," he said. "Likewise, re-remic is a new type of securitization operating in the suspect mode of previous derivative products and adding only a little more flash in the pan. We need a durable solution."
