As the Alt-A mortgage market falters, Wall Street firms are reviving an old concept to repackage triple-A bonds that may soon fall from grace. This is an effort to avert sell-offs by investors or potentially spruce up their own holdings as they search for buyers.
On June 6, Barclays Capital published a report titled "Phoenix Rising: Re-enhanced Alt-A Seniors Reduce Risk Without Jeopardizing Value" that describes splitting an Alt-A-backed bond into a "re-enhanced" larger portion and a riskier smaller piece. The deal represents a bond Barclays is looking to restructure, and it's gauging interest in such a transaction. Other major MBS dealers have been testing the waters and their efforts appear to be picking up.
Huxley Somerville, head of Fitch Ratings' RMBS unit, said that the rating agency halted issuing new ratings on re-enhanced bonds in early March, until it reviewed its ratings methodology. That review lasted until May 9, after which Fitch rated two re-enhanced deals in May, Somerville said, and it's been asked to rate another 10 or so.
Today's re-enhanced deals, also known as ReREMICs or resecuritizations, are nothing new and have surfaced when the mortgage market hits dry spells. Michael Youngblood, a portfolio manager at Arlington, Va.-based FBR Investment Management and director of the firm's research on non-agency RMBS, said resecuritizations emerged in the 1994-1995 time frame and again starting in 1998 and into 2000.
Youngblood said his group has looked at a few of this year's deals, "but not with sufficient interest to analyze them. We believe there are better relative value opportunities in the non-agency market, not just with Alt-A but also prime and subprime securities."
The strategy, however, may prove useful to some market participants, especially as Alt-A mortgages face growing pressures. The ongoing credit crunch has crimped homebuyers and so made it difficult for troubled Alt-A mortgage holders to sell their homes before foreclosure. Rising unemployment is another factor likely to prompt more foreclosures. Such factors are bound to damage bonds' Alt-A collateral and prompt the ratings agencies to put more issues on negative ratings watch. That's problematic for institutional investors whose bylaws require them to sell bonds falling below triple-A.
Consequently, Somerville said, the shelf life of the re-enhanced bonds is largely limited to the period in which they're on negative watch by one or all three of the ratings agencies.
"Once ratings are affirmed or downgraded, the rationale goes away," Somerville said, adding that given the level of market uncertainty today, investors may still entertain concerns even if a bond's triple-A rating is affirmed by all three agencies, spurring a ReREMIC anyway.
In its report, Barclays illustrated how the re-enhanced bond performs better than bonds backed by similar Alt-A collateral. The bond is split into a $221 million super senior class and a $39 million senior support bond that absorbs the first collateral losses, bolstering the credit of the larger piece and reassuring its investors. The re-enhanced portion also provides a more attractive yield compared to existing bonds that hold similar collateral but have not been restructured
"Re-enhanced senior classes give new life to poorly structured or enhanced underlying non-agency bonds and provide new opportunities for risk-averse buyers who have shied away from dicier segments of the Alt A sector to re-engage it," Barclays said.
Sharon Greenberg, a Barclays analyst and one of the report's three authors explained, "It's taking a bond with the same rules and changing them to better shore up the credit protection for a certain portion of the outstanding bond."
Greenberg said that re-enhancement deals could originate from bonds that the dealers are holding or those held by investors. The Barclays report does not describe in detail the $39 million, subordinate portion of the transaction. "The other portion of bonds will have to find a home as well, with an investor willing to do the credit work to understand the risk," Greenberg said.
Somerville said it is important to distinguish between sequential and pro-rata payments to the subordinate tranche - Barclays proposed transaction is sequential. Sequential structures pay down the senior portion first, whereas pro rata payments are distributed evenly, potentially paying down the subordinate piece sufficiently so that it would be unable to weather back-term collateral losses, and those losses could eat into the senior piece.
"All things being equal, the subordinate piece needs to be bigger with pro rata transactions," Somerville said. He added that, depending on the specific deal, sequential transactions called for subordinate tranches of approximately 10%, and pro rata ones closer to 30% or more.
Youngblood said today's re-enhanced transactions are undermined by the "state of flux" of the rating agencies' ratings criteria, the potential change in the ratings agencies' compensation under the accord reached June 6 with New York State Attorney General Andrew Cuomo, and the "continuing torrent of downgrades of these securities." Youngblood added that re-enhancement deals originating from dealers' own inventories of bonds should be analyzed carefully. "They seem better suited to the needs of dealers trying to reduce their inventory positions," Youngblood said.
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