All the rating agencies have recently issued warnings about or downgraded re-securitizations, known as re-REMICs, and while those deals issued over the last few years appear hardy enough to withstand another housing downturn, their resemblance to infamous CDOs raises concerns.
Moody's Investors Service issued a special report Jan. 18 describing its concerns about RMBS re-REMICs, saying, "During the past two years, we rated less than 1% of the approximately 5,500 RMBS re-securitizations that were rated and issued in the market." That amounted to just three ratings in 2010 and 38 the year before. Last June, Fitch Ratings detailed the types of re-REMICs for which it declines to issue ratings, including those backed by subprime or Alt-A collateral, and noting, "Fitch currently rates less than 10% of re-REMIC transactions it has been presented to review."
Standard & Poor's, meanwhile, announced on Dec. 15 that it was placing 1,196 ratings on 129 U.S. RMBS re-REMIC transactions on CreditWatch negative, not due to performance concerns but because it modeled their cash flows incorrectly.
DBRS has been the only rating agency to take recent action, downgrading 415 RMBS classes and 66 re-REMIC classes on Jan. 10. The accompanying report noted that a majority of the downgraded re-REMIC transactions are backed by prime and Alt-A products.
The rating actions in part reflected an update to DBRS's rating methodology, which it described as related to "loss severity, default timing curves and the number of cash flow scenarios run ..." DBRS added that the negative rating actions also "reflect the prolonged negative trend in the U.S. housing market and unemployment rates, which have contributed significantly to the increased default expectations in more seasoned vintages and significantly lower prepayment expectations."
House prices remained flat and even increased slightly in 2010, contrary to forecasts early in the year of prices dropping by as much as 20%. In November, however, the S&P/Case-Shiller index recorded housing prices falling 1.6% from the month before. And major metropolitan areas including Atlanta and Chicago saw housing prices fall more than 7% from the year before, mostly in November and October.
What that means in terms of re-REMIC ratings, however, remains cloudy, given that many deals garnered a rating from one agency but were denied a credit stamp by the others. Moody's noted in its report that unlike many critics of re-REMICs, it believes "properly structured transactions" do in fact change investors' RMBS risk exposure. Nevertheless, that the rating agency has attached its stamp to such a small percentage of rated re-REMICs speaks for itself.
Re-REMICs typically split one or a few RMBS bonds into highly rated classes - typically rated 'AAA' - and lower-rated classes, with the latter portion absorbing hits to the underlying assets' cash flow. Moody's noted the volatility of potential losses on re-REMICs as one reason for its ratings reticence. It also pointed to the possible bankruptcy of the re-securitization sponsor resulting in a change to expected payments, ambiguities in the legal documents of the underlying RMBS, and delays in foreclosures delaying payments to the underlying bonds.
S&P's methodology snafu is a technical issue rather than a statement about re-REMICs' performance, but it could nevertheless be problematic for investors. In a short two-page statement, the rating agency said Dec. 15 that it "incorrectly analyzed the timely interest payments and did not incorporate an analysis of the effect of interest paid pro rata on the senior securities."
Apparently, the rating agency assumed that losses to the seniors would be sequential, hitting the lower-rated classes first before touching the triple-As, but discovered ex post facto that at least some of the losses would be applied pro rata across all of a bond's classes. "This means," said Scott Buchta, head of investment strategy at Braver Stern Securities, "that in the event of interest short falls, the seniors will do worse than expected and the [subordinated classes] better."
Downgrades of a notch or two may pinch investors in the senior classes, but more severe downgrades to below investment grade could have serious implications for banks and insurers, many of which are still operating with perilous capital levels. The severity of potential downgrades from S&P, however, remains a mystery, because the agency has yet to act, or even clarify what changes to its methodology it will make.
"It is unclear how S&P intends to stress these bonds for interest shortfalls and what the stresses applied for each rating level will be," said Barclays Capital in a note published Dec. 16, the day after the rating agency's statement.
As of last week, S&P had not clarified those points, and it declined to comment both on the methodology issue as well as its outlook for the re-REMIC market. Barclays also did not return phone calls seeking similar information.
Barclays' report said that 70% of the bonds under negative watch were issued in 2010, and that "it is extremely hard to break 2010 [re-REMICs] super seniors from a credit standpoint." The report said the same holds true for many of the 2009 re-REMICs, although there likely will be some downgrades of 2009 senior classes from early that year, as well as from 2008. Barclays executives did not return phone calls seeking their current outlook on re-REMICs.
"I think that many of these bonds have been structured to withstand a significant drop in home prices and the ensuing pickup in defaults and severities that would ensue," Buchta said. He added, however, that 2007 re-REMICs were often issued with an extra 10% or so of subordination, and that many of those bonds have since been downgraded. More recent re-REMICs, he said, have required two to four times that level of subordination. Buchta said that of the $40 billion to $50 billion of re-REMICs issued in 2008, those issued early in the year were more likely to have lower subordination levels and "thus would have more exposure to being downgraded or potentially taking losses."
Bose George, a mortgage analyst at Keefe, Bruyette & Woods, said that the re-REMIC market never got big enough to cause major capital problems for the banking industry. He added that he has "no idea where these securities ended up, but it could have been at smaller banks where it could be a problem. We're trying to find out more information about the magnitude of this issue."
George said that many re-REMICs were structured in 2008 and 2009 to incorporate price declines of 15% or more, and since until now those declines have not occurred the bonds have actually performed well. And, during the throes of the credit crisis, re-REMICs arguably enabled loan originators - mainly banks - to generate capital instead of selling their RMBS assets at steep losses, and gave investors a source of otherwise scarce highly rated bonds.
CDOs also performed well for investors and retained their high ratings, until the market collapsed suddenly. Dean DiBias, high-yield portfolio manager at Advantus Capital Management, said his firm views re-REMICs in a similar vein to CDOs, as "a form of alchemy. When you're talking about deals created solely for arbitrage, investors in those assets classes typically haven't benefited."
While simpler structures than CDOs, DiBias said, like their infamous cousins re-REMICs are reprioritizing how losses are allocated and interest and principal are paid to different classes."It's taking something that's complex to start out with and adding another layer of complexity," he said, noting that several re-REMICs have experienced severe downgrades.
DiBias pointed to CMLTI 2007-OPX1 A1A, a $603 million RMBS backing nine classes rated 'AAA' that was first rated in March 2007. Moody's and S&P put it on negative watch in May 2008.
In April 2008, however, the bond was re-REMICed into 80% 'AAA'-rated super-senior classes and the rest support-senior classes also rated 'AAA'. Moody's put both sets of classes on credit watch two months later, and S&P followed in October of that year. In May 2009, Moody's downgraded the super-senior bonds to 'A2', and in October 2009 S&P's rating on the paper fell to 'BBB', while at the same time the Moody's rating on the support seniors fell to 'Caa3', and S&P's to 'CCC'.
"What I find amazing is that it was less than two months after issuance that Moody's issued its first ratings warning on a 'AAA' new-issue re-REMIC," DiBias said.
Moody's and S&P declined or did not respond to requests to provide details about the number of re-REMIC downgrades they have made since 2007 or their severity. More puzzling still, even the ratings S&P put on negative watch appear inconsistent. Amherst Securities Group noted in a Dec. 16 report that the agency rated two securities backed by the same collateral at a similar point in time, but chose to put one on watch and not the other. "The BofA security is on watch for downgrade; the JPM security is not. This makes no sense to us," Amherst said.
Fitch noted last June that of the more than 1,800 re-REMIC classes rated 'AAA' by the agency since the beginning of 2008, only 20 have been downgraded to single-B, and they were related to "transactions backed by Alt-A or prime collateral whose performance deteriorated sharply following the [Lehman Brothers] bankruptcy and the dramatic increase in unemployment in late 2008 ..." Fitch did not respond to queries seeking an update.
