As the securitization industry tries to make sense of life after the credit market meltdown, we at Asset Securitization Report thought it would be a good time to sit down with some of the top players in the RMBS and CMBS market and hear their views on where we've been, where we're at and where we're going.
ASR: The first question, on the RMBS side, is: How did we arrive to where we are today? What do you see as the main contributors to the RMBS market getting into the mess it's in?
WEAVER: I think startlingly poor loan quality. And the reason that we saw a spate of these mortgages issued with such poor loan quality was the fact that the participants in the market, when you look throughout the food chain, understood these were very aggressive, very low-quality loans, but most of the participants thought they weren't taking much risk. They were going to be selling it after they originated it, so it didn't really matter much what the loan quality was. So throughout the food chain, people thought, Yeah, they're risky loans, but I'm safe.'
MAHONEY: A lot of news articles are saying that it's the securitization market-the inability to sell these loans into a liquid market is the reason in the first place. Do we bear the fault or the blame? Perhaps. The rating agencies were saying, We think this is triple-A quality at this enhancement level.' So perhaps they were a little off in that analysis. But nobody would have been able to originate those loans if there was no market to sell them in. Correct?
WEAVER: When you have a free market, things overshoot. I don't think that's an indictment of the tools themselves; it's just what happened. When the stock market gets overheated, you don't say, Why do we have a stock market?' I think blaming securitization is missing the point.
WHEELER: I also say you have to consider that securitization is a point in the process. You go through, you analyze a set of data, and you project what's going to happen. We didn't have a lot of negative experience in residential housing, the data on subprime wouldn't have been sufficient to size it up at the time. Whereas the other securitized products, credit cards or auto loans or CMBS, we have 20 years of data on a lot of them. It's only analysis when you do securitization. It's going to be prone to error.
KANEF: What you had was very aggressive financing that enabled people to get into homes with very little equity. And now there's no ability to refinance. And those things have acted together to make this a very stressful environment.
RAJADHYAKSHA: It's not the most popular theory in a room full of securitization research people, but policy does deserve some of the blame. We were talking about secondary markets acting to police the risky assets. Sure, you originate risky assets, but if the secondary markets are not willing to pay up for them, eventually fewer of them will be originated. The reason that didn't happen is, and I know I'm going way back in time, but the Fed just kept rates too low. We had 1% for two years. And the reason we got down to that level was simply to fight inflation. There was no evidence of inflation, yet they still remained at that level.
SAARI: Even when the Fed finally did make the decision to start moving, the market was so creative in terms of the products it was developing for borrowers, it took an awfully long time for the Fed's actions to really get in there and slow that borrower base. So that's something that was unforeseen on the part of the Fed and maybe to some extent the market too.
ASR: How much of a role should the Fed and other regulators take? What about the super SIV rescue fund that's being created with the help of the Treasury Department? Is that a workable idea?
SAARI: These are the reasons Fred and Fannie were created, to help provide liquidity when necessary. In my opinion, this is the time to take some of the shackles off and let them have flexibility. If there were ever a time, the time is now. Congress is talking about a lot of the right things, but I think at this point it's still of limited benefit to borrowers. Things like the FHASecure program, that's an excellent idea. It's going to help a lot of borrowers, but it's probably more for managing the downside than eliminating the downside. I think there are options that Washington needs to look at more seriously, particularly Freddy and Fannie.
WEAVER: It's an enormous problem that could be dealt with only by a massive governmental program on the order of 100s of billions of dollars, and I don't think there's the will to come up with that kind of money, nor is it necessarily appropriate when there's certainly some culpability out there. The things that are being proposed will help around the edges. They will help that small subset of borrowers who can possibly go into other products. But the fact is there's a very large set of borrowers who were given loans that don't make economic sense. They are now seeing their loan rates increasing and their home value decreasing. There's nothing to do about that fact but to let it play out its natural course. That's what will happen in all likelihood. But for the most part, it's beyond the scope of the government to really solve a multi-100-billion-dollar problem.
RAJADHYAKSHA: I agree with that in part. Monetary policies are not the way to solve this thing. Take a look at where we started the third quarter of 2007, because remember, in February to March people were going out of business at a very fast pace. We waited, and in April nothing happened. The difference this time around, in the third quarter, is that bank balance sheets exploded in size. One of the reasons is, as we found out later, the most risk-averse investors out there, mainly investors invested in the commercial paper market, were apparently buying dealer assets, which are among the riskier assets out there. You had this whole situation where about $250 billion moved from off to on balance sheet. And at the same time, when Countrywide, for example, hit the $33 billion line of capital in separate chunks, somebody is providing those lines of capital.
MAHONEY: One of the things that regulators and the Fed and Treasury are trying to do, and I agree with you, is sort of play at the edges. But I do think cutting the Fed fund rate is an attempt-and I think we'll see another Fed fund rate cut before the end of the year-I think it's an attempt to wall off the general economy from this problem. It's an attempt to keep the rest of the economy from sliding into a recession. So to that extent, I think it's a positive. I'd love to see that because at least that, to a certain extent, will buffer the worst case losses you see. If people can hold on to their jobs, then maybe there's a chance that some of these bad loans won't be as bad as we anticipate them to be. That's really almost the only thing they can do short of a massive RTC-type solution for all these loans, which I don't see happening anytime soon.
WEAVER: We actually do need home prices to decline. Home prices are too high. That's a real problem.
MAHONEY: The best news that you hear is housing permits are plummeting. Every time I hear that, I think, that's great, because I know the inventory now is going to start coming down a little bit.
WHEELER: I should jump in with a comment on [the super SIV] fund, which is not by any means meant to help the housing market. And take what I have to say with a grain of salt, because obviously Citi is involved in that fund. But you look at the structure, it's really only going to take good assets in on a liquidity basis. They have other banks involved that aren't involved in the home market, so they'll provide that third set of eyes to make sure it's done at market value. ... It's going to be negative selection. They must have expected they wouldn't be able to sell new paper on a program that would take in subprime. It was unfortunate; from what I read, it looks like it was leaked before they finalized a lot of the details. We're still hearing new details about how it will work. And I don't think there's an intention to leave the other SIVs hanging; for the most part SIVs don't hold a lot of subprime. It's usually a fairly diversified pool. Still, it has to be said that some sort of liquidity facility is needed to make sure this doesn't become a fire sale situation across the board.
MAHONEY: Anything that extends the liquidation horizon is positive. The market loves a party, a counterparty that's in trouble and needs to sell, they love that. They will rip your eyeballs out. So that's where this helps, it keeps that from happening, and it stabilizes the market. But I don't think it's a solution. And it raises a lot of questions about adverse selection, what's left behind.
WHEELER: You almost wonder if they need a second one for bad assets.
WEAVER: The first one should have been for bad assets.
ASR: So what about the ABS CDO managers? Are they gone? And if so, who is going to buy the RMBS paper they were buying? Are there other buyers who might step in?
WEAVER: It goes back to the people who were around before the CDOs took over the world, the real money accounts that will buy happily, but at wider spreads. And there will be more gatekeepers of risk than the CDO manager had.
SAARI: There is the possibility of the originators actually retaining more of the BBB and below. The idea being that who better than they to fully understand what these loans are about, to manage these loans and be the liquidity provider prior to when the real money does come back.
ASR: And the structured finance/ABS market in general? Is this the end of the world as we know it? Is this the end of the subprime market? Or are things going to come back together?
MAHONEY: We're sort of in a gray area. We're looking at subprime pools that are still trying to get done in this market. And the subprime pools are a lot different now than what we saw six to nine months ago. The market is trying to see if there's demand, if there's any possibility to do a new subprime pool' that has higher FICO, 90% or 80% documentation, smaller percentages of ARMs to the subprime borrowers. I think if that market emerges, if they can figure out a way to recreate the subprime mortgage into something that's less volatile, less risky, we might start seeing it showing up in ABS CDOs again. It will be a different product, a different risk, but I think it might show up. Otherwise, you're going to see a lot more diversity in the assets. You're not going to see, in the near term, 70% subprime, if you see any ABS CDOs. I think it's a toxic name right now.
WHEELER: We did a piece three weeks ago on the value of credit cards at that time, which was LIBOR plus 40. And we highlighted that you could get a huge spread in autos and some other products. And when you look at people who understand those products, they would go back and buy them; it's just that the liquidity was removed from the market in August. There are not many people who are in the position to actually be able to buy them. So we think the products are there, the expertise is there, and as the market starts to see more liquidity [people will buy them], but until then it looks very bleak.
RAJADHYAKSHA: But this is nonresidential.
WHEELER: But even when I look at some of the residential, it's not hard to see that some of the fixed-rate residential has some value. And I can say that about many other products. I might even say there's some value in CODs in some form or another. But from that standpoint, these are unique circumstances where you had several investors who knew their products early in the year, invested when they cheapened, and then they got their heads handed to them in June. But it looked like a great opportunity, so they probably tripled down. And then we came to August, where we had the liquidity carved out in the market. So it seems like all of the products have cheapened. But in fact, they cheapened because nobody has the wherewithal to buy them. Some of these products are fine and will eventually come back. And dare I say, even some of the residential ones.
WEAVER: It's a very unique crisis here. And I think it happened largely because these subprime loans were bridge loans. In two years these people are going to have to refinance. And they couldn't because the market shut down. And that's very different from any other mortgage product. It's different from what's going on in cars and autos. But most of them are profitable enough, are credit enhanced enough, that those types of slippages in the numbers are not going to be a big issue. Where it's most pernicious is the subprime situation where you gave people a two-year bridge loan.
SHUGRUE: So you suggest the problem will be around for the next 24 months?
WEAVER: I think longer. If you look at the wave of resets, which is going to be the precipitating event, you have 18 months of that. When you consider how long it takes for people to default and then go through the system, you have at least three years of distress in the housing market for the consumer, and you could actually have a longer tail end than that.
WHEELER: That makes it entirely different than 1998, entirely different than 2001. In fact, you're going to continue to read media stories about how this broker gave the poor person the mortgage; how it went to the security guy who then securitized it; then it went to the mutual fund guy who then has the worst performance ever. It's almost like reading a Disney story; it's compelling reading. It won't be until we see enough of that story and start disassociating [subprime] from the other securitized products, and we start ignoring it and say, of course subprime is bad. But we're several months away from the point where people are not highly aware of the issue. Because it's going to be very personal, it's going to be in every state, and as Karen just said very ongoing.
ASR: Is there anything being done now that could have a positive effect over the coming months? For example, loan modifications?
MAHONEY: Moody's came out with a report that said only about 1% of the loans eligible for modification were actually modified, which is shocking to a lot of people. We talk to our servicers on a regular basis, and what we're getting is, We're modifying as much as we can; we're calling everybody before their reset dates.' Then Moody's comes out with that study and says only about 1% of those loans are getting modified. I think that was a huge wake-up call for everybody.
WEAVER: On the residential side they do not get reimbursed for modifying a loan, whereas if they take it into foreclosure, they do. It's a disincentive. We tend to assume that all these borrowers are ready, willing and able to sign mods. We can't even contact these people. That 1% was published in the spring, but 50% of borrowers go from being delinquent to having their home taken back without returning a phone call.
RAJADHYAKSHA: This 1%, does that include curtailment?
KANEF: It was actually a broad statement to the servicers. One thing I think is important to make clear is there were sizable percentages of the loans that had actually refinanced out of the pool. And then, in addition, we were largely talking about loans that originated in 2005. And so the resets were mostly two years. I believe that at least the early experience with those loans is that they, for the most part, have remained current after the reset date. Now, obviously the debt-to-income exposure to those borrowers has changed in a significant way. But these borrowers are in a little bit of a different circumstance perhaps than people who first took out their loans at the end of 06. It may be that lenders are acting in a prudent way, and that servicers are prudently servicing the loans in a way that makes sense for this wave of adjustments. Now, the real question is how quickly servicers can switch from a perhaps prudent approach that doesn't modify large numbers of loans, to an approach that by necessity requires very significant outreach, very significant amounts of diligence and a very significant amount of modification.
ASR: We can't get out of here without picking on the ratings agencies a bit, as seems to be fashionable lately. So, does the market need to rethink the whole rating agency model and how the rating agency fees are paid? And how do we rebuild trust in the ratings?
KANEF: I guess as a model, generally speaking, the issuer-pay model that is currently used does contain conflicts. And Moody's, and I believe the other rating agencies, are aware of those conflicts. And we've structured our business in a way to address those conflicts. So, for example, the ratings are the result of a committee, not any one analyst. One analyst is not making a rating on their own; it is the result of a committee process and a committee vote. In addition, the individual pay for analysts is not based upon the number of deals they rate or the individual ratings they provide, but the quality of their work. And other models would also have potential conflicts of interest. One model, the one most commonly referred to as another potential model, is the investor-pay model. If the investor is paying, the investor may have a desire to have a low rating, which permits them to get very significant spread. So they may have their own perspective, and therefore, there may be a conflict there. It's also the case that the investor-pay model would not provide the public good that the current model provides. So the issuer-pay model provides ratings that are publicly available, and those ratings are available to all investors. They're available to regulators and other parties. If you have an investor-pay model, the public good aspect of ratings would go away because you would only provide the rating to the specific investor who requested the rating and paid for the rating.
ASR: Let's wrap up the RMBS portion with a look forward. Where are we in the cycle? Is the worst over? If not, how bad will it get? And is there any good news anywhere?
SAARI: Permits and starts are down.
MAHONEY: That's the only one I got.
WEAVER: I got one. We have seen a lot of cases of investors starting up funds, distressed funds, to invest in this area. There are people out there getting the general sense that whenever you see this many press articles with this many dire predictions, there's got to be some value out there. I think that is encouraging. When we were talking about the reset thing, it's a couple of years of, I think, unavoidable pain. A lot of that is already priced into the market, perhaps not all of it. But there's no question there's a lot of pain in there.
MAHONEY: I think most of the bankruptcies are behind us. The real troubled names have been acquired or they're out of business. So hopefully we're not going to see big names on the front of the Wall Street Journal filing for bankruptcy. I think the worst of that is behind us.
RAJADHYAKSHA: I wouldn't discount the policy measures. It's an election year. They don't help with losses already in the pipeline, but they will help a lot of people.
ASR: Though the fundamentals are still strong across most asset types, including the commercial real estate sector, many believe the CMBS market shows many of the same worrisome attributes as the RMBS sector. Is the CMBS market the next shoe to drop?
PHILIPP: There are clearly some similar trends as far as aggressive underwriting, but I believe in a very different order of magnitude. And commercial real estate is a different product from residential. Basically, loans are sized to the cash flow from the property, and that's transparent at the beginning of the process and as you monitor these deals going forward. So I think there are pretty meaningful differences between the businesses, and the fundamentals that support company cash flows are strong. So even if we do slide into a recession, we're starting from a good base.
WHEELER: The big thing to understand is the buyer base for the CMBS is a real cash-buyer base. We tried to do a recession with our model three weeks ago, and it would take an incredibly steep treasury curve to actually drive a significant decline in the values. We actually managed to show that it was possible to envision a 20 percent decline in value. But you would have to have had a tremendously high long-term treasury to achieve that-something of the magnitude of almost 9%. And it seemed like a very likely outcome.
PHILIPP: I think the key is that underwriting in this space is overbooked. In a lot of deals, 10 loans make up half the pool. So here investors, rating agencies, subordinate bond buyers are re-underwriting individual loans. I don't think that would happen in the residential space. And there's publicly available data as to what taxes are, what electricity bills are, what the average market rent is. The information is available, and people have the ability to second-guess it.
SHUGRUE: Also, CMBS is based upon assets that have cash flow, versus RMBS, which has no cash flow. There is no nonconforming CMBS market. There's no subprime CMBS market. It's a conforming prime market. Borrowers in CMBS transactions are borrowers with real cash equity. Further you have real warm bodies, with significant capitalizations, who own the bottom tranches. And they have capital and the wherewithal and the liquidity and proper incentives to work out and fix problems.
WHEELER: These are also fixed-rate loans for the most part. There's no two-year reset. Most of the time, we're looking at loans that won't come up for the balloons for seven or 10 years. From that standpoint, there's no trigger date. If the economy falls into a recession, most of the market will hold up pretty well.
ASR: Are there any areas of CMBS that you see as troubling?
WHEELER: We do have some caveats on the market. We have been skeptical of retail now for a few years and are expecting problems there. And we've been wrong all three years. At some point that's going to come home to roost.
MAHONEY: You're betting against the U.S. shopper?
WHEELER: It's been very bad so far; my own wife is working against it. It's not something we're proud of. We've been very good with hotels, calling that one in and out. But we thought that had reached its peak in 2005, so we're suggesting you look at hotels very carefully, make sure you're not getting into any interest-only type loans. Our forecast for hotels is a lot more volatile than the one for office or multifamily or industrial.
PHILIPP: All real estate is local. There are basically 50 major areas with five major asset classes, so you almost have 250 markets. While most of them are fine, you can point to a number that isn't.
WHEELER: Another one is condo conversions. I worked on several condominiums myself in the early nineties. That personal experience just didn't allow us to believe it was a market that should be securitized. We looked at the rating, agency parameters. We understood them. They kind of made sense. But when you pooled them, it just didn't work. If they were diversified with other products, it could have. But you put them all together...
PHILIPP: One of the keys is timing. Like any market, the early guys do the good deals. And the early condos that could be bought on the basis of being a rental property had an upside. The later deals were paying for the upside, and then when that doesn't work out, there's no rental fall back. You can look at advantages and say the condo conversions done in 05 in 06: They overpaid. They were paying on an entirely different framework that didn't work.
WHEELER: The three done in 06 are all in trouble now.
SHUGRUE: Three deals for $4 billion over a comparable $600 billion of production during a comparable period?
WHEELER: That's because the investor base was more than prepared to say, This doesn't work.' Several of the analysts said we shouldn't be seeing this.
PHILIPP: It doesn't work when done poorly, like a lot of things. The first couple worked well. The third one was stretched, and I'm glad we didn't see more after that.
WHEELER: I don't think some of the investors thought the first two were that good. (Smiling and indicating Philipp) We actually see each other quite a bit: We do this everywhere.
ASR: So, how would CMBS markets fare in a recession?
WHEELER: You would see an uptake well into that 2% or 3% ground, and you might even get CRE CMBS increasing to 1%. And understand, in 2005 and 2006, CDRs were running at about .05%. That would be a pretty substantial increase. The market can withstand CDR at 1% for quite a substantial period of time without affecting any of the rate classes. You start going over 1%, you might see some downgrades at some point. So far this year, I'm sure you guys have the numbers, but I think Moody's has six upgrades for every downgrade or something really incredible. That would change. But I don't think you'd see mass liquidation.
And it would have to be a full-blown recession. In 2001, there was officially a recession. We got up to a 2% delinquency rate at that point. As of today, we're calculating at .32% on CMBS. We have more than enough room to take it up to a factor of 7x or so before we would see people start to get concerned about some of their investments.
PHILIPP: One of the keys in interpreting what Darrell just said correctly is headline risk. The delinquencies are on the order of .3% or .4%. If the headline is, CMBS delinquencies double,' everybody will head for the hills. Doubling from 2% to 4% percent is meaningful. Doubling from .3% to .6% is not. But when the market is nervous, it gets taken out of context.
SHUGRUE: The biggest thing that's not on your list of questions that merits discussion is the lack of correlation between the CMBS index and the CMBS cash market. Because there's been a logical conclusion that if ABX is a predictor of subprime, we should short ABX. If somebody missed that trade, they want to capitalize on that trade. Let's short the next guy. And if you look at CMBX credit spreads this week, they had a very wide movement; they almost doubled down to 750.
WHEELER: 700.
SHUGRUE: So the dedicated buying base for CMBS cash bonds that underwrites every single investment, which looks at the cash flow, said, I'll pay you 12 plus 300 for that particular investment,' while a hedge fund trader said, I need to get paid 700 for that same investment.' And there's a remarkable lack of correlation. That says that people believe the next shoe to drop is inside CMBS. I would suggest that's an improbable read, because we actually have cash flow and loan duration-loans that don't reset in the short term.
WHEELER: The funny thing is, we take probably 10 different calls from 10 different hedge funds every week, and most are interested in shorting the CMBX. And you explain it to them for five or 10 minutes, and the call starts to go on longer and longer. One of them followed up yesterday, and it was interesting, when it got to 700, he said, Is this when I'm supposed to go long?' And I was shocked. It's a very technical bid that's going on there. We've tried to hedge with CMBX; it just doesn't work. But in the long run, people realize the value. I've now seen several hedge funds reverse those trends. And I think they realize they're much longer-term assets. So it's not likely the next ABX, but you will see a lot of technical trading going on. There are huge opportunities in some of that trading.
SHUGRUE: The recession affects RMBS very quickly. If you've been laid off, and simultaneously the coupon on your home doubled, you cannot make that payment. With CMBS, you have dated cash flows, and you further lock in your rate for the next 10 years at a favorable level. So even if you have a recession, you might not see the impact of that recession on a CMBS security for five years. That's a long time, generally speaking.
MAHONEY: Are there property types in recession that you feel could be more vulnerable?
WEAVER: Hotels.
PHILIPP: Hotels are leases that last one day, and they have a lot of operating expenses. So they're the first ones to go up in an upturn and down in a downturn. We believe they're softening now. We're seeing some construction in the hotel sector, and we're forecasting a little less demand. That's the one we're keeping an eye on. Apartments can actually do well because apartments are the only sector that have an alternative, which is housing, and some of these subprime borrowers probably came from there and will go back in that direction. That's probably one of the bright spots.
WHEELER: People were buying houses before, because they were worried [the houses] would appreciate and they wouldn't be able to afford them next year. That psychology has affected every multifamily market in lots of ways. It's our favorite choice.
ASR: Let's wrap things up with a Chris Matthews-style question and just go around the room. In the lines of, Tell me something I don't know,' what are your thoughts on issues the market is overlooking, either positive or negative, that will make headlines in the near future?
SHUGRUE: Weak dollar makes U.S. real estate very attractive to foreign investors.
PHILIPP: I think that 2008 will be the year of property derivatives in the U.S., based on value indexes. This has been going on in the U.K. for three or four years. Farmers have been using it for 50 years. It's an interesting time to take your targets.
KANEF: Non-real estate consumer assets in the U.S. continue to perform very well.
MAHONEY: I was struggling trying to find a bright spot. When you look at housing prices, year over year, it's been very, very negative. And I'm optimistic that in 2008 we'll start seeing at least some stabilization on house prices.
SAARI: Don't discount a rate increase from the Fed, depending on the dollar and inflation.
RAJADHYAKSHA: The one thing that will surprise people is that housing and mortgage credit will do really poorly in 2008, and the economy will still escape a recession.
WHEELER: We never talked about CRE-CDOs, but as we run out of CMBS issuance, they will actually have some issuance in 2008, which will be a surprise to many.
ASR: Karen, the final word.
WEAVER: I think the big question is whether or not we're going to go into a recession. And I think the answer to that really lies on how homeowners deal with the fact that most of them are going to see a double-digit decline on the value of their home. We don't have any data on how the decline will affect the propensity to consume, it's all going to depend on the confidence. How they react to that change is going to drive consumer spending.
Participants
Michael Kanef
Managing Director and
Co-head of ABS
Moody's Investors Service
Victor Mahoney
Managing Director, U.S.
Consumer and RE Assets
CIFG
Tad Philipp
Managing Director, Commercial MBS
Moody's Investors Service
Ajay Rajadhyaksha
Co-head of U.S. Fixed Income Strategy
Barclays Capital
Eric Saari
Managing Director, Global Public Markets
TIAA-CREF
Ed Shugrue
Senior Managing Director Guggenheim Structured Real Estate Advisors
Karen Weaver
Global Head of Securitization Research
Deutsche Bank
Darrell Wheeler
Global Head of Securitized
Strategy and Analysis
Citigroup
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