Non-Agency RMBS: Private Label MBS - Quick Commentary and Valuation Overview

A few months ago I wrote an introductory post on Maiden Lane and Non-Agency RMBS.  Since then, I've wanted to bring on someone to help write posts on the various flavors of structured/securitized finance.  If you remember, in November, I reached out to readers to see if people would like to contribute.  Luckily, I got a perfect match on the structured finance front.  In 2012, we will try to do at least one post a month discussing everything from CMBS to Prime-X to CLO liabilities.  As we add new writers throughout the next few months, I will add them to a contributor section in the right side-bar so you can see all of the relevant posts to a topic.

With all that said, here is an introductory post on the valuation on private label / non-agency RMBS.  We will be doing a few posts explaining some of the introductory materials in the coming weeks.  Enjoy!

Private Label MBS - Quick Commentary and Valuation Overview

As a subset of the structured products world, non-agency RMBS are essentially claims to cashflows from pools of non-agency guaranteed mortgages. These securities are backed by mortgages that were not qualified to be securitized by the GSEs due to their large balances, lack of full documentation, low credit scores or non-standard terms such as negative amortization schedules. As a result, non-agencies are very sensitive to the credit performance of their underlying collateral.

Current Landscape - 2011 performance:

Non-agencies experienced continuous price appreciation throughout 2010 and into March of 2011, driven primarily by supply constraints and relative cheapness of the sector. Since then excess supply from Maiden Lane II and European Banks, rally of the forward curve and heightened macro-economic volatility have brought the sector down 30% from their March peak. Nomura Securities has recently published that the spread between the ABX 06-2 AAA and CDX HY 5yr is trading at 1 year wides – the relative value is further highlighted by the fact that spreads in the ABX are loss adjusted. In light of the opportunities provided by this sector, I have provided an overview of the valuation process of non-agency bonds below.

Valuation Overview

1) Identifying Characteristics of the Bond 

• Collateral type- borrower type (SP, AA, OA, Jumbo), Fixed vs ARM, loan count, geographic concentration
• Structure- seniority, credit enhancement (OC/XS), sequential vs pro rata, delinquency and loss triggers

This information is readily available on both Intex and Bloomberg. The classification is useful as different collateral types/seniorities will result in drastically different cashflow projections and discount rates.

2) Projecting Cash Flows 

The 3 primary drivers of non-agency RMBS cashflows are CPR (voluntary prepayments), CDR (defaults) and SEV (severities). These assumptions take the form of time denominated vectors and should reflect both the current collateral performance and the investor's macroeconomic views. Close to the entire universe of non-agency RMBS waterfalls is modeled on Intex. Intex can take in the user's assumed cpr/cdr/sev vectors and output the expected cashflow profile of the bond (which will vary depending on its position in the deal's capital structure). Thus, producing an accurate cash flow profile is dependent on the investor's cpr/cdr/sev assumptions. (Dealers will often aid investors in running the bonds based on their assumptions of the collateral.)

In general, non-agency collateral types have exhibited the following lifetime cpr/cdr/sev:

While these numbers can be used as general guidance, cashflows must be projected at the deal level. Below are some more general points on cpr/cdr/sev to use for further guidance:

• Historic 1-month, 3-month, 6-month, and 1-year cpr/cdr/sev data for a deal can be found on Bloomberg by typing “SEV”. This can also be found on Intex by expanding the history in the collateral section. In absence of special situations that can cause drastic spikes in immediate prepay, default or severities (ie. servicer takeover or resolution of servicing lawsuits), the most recent 1-month or 3-month numbers can be used to proxy for the deals’ near term cpr/cdr/sev’s.

• Longer term prepayments will generally experience burnout and trend downwards as borrowers with the means to prepay will have already done so during 2010-2011, when refi rates hit historic lows.

• Medium term default levels will likely exceed those of short term as cdr’s have been relatively muted in 2011 due to servicer lawsuits from improper foreclosures and modification initiatives. Cdr’s are expected to pick up again in the upcoming year as the foreclosure moratorium continues to lift and as servicers run out of loan mod options. Long term defaults will likely also exhibit a slight drop as the collateral pool will also experience credit burnout. Note that differences in cdr curves can be seen across servicers (Countrywide serviced bonds have muted cdrs while Carrington bonds have recently been liquidating above 20 cdr)

• 2 main ways to project long term default:
• Collateral multiplier: Look through Bloomberg, Intex or LP’s collateral stratifications and identifying the % size of the 1 year current and 60+ (inclusive of BK, Foreclosure and REO) buckets. One can then run various default vectors on intex until they reach remaining liquidations to around 1.5-2x size of 60+ delinquency bucket and/or 100 minus 1-1.25x size of the 1-year current bucket. 
• PD by Collateral Bucket: Assign a probability of default to every permutation of CLTV, FICO, and Loan Balance bucket within the remaining collateral and take a sumproduct of the probability with the relative size of each bucket to arrive at the remaining liquidations number.

• Given a large portion of cashflows for distressed non-agency sectors come from liquidation proceeds, projecting severities is perhaps the most important part of RMBS investing/trading. Base adjustments to cohort level severities are made based on loan size, where smaller loans generally receive lower recoveries,  geographic distribution of loans, where higher concentrations of loans in judicial states imply longer liquidation timelines and higher severities, general timeline for liquidations of delinquent loans and HPA adjusted for LTV. In general, dealers are expecting a slight increase in medium term severities due to 2011’s extended liquidation timeline. Long term severity will likely decrease below current levels due to generally better collateral composition (LTV of current collateral is low from a historical perspective), increased concentrations of modified loans (modified loans exhibit 7-8% lower severities) and will also incorporate the investor’s view on hpa (higher hpa implies lower severity).

• Additional considerations: For subprime front pay bonds, investors pay very close attention to servicing trends. Recent consolidation of the servicing industry (acquisition of Litton, HomeEq and Saxon by Ocwen) has resulted in significant servicer recaptures and disruptions to cashflows to front pay subprime bonds (Ocwen is known to be one of the most aggressive servicers in terms of recaps). One can sanity check payments streams for these bonds by looking at projected interest versus actual interest received in recent periods.

3) Discounting/Valuation

Finally, one must discount the obtained cashflows with an appropriate risk adjusted yield/oas to arrive at an intrinsic price (yields are most commonly used). These yields generally vary with macroeconomic fluctuations, housing price uncertainty and housing policy developments.  Given the uncertainty of the collaterals’ cashflows, investors/dealers will generally run yields of non-agencies at different cashflow scenarios (stress/optimistic) and arrive at a narrow range of potential prices.

From recent BWIC’s, the range of non-agency collateral types have exhibited the yields presented below:

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Non-Agency RMBS: Maiden Lane II and Its Effects on the Liquid Credit Markets

In late 2006, the head of distressed debt at a large multi-strat fund called my former boss and said: "We have been buying protection of hundreds of millions of subprime and Alt-A. Get involved." So in early 2007, I started looking through prospectuses and shelves and we bought protection on a number of deals as well as both vintages of the BBB- 2006 ABX. I must have hit CLP GO ten thousand times in 2007 looking for the worst of the worst. For instance, here is the CLP screen for CWL 2006-8 (using M6 here)

And the CLC screen (Collateral Composition) - There are 12 other pages listing the range of rates, LTVs, size, maturity, etc on the underlying mortgages,

To give you reference, the most senior tranche of this deal was rated AAA by both rating agencies. It is now rated B-/Caa2.

At the time, we were too cheap to subscribe to Intex and would sometime go to other, larger fund's offices to run scenario analysis on many single name deals. We made a lot of money on the trade but unfortunately did not size it correctly like many funds not managed by Paulson & Co. Outside of covering our positions and watching the train wreck unfold as 60+ delinquency shot through the roof, I spent very little time in late 2008 through 2009 looking at this stuff.

In early 2010, I started talking to other analysts at some funds and buy side shops who were dipping their toes back into the market. I spent a little time here and there looking at BWICs coming off the various desks but nothing in earnest. I still saw a little value in stressed & distressed credit as well as special situation high yield and focused my efforts there. But as we got further and further into the year, and the risk trade was put on, and yields started really becoming unattractive in corporate credit, my interest was piqued further.

Josh Friedman, co-founder of Canyon Partners, in a recent panel at the Milken Institute's Global Conference gave his reasoning for being long this asset class (40% of assets in his funds long):

"You are fighting headwinds in the high yield market...where you have hundreds and hundreds of players in the market scrambling searching for yield...or buying high yield bonds where there have been massive inflows into the market. The nice thing structurally about this market is there haven't been natural inflows into the market, there have been natural sellers. You have multi-trillions of dollar of paper with nothing but sellers. Meanwhile, the supply side of the market is naturally speaking because of defaults and prepayments, so there is less and less and less of paper available. The market actually shrinks 1.5% every month..."

Go here for the video: http://www.milkeninstitute.org/events/gcprogram.taf?function=detail&EvID=2726&eventid=GC11 (minute 25 or so...the whole panel is incredible)

In March, AIG announced that it offered to purchase the Maiden Lane II portfolio from the Fed for $15.7 billion. The Fed purchased these assets in late 2008 for $20B. At that time, the par outstanding or face value of that collateral was $39B whereas as of February 2011, the par value was ~$31B. According to UBS: "As of March 2011 the fair value of the portfolio was $17bn, consisting mainly of non - agency subprime (54%) and Alt-A (29%) RMBS."

The Fed balked at the purchase price offered by AIG and instead announced that it would be using BWICS (bids wanted in competition) to liquidate the assets. While at first this tactic seemed to be working moderately well, it started to become impossible to wade through the BWIC lists with any sort of confidence in either the analysis (not enough time to run the numbers) and true clearing price. Fatigue set in, people started to get ancy, and then they had to de-risk. It got so bad that last week, ~50% of the bid list did not trade. Here is a fantastic chart from Bofa ML depicting the Maiden Lane II bid lists (click to enlarge - DNT = did not trade):

The problem of course, is that as buyers were already choking on non agency RMBS from Maiden Lane, there was no one to unload to. So instead, they started hedging themselves with our good old friend the ABX (all vintages) and CMBX. And as many people know, the ABX and CMBX are not the most liquid cohorts out there, but its the best in the bunch of an illiquid world. It has gotten so bad, that in their most recent "Securitization Weekly", Banc of America Merrill Lynch writes:

"Given the weakening of the economy since the sales started, we think the next logical step is to halt the sales altogether or sell the entire portfolio at once, and allow the market to reset to lower levels."

Continuing the point above, as macro worries arose, funds (and the Street) needed to lower their long exposure any way possible. So to get "less long" or de-risk (either sell or go outright short) they must turn to more liquid environments like credit (and equities). Specifically turning to credit, the most liquid options out there are the on-the run synthetic indexes (HY16 & IG16). Barclays noted in a recent strategy piece that the HY CDX trades 5x more per week, on average, than the ABX and CMBX indices combined. And according to DTCC, we've definitely seen an increase in HY CDX volume trading over the past 2-3 weeks.

In theory, both the HY and IG synthetic indices should trade, on price (or spread), at a level equivalent to the total underlying CDS in each vehicle. In fact, though, the HY CDX index is trading 1.5 points cheaper to where it should theoretically trade (called the intrinsic level) as hedgers have outnumbered outright buyers. While I'd expect this to close as entire funds and desks on the street are set up to arbitrage this away, it has been painful to watch as people have been tentative about doing anything. Cash has also been weak as outflows to high yield credit were quite significant last week and the risk trade has been off (for all the above reasons + macro concerns).

It remains to be seen what the Fed will do with further Maiden Lane II BWICs. It definitely has cheapened up a number of assets. As mentioned in a previous post, I do think that certain sectors of non-agency, specifically Alt-A and seasoned sub prime are interesting - but the technicals are a disaster. I'll continue to do my work and add selectively to position with full knowledge that it will be impossible to catch the bottom here.

A trader, playing in a similar space, sent me the below. Nonetheless it's going to be a very interesting summer in the credit and ABS markets:

"On top of your RMBS in your email I wanted to add a few comments in regards to the non - agency CMO market. Which in my opinion is one of the only asset classes that still has absolute upside along with attractive yields. We have seen CMO prices off 5%-10% since Feb.. due to a flattening yield curve and higher supply. Loss adjusted yields are still very attractive. Technically: Demand for NA CMOs picked up substantially in Jan/Feb of this year and appears to be here to stay. The new depth to the market has brought several of the early liquidity providers (e.g. central banks) to market. The most notable seller is the Fed (Blackrock managed) who is selling the Maiden Lane II portfolio. This additional supply has kept the market soft and should create some good buying opportunities this summer. Fundamentally: Recent housing news did not come as much of a surprise to anybody and it did not help. That said the feeling from the research I have seen is that there is more upside then downside. Based on the current market, I think remaining patient and accumulating dry power is smart. That said legging in over the summer could be the best avenue to take advantage of based on the recent sell off. The sense is another 1 or 2 points lower is where the buyers lie"

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