On the securities performing at December 2011, a universe of approximately $1.42 trillion, R&R estimate the amount of additional losses likely to materialize is $300 billion, with one-third concentrated in ten arranger names, including Countrywide, Morgan Stanley and JP Morgan. About 17,000 tranches, or 34% of the universe analyzed by R&R, may lose up to 83% of their remaining principal.

In addition, R&R estimates that approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. Failure to allocate realized loan losses could distort the valuation of related RMBS tranches.

“The light at the end of the tunnel is still a long way off for RMBS,” said Iuliia Palamar, head of ABS research for R&R.  “We are now drilling down into the analysis to identify the individual transactions by vintage, servicer and other important issues with respect to these losses.”

Unallocated Losses by Security Vintage

In the course of conducting valuations on RMBS, the R&R analytics team discovered widespread, serious, repeated data discrepancies. Ann Rutledge, a founding principal, asked the team to measure the magnitude of the discrepancy on the RMBS universe. To do this, R&R subtracted cumulative losses allocated to the tranches from unallocated, expected losses, calculated as the sum of defaults, bankruptcies, foreclosures and REOs minus recoveries. “The results were very disturbing: $175 billion of unallocated current losses and $300 billion of imminent losses,” Rutledge said.

Rutledge commented that she was not clear why these losses are being held in limbo instead of being properly allocated, since the data used by R&R in the calculations were included in the servicer reports. She cautioned, “Investors should be concerned about receiving inaccurate bond performance information and paying unnecessary fees.”

The implication for bond holders in RMBS is significant with respect to both estimates.  Subordinated securities in the RMBS with probable future losses ought to be written down by such losses but instead may be continuing to receive interest owed to more senior tranches. It could also mean that servicers are earning fees against loans that have already been liquidated, which also reduces the amount of cash to pay senior bond holders.  For example, in one month, servicers could generate $75 million or more in inappropriate fees against the $175 billion in unallocated losses.

Rutledge also noted that R&R has observed a steady increase in amount of limbo losses, raising the prospect that a significant amount of funds are still being misallocated for bond investors.

“The system for MBS is still fundamentally broken,” she said. “All the loose ends need to be identified and knit together into a well-functioning system before investors can feel comfortable investing in RMBS once more.”

R&R Consulting is a credit rating and valuation boutique. Founded in 2000, R&R has a patented process for obtaining current intrinsic valuations on structured securities in the secondary market.

Inquiries should contact Iuliia Palamar at +12128675693 or iuliia@creditspectrum.com

M is exactly right. But, a good start towards structural evolution would be to embed a quality signal in price. That is what ratings are supposed to do.

A marketing expert, Dr. Chan is famous for creating fluid situations where Hong Kong’s leaders can speak to students about themselves and their work. He has produced a lot of rare, high-quality multi-media leadership content this way, which has been distributed through the university.

The title of my talk was “Financial Market Tectonics: Stability Precedes Liquidity.” This is just another way of saying, don’t turn debt into equity!

The argument goes like this: debt quality is a function of stability of returns, not rates of return. If you try to have your cake and eat it, too, by combining contractual enforceability with high rates of return, you will destabilize the system. But, if you let debt be debt and take it to the limit, you will end up with securitization. And, stable securitization markets have their own special risk measurement imperatives and challenges, about which we are just becoming aware.

The public version of the accompanying power point presentation is here.

This talk was the happy result of being reunited with Joseph Cheung Wang Ngai, my former student at Chung Chi College (CUHK) in the 1970s, who is a legal-accounting-investments polymath. Everything was expertly taken care of by Daryl Law Shuk Yee, EMBA Project Coordinator, so that I was free to just waltz in and speak!

Beane’s own disappointing career as a player was said to validate the notion that raw, backward-looking stats should not be used to value players. He finds success by using quantitative measures to lead the A’s against many better-funded teams, and reaches new highs in the American League rankings.

I have long believed that Moneyball, not The Big Short, tells the real story of the Credit Crisis. Investors relied heavily on credit ratings when they bought structured securities. The credit rating agencies relied on statistics to create and validate their ratings–hence their designation as Nationally Recognized Statistical Rating Organizations. But, the statistics used by the NRSROs to create ratings on structured securities had little or no predictive value.

This technical deficiency didn’t matter for rating corporations, because fundamental credit risk changes slowly, and nobody really relies on ratings to price corporate bonds anymore, anyway. But, structured finance, like baseball, is intrinsically dynamic. So, when you have put a lot of money on securities whose value is changing, you don’t just want to know what a bunch of analysts sitting around a table thought before the deals were issued. You want know how your deals are doing today, and if you’re likely to lose any money.

We mentioned this analogy to Michael Lewis a few years before the Crisis happened.

It doesn’t seem such a difficult concept to grasp now: that the misuse of statistics is at the bottom of the extravagantly wasteful Credit Crisis. If all the people who love the Moneyball story were willing to pressure the government to enforce the statistical integrity of credit ratings, we could start lending once more and rebuild the economy.

But, then again, it’s a different game when well-capitalized professionals grow used to skimming money from a statistically illiterate public.

I discovered Apple was attracting - employing – young people from all walks of life (even Wall Street dropouts) who wanted to share their knowledge with customers and be part of a positive phenomenon.

I watched how customers came in droves to fondle these beautiful objects with their eyes, and sometimes their wallets, many of them completely oblivious to (and certainly none intimidated by) the complexity of the technology inside.

Could structured finance achieve a transformation like this? Become something whose inside is as beautiful as its outside? Be adopted by young people as a tool to support their values and ideas financially, through collaboration and crafting the right incentives?