R&R Consulting » Fraud

RMBS Losses in Limbo: As Bad As They Seem, The Reality May Be Much Worse

Ann Rutledge — Wed, 25 Jan 2012 14:40:25 +0000

Since the financial crisis in 2007, residential mortgage-backed securities have been hit with high levels of borrower defaults, realized losses and credit rating downgrades. Realized losses declared on private residential mortgage-backed securities (RMBS), already much higher than original rating agency and investor estimates, are projected to rise substantially in the coming months, according to a recent analysis by R&R Consulting, a credit rating and valuation firm in New York.

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

Moneyball and the Credit Rating Agencies

Ann Rutledge — Tue, 11 Oct 2011 15:25:39 +0000

Moneyball by Michael Lewis is a story of the Oakland Athletics, an under-capitalized baseball team managed by Billy Beane. Unable to afford expensive talent, Beane turns to sabermetrics, baseball statistics that measure in-game performance, to select a lineup of cheaper players with lopsided abilities.

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.

The independence of collateral managers

Ann Rutledge — Wed, 22 Jun 2011 16:29:21 +0000

“The real question throughout the subprime crisis was whether the collateral manager’s role was legit, or whether these firms lent their names and the appearance of objectivity to facilitate the sale of securities that were defective,” said Ann Rutledge, principal of structured-finance consulting firm R&R Consulting. See Serena Ng’s article in today’s WSJ, ‘Collateral Managers’: Independent or ‘for hire’? http://on.wsj.com/ilRuvs.

Ann Rutledge on ‘Wizards of Odds’

Stacy Mosher — Fri, 20 Jun 2008 14:27:00 +0000

“The SEC’s ‘subprime mortgage’ problem is that the crisis has exposed a very serious information problem in the capital markets, and a perverse truth is revealed: financial firms make less money from information than from exploiting loopholes in our fragmented, deeply flawed capital market information systems. The SEC is the guardian of these fragmented, flawed systems, so it is very difficult for the SEC to take any action at all.” R&R’s Ann Rutledge makes this observation in her article “Wizards of Odds: The Rise and Fall of Rating Agencies,” posted on RGE Monitor. Ann warns that the SEC’s Proposed Rules for Nationally Recognized Statistical Rating Organizations fall short of addressing this fundamental issue, which in reality requires a massive overhaul of both the ratings system and GAAP. Read Ann’s article in full on the RGE Monitor Web site.

Rope-A-Dope Securitization Economics: Part 2

Ann Rutledge — Sat, 05 Apr 2008 14:49:00 +0000

In Rope-A-Dope 101, we said there are five ways to mask the credit quality of a structured bond, that it is done by manipulating an “invisible” boundary where the consequences of being on one side or the other are not symmetrical, and that the boundary is only invisible to the investor. In Rope-A-Dope 201-205, we will go through each of the five in more detail to show how the cheating takes place, beginning with: Recognize a bad (credit) event late.

Default and delinquency are bad credit events. The meaning of delinquency is strictly financial. It represents the point in time when the borrower’s payments begin to lag the contractually due amounts. Default on the other hand is a political event. It signifies that the lender has lost faith that the borrower will repay and starts proceedings to try to recover the capital. The right time to declare a default is a judgment call, made in light of the borrower, the loan purpose, the type of collateral and the due amount. Give the borrower too little time and he will not be able to repay you. Give the borrower too much time and he will not want to repay you but will divert funds originally intended for you to other uses. Despite the judgmental aspect of when to set the cutoff, however, good credit policies always have an arm’s-length cutoff, which good credit managers consistently enforce.

The simplest game is to securitize receivables whose credit and investment (C&I) policy doesn’t define default in days-delinquent terms. Information about loan status disappears upon sale or transfer, because the clock is reset to “zero days delinquent.”

What happens? If the cutoff is not in the definition of default for purposes of setting eligibility criteria, the receivable will always be “current” even after it stops paying. That loophole allows it to be securitized again, and again as if it still had full value, because the buyer can never discover what the seller knows, namely that the receivable is worthless.

Is it legal? The Uniform Retail Credit Classification and Account Management Policy has clear cutoffs for consumer loans. The default definition for wholesale lending under the U.S. Basel NPR (September 2006) is well-intended but has no teeth. It is also out-of-synch with regulatory guidelines elsewhere that have a clear cutoff.

Another common game, mainly in ABCP conduits, makes use of a double-standard: the original cutoff for the transferor, and a more lenient cutoff for the SPE.

What happens? Say the cutoff of the original receivable is 90 days and the cutoff for the conduit that buys the receivable is 120 days. An 89-day delinquent receivable may be sold out of portfolio and funded in the conduit for another 119 days. And new notes can be issued against it, even though it is still unpaid at 208 days, because it is still “current.” (For a thorough discussion of calendar tricks, see Sam Pilcer’s Understanding Structured Liquidity Facilities in Asset-Backed Commercial Paper Programs, ABCP Commercial Paper Market Review, First Quarter 1997.)

Is it legal? Calendar tricks are acceptable in fully-supported conduits, where the conduit administrator provides a credit backstop. By rating agency and market custom, they are not permissible in partially-supported conduits where receivables should be funded at fair value. However, since loan-level information is never disclosed in ABCP conduits, this trick is utterly beyond the capacity of investors to discover, unless or until it is too late.

A third game is to “fix” the delinquency clock so the cutoff is never reached. The most common version of this trick is to keep track of delinquencies using recency rather than contractual accounting.

What happens? With recency, the clock is reset to zero and the borrower is deemed current, regardless of whether or not the contractual amount has been paid. The consequences are the same as above: only the seller can see that the loan is not worth what the buyer pays for it.

Is it legal? Bank regulators frown upon and discourage it. Under the Revised Uniform Retail Credit Classification and Account Management Policy in 2000, the FFIEC highlighted the abuses of the recency method and articulated a preference for the contractual method. The revision imposed a limit on institutions using the contractual method, who would not be allowed automatically to change to recency without seeking and obtaining permission.

Finally, Market Value games are based on the use of traded price as a proxy for fair value when price formation becomes disconnected from valuation. Market value games are the rationale for Market Value CDOs. They also led to the August 2007 U.S. ABCP liquidity crisis.

What happened? Demand for prime mortgages in the late 1990s was strong. It was common for delinquent loans to be bid at par in dealer markets. That is why rating agencies came to accept market value swaps (MVS) in extendible notes (SLNs) issued by single-seller mortgage conduits. MVSs came to be viewed, incorrectly, as a credit protection. Their role in these extendibles continued long after the original rationale was forgotten and the mortgage collateral was no longer prime.

Is it legal? So long as the swap is documented and the counterparties are not proscribed in their own rules from making the trade, it is perfectly legal. But it is not credit protection.