25 Jul Inverse Floaters: How Have They Performed?

Structured credit ratings spectacularly failed AAA and AA investors, and they also hollowed out the market for mezzanine risk.

A healthy structured market needs investors willing to sacrifice yield for certainty. It also needs investors willing to sacrifice certainty for yield, without whom risk transfer in structured finance is impossible. Ask for the full report.

I. Defining the Cohort: Inverse Floaters

We wrote this piece to highlight an obscure, unexpected niche in an overall dismal market: RMBS tranches currently yielding 25% and higher. As a group, these are highly leveraged securities that pay inverse floating coupon rates. Their rates are determined by a formula of a following type:

Figure 1: Tranche Rates

Unlike the IO inverse floaters issued and retained by Freddie Mac recently discussed in the media, these tranches are not interest-only (IO) in nature. Having much smaller prepayment risk, they seem to us to be a much better investment. In many deals, including that illustrated below, the tranches are also effectively at the top of the waterfall structure.

Nevertheless, there are material credit differences between the transactions, so investors should not infer that the performance characteristics of inverse floaters from different issuers are uniformly good.

II. Issuers of High Coupon Inverse-Floaters

The leading non-agency issuers of deals with inverse floaters are Countywide Home Loans, Residential Accredit Loans, Lehman Mortgage Trust, Wells Fargo Mortgage Backed Securities and J.P. Morgan Mortgage Trust. Almost 70% of the deals were originated in 2007, but some were originated in 2005 and 2006.

 Figure 2: LIBOR History

The origination history tracks historical LIBOR rates since most of the tranches were issued immediately prior to the period of quantitative easing, after which such issuance would not be feasible, as is readily seen in the graphic above.

III. Calculating the Tranche Coupon

Deals with inverse floaters are structured by partitioning the fixed interest rate on the assets into two or more tranches of floating rates for the liabilities, the sum of which equals the fixed rate of the collateral. For example, the deal depicted in Figure 1 has two tranches, A-1 and A-2. These are paying floating interest rates at an average rate of 6.25%, the pass through rate. Note that the initial balance of class A-1 is 8.33 times higher than initial balance of class A-2. This is where the coefficient in the formula of class A-2 coupon rate calculation comes from.

Interest paid on inverse floating tranches often constitutes a very significant portion of total interest paid, and sometimes of total transaction cash-flow. By making the balances of a tranche that is paying floating rating much higher than that of inverse floater, the coefficients on the floating rate formula can be increased proportionally. The table below shows that interest paid to inverse floating tranches sometimes accounts for as much as 20% of total distributed collections.

Figure 3: Coupon Payments on the Inverse Floating Tranche

Over the course of several years, some of these tranches have received more in interest then the invested amount. For example tranche A-2, with an initial balance of $21 MM, has received more than $35 MM in interest payments but only $10 MM of principal has been repaid.

IV. Non-Intuitive Waterfalls are Part of the Package

Another interesting feature of deals like is that they have uncommon rules of principal distribution like the following:

Prior to the occurrence of the Credit Support Depletion Date-

• An amount equal to the Class A-5 Accrual Distribution Amount shall be distributed to the Class A-9 Certificates until the Certificate Principal Balance thereof has been reduced to zero, and then to the Class A-3 Certificates and Class A-4 Certificates, concurrently, on a pro rata basis in accordance with their respective Certificate Principal Balances, until the Certificate Principal Balances thereof have been reduced to zero;
• An amount equal to the Class A-14 Accrual Distribution Amount shall be distributed to the Class A-12 Certificates and Class A-13 Certificates, concurrently, on a pro rata basis in accordance with their respective Certificate Principal Balances, until the Certificate Principal Balances thereof have been reduced to zero;….”

Needless to say, this “waterfall” does not resemble a standard waterfall in the least. Although allocating Class A-5 distribution amount to a number of classes other than Class A-5 itself does not make the modeling of the deal much harder, especially when using a logical tool like the Waterfall Editor (WFE), it makes little sense intuitively, and so the value intuition of deals like this without rigorous modeling is close to impossible.

Figure 4 below illustrates how WFE naturally allocates the A-5 Accrual Distribution amount out of sequence, i.e., first to Class A-9 and then to Classes A-3 and A-4 pro rata. WFE automatically creates principal distribution amounts and assigns them to their corresponding classes. Thus, all the analyst has to do to correctly model the waterfall is to reassign these principal distribution amounts to appropriate classes, in line with the prospectus.

Figure 4: Graphic Illustration of the Waterfall in Waterfall Editor

V. Value Play

To sum up, non-IO Inverse Floaters as a group appear to be much riskier than they, in fact, are given the current rate environment. Ratings do not typically reflect the impact of capital structure correctly, or at all, and may not be an accurate guide to the payment risk on structured securities where principal shortfalls are in most cases exceeded by the net present value of expected interest cash flows. This decoupling of ratings and value is made clear in Figure 5. Most of the inverse floating tranches we found are currently rated in the CCC to D range by S&P and the Caa range by Moody’s:

Figure 5: Current Ratings on the Securities Analyzed

Research like this demonstrates that there are still outstanding investment opportunities for value investors with a good grasp of the tools and concepts of structured finance. Whether they will be able to persuade their accountants, auditors and examiners that the value exists, is another question.