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A Look At Structured Finance Investment In 2010 - The Beryl Consulting Group

John Sherman , The Beryl Consulting Group , Senior Advisor , April 12, 2010


As part of a continuing series, The Beryl Consulting Group gives its 2010 outlook and hedge fund portfolio construction for the structured finance sector in light of the events of the past two years.

This paper will summarize Beryl Consulting's 2010 outlook and hedge fund portfolio construction for the structured finance sector in light of the events of the past two years. We will first provide an overview of the effect of the global crisis on US structured finance hedge fund managers with a particular focus on residential-mortgage backed (RMBS) and commercial mortgage-backed (CMBS) securities. Based on our analysis of credit fundamentals, we will identify areas of attractive return opportunity in this space for the next two years. Finally, we will construct several multi-manager credit portfolios.

The meltdown in US subprime RMBS, Alt-A RMBS and CMBS markets was one of the major contributing causes to the crisis. Poor credit underwriting standards combined with mortgage structures that proved to be unaffordable to borrowers led to rapidly rising delinquency rates, which translated into record foreclosures and a nationwide fall in housing prices.

New origination for subprime RMBS, Alt-A RMBS and securitized CMBS largely ceased during 2008 and 2009, forcing structured finance managers to focus on managing 2005, 2006 and 2007 and earlier-vintage deals that were trading at distressed levels. As a result, a number of hedge fund managers side-pocketed less liquid investments and/or imposed restrictions on client redemptions. Some managers, with less liquid portfolios which were well below their high water marks required to earn incentive fees, closed their funds to new investment and created new vehicles or share classes for future investors.

US Structured Finance Market

All structured finance markets came under stress during 2008 and 2009, starting with credit deterioration in RMBS and followed by increasing delinquencies and defaults and dramatic spread widening (fall in prices) across all asset classes.

RMBS Performance Review - The US RMBS market can generally be divided into prime (borrower FICO score of around 720 or higher), Alt-A or mid-prime (borrower FICO score of around 680 to 720) and subprime (borrower FICO score below 680).

The dramatic markdowns in RMBS collateral were driven by both the deteriorating credit quality of the underlying mortgage pools and the significant reduction in liquidity caused by the crisis.  Many hedge funds were forced to liquidate RMBS collateral at distressed prices in order to meet client redemption requests.  Other financial institutions sought to reduce the size of their balance sheets or improve their capital ratios by removing RMBS collateral from their books. 

When homeowners have negative or minimal equity in their homes, they have an increased financial incentive to stop making their mortgage payments.

From its peak in the second quarter of 2006 to its most recent report, the S&P/Case-Schiller Composite 20 Home Price Index, an index calculated from repeat sales of single family homes, was down 29.2 per cent. An additional 8-10 per cent drop in home prices is projected by market participants. 

Option ARM Mortgages

Option adjustable rate mortgages (Option ARMs) include provisions to reset the loan interest rate to a higher level.  This can result in monthly payments that are dramatically higher and become unaffordable to the borrower.

Pay-option adjustable rate mortgages (Pay-Option ARMs) include provisions that allow the borrower to have the option to choose their payment amount and delay payment of interest and/or principal. The amount of the payment deferment is capitalized onto the loan balance, thus reducing the amount of equity the borrower has in the home in an environment of stable or declining housing prices. This increases the likelihood that the borrower will default on the loan.

Reduced Quality of Loan Underwriting

Starting with the 2005-vintage origination and escalating in the 2006 and 2007 vintages, credit standards for RMBS loan underwriting deteriorated dramatically. More stated income and interest only payment loans were included in mortgage pools. Appraisals used to determine eligible loan amounts became inflated.  Fraud became more widespread as mortgage originators sought to maintain transaction volume after the best quality borrowers had already refinanced.

Rising Unemployment

Increasing job losses across all regions of the US left some borrowers unable to afford their mortgage payments. The US unemployment rate, which had been 4.4 per cent as recently as May 2007 increased to 9.8 per cent by February 2010.

CMBS Performance Review

Other structured finance asset classes also had dramatic price drops.  The table below shows the prices of most rating classes (tranches) of CMBS securitizations fell dramatically from January 2008 through April 2009 before the prices on most rating classes recovered later in the year.

Some of the contributing factors to the decline in prices for CMBS securitizations include:

Aggressive Structuring of Transactions

More recent vintage CMBS securitizations had lower required equity contributions than were sustainable in a declining US economy.

Economic Downturn Results in Reduced Property Cash Flows

As the US economy entered a recession, some businesses were unable to make their scheduled rent payments and replacement tenants paid a lower lease rate.  Moody's projects those cash flows for commercial properties will reach a decline of about 20 per cent across all property types and markets since the highs reached in early 2008.

Declining Property Values Lead to Lower Default Recoveries

Declining cash flows and reduced market liquidity led to lower recoveries on the sale of defaulted properties.  The Moody's/REAL Commercial Property Price Index showed price declines of 42.9 per cent from the peak of the market just two years ago.

With the dramatic increase in delinquencies and fall in residential and commercial property values, the projected losses on RMBS and CMBS deals rated by the rating agencies were well in excess of what had been originally modeled. As a result, the rating agencies made large downgrade adjustments to many of their ratings on RMBS and CMBS securitizations.

Asset backed collateralized debt obligations

ABS CDOs are re-securitizations of other structured finance asset classes, primarily tranches backed by subprime and Alt-A RMBS, and to a lesser extent, CMBS. The large magnitude of the downgrades in RMBS and CMBS tranches triggered the Event of Default tests in many ABS CDOs, which were calculated based on the rating levels of the underlying securities, resulting in the collateral in many of these deals being liquidated at distressed prices. The distressed collateral prices were so low that all but the most senior tranches of these ABS CDOs typically had zero recovery value. Distressed ABS CDO liquidations caused further downward pressure on RMBS and CMBS prices and caused many financial institutions to realize immediate and substantial losses on their ABS CDO portfolios.

Current RMBS Credit Fundamentals 

The table below suggests that 12.75 per cent of the 55.9 million homes in the US with a mortgage will eventually liquidate. These numbers encompass loans that are already delinquent. They do not capture loans that are current and will go delinquent going forward. Performing loans are going delinquent at a far more rapid pace than loans are liquidating.

Attractive Return Opportunities for US Structured Finance

Although asset prices have recovered dramatically in many sectors of the structured finance market, the underlying credit fundamentals remain weak, if not distressed. Significant additional market price appreciation in most sectors is highly unlikely. Market liquidity has improved dramatically from the depth of the crisis in April 2009 with the US government, hedge funds, re-remic (re-securitization) issuers and Public Private Investment Program (PPIP) sponsors continuing to be purchasers of paper. Financing for private purchases has become more available.

The Troubled Asset Relief Program, launched by the Federal Reserve in March 2009, offered cheap loans that investors used to buy newly created bonds backed by auto, credit card, student loan and equipment loan debt.  It was created when the market for these asset-backed securities froze in 2008 when investors lost confidence in the collateral backing them. We believe the expiration of the TALF program in March 2010 is unlikely to have a major affect on the stronger issuers and higher quality bonds as these deals no longer rely on the TALF program. However, deals backed by floor plan, private student loan, retail credit card and subprime auto loans are likely to be more impacted by the expiration of the program, but they represent a relatively small part of new issue market.

Home Affordable Modification Program (HAMP), part of the US Treasury’s Home Affordability & Stability Plan, was designed to help at-risk homeowners by providing a framework for consistent handling of modifications. In our opinion, the HAMP program has been largely unsuccessful.  Only 13 per cent of the modifications include the principal reduction necessary for negative equity mortgage modifications to be effective. The re-default rates for HAMP loans 12 months after modification range from 41 per cent to 65 per cent, depending on the loan type.

The credit fundamentals of RMBS are still weak. However, mortgage technicals are strong and therefore we believe will provide sufficient price support. The Financial Accounting Standards Board’s (FASB) proposed position would allow other-than-temporary impairments (OTTI) to be marked to expected credit losses rather than expected fire sale prices. This suggests limited selling by regulated entities. If this relief was not forthcoming, rating downgrades would have triggered selling.

In November 2009, the National Association of Insurance Commissioners (NAIC), chose Pacific Investment Management Company (PIMCO) of Newport Beach, California, to conduct a loan level analysis of more than 18,000 RMBS securities owned by US insurers. These PIMCO evaluations replaced rating agency ratings in determining how much capital insurers need to have to guard against losses on these investments. The PIMCO valuations projected lower losses than the ratings-based approach and this provided capital relief that further reduced insurance company pressure to sell these securities.

The deposit base for US banks has grown by close to a trillion dollars since 2007. With interest paid on investor deposits near zero, there is a significant spread to be earned by investing in risk assets. This steady demand for assets should drive spreads tighter (prices higher), even in the face of some further deterioration in credit fundamentals. Even if the Fed engages in tightening, there remains some Fed induced liquidity that is yet to be fully invested.  This can provide price support for structured finance for the short to intermediate term.

We have identified the following attractive return opportunities in structured finance for the next 12 to 18 months:

Long Non-Agency Senior RMBS Tranches

Current prices for non-agency senior RMBS tranches imply continued deterioration in the housing market.  Even after the 2009 rally in these securities, market prices continue to reflect worse scenarios for home prices, defaults, recoveries and prepayments than are currently being observed.  Public Private Investment Program (PPIP) managers provide another source of demand for these securities with close to $20 billion of purchasing power.

The recently announced changes in the HAMP modification program focus on principal reduction for mortgages that, based on current appraisals, have negative equity. Owners of senior tranches of non-agency RMBS deals could see increased value in bonds trading at a discount if more modifications are successful and these mortgages are refinanced, resulting in these loans being repaid at face value. The securities that will benefit most will be those with high default rates and low dollar prices.

Short CMBS

The fundamental picture for CMBS looks as bleak as residential, but CMBS currently trades at least 500bps tighter than RMBS. Most CMBS are structured as balloon mortgages, and given that exiting refinancing is difficult to obtain compared with the pre-2008 market in which they were originated, the securities have very substantial rollover risk.  There are more than $150 billion of loans bundled into CMBS that will come due between now and 2012.

Long New Issuance Structured Finance Paper

If new issuance of structured finance paper returns to the market in any significant volume in the future, and there are some signs it may do so, the significantly wider offering spreads combined with discount pricing will make the securities more attractive than the bonds offered pre-2008 and the level of credit enhancement for a given rating level will be greater.

Idiosyncratic Opportunities

The structured finance market has a number of sectors where the market significantly discounts intrinsic value due to complex structures, lack of liquidity, as well as lack of transparency. Examples of these securities include insurance receivables, manufactured housing bonds, rental fleet asset-backed securities, student loan auction rate securities and trust preferred CDOs.

Conclusion & Recommendation

Hedge funds that focused their investments in structured finance collateral had, for the most part, a difficult year in 2008, but their returns generally recovered during 2009. 

For 2010 and beyond, manager focus will shift from market timing to security selection. Security selection, trading skill and risk management will be important determinants in generating acceptable returns during 2010 and beyond, as the delinquencies and projected losses on many of the pools backing subprime RMBS, Alt-A RMBS and CMBS securities are projected to be, on average, in excess of the credit enhancement available to cover those losses.

Beryl believes it has selected a universe of potential managers that meets these criteria. A robust organization with institutional quality infrastructure is essential.  When constructing its Structured Finance Hedge Fund Cohort, Beryl chose funds that focused primarily on US structured finance securities.  The Cohort consists of 8 funds that invest on a long/short basis, often with a long bias, and typically utilize hedging as a significant part of their investment strategy. 

Beryl believes it has constructed a portfolio of managers that, based on their level of experience and quantitative tools, can generate above market average returns with lower volatility. The portfolio of US structured finance managers can be invested in as either a bespoke strategy or in combination with other hedge fund investment strategies. The portfolio can also be customized to meet investors’ investment objectives and liquidity requirements.  

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