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Here are two interesting articles from the Wall Street Journal describing events in both the RMBS and CMBS industries, that give us an idea of what is happenning at to opposite ends of the investment spectrum. Mortgage Funds Brace for Major Shift and Small Investors Lost It All in Memphis.

In the first article there are 2 points worth noting:
1.1) Mortgages that are underwater. 
The Markit index of subprime securities issued in the second half of 2006 recovered from below 60 (March 2009) to around 80. This points to the need for staying power to recover losses if one is already in the market or the discounts to look for if one is getting into the market.

1.2) Prepayment & loss assumptions.
My belief is that many mortgage deals (CMO, CMBS etc) were based on ‘optimistic’ (or ‘pessimistic’ depending on your point of view) prepayment assumptions which no longer hold. Low rates would suggest an increase in prepayments, but this will not the case because banks are essentially not lending. That is, bond structures based on 100 to 350 PSAs are probably seeing prepayment rates at 0 PSA. That means one has to rethink the support & subordinate bonds.

The second factor, losses, is a very severe factor and in my opinion, not adequately built into deal portfolios. An early estimate is that CMBS asset defaults are now around 6.4% – 6.8%. A huge increase from a previous 1.8%. However, given the two recent big defaults Crescent Real Estate Equities and Stuyvesant Town and Peter Cooper Village, one should expect the dollar defaults to be greater because of the dollar skew further to the right. The only way to handle losses is to factor transactions at deep discount. This articles shows that some fund managers are doing that.

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In the second article, we note
2.1) CMBS delinquencies.
CMBS delinquencies climbed to 6.5%. This is in line with our first pass default estimates of 6.4% to 6.8%.

2.2) Banks are having difficulties providing credit.
40 banks turned down the opportunity to refinance the Cherry Road property. Without a healthy functioning securitization industry, banks are unable to provide credit, and therefore hampering this economic recovery.

2.3) Duration Matching.
My guess given the wisdom of hindsight, properties like Cherry Road should have be financed with a longer term debt, 10 years instead of 5.

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When juxtaposed these two stories tell us:
3.1) Shift Focus.
The need to shift the focus of cash flow securitization analytics from prepayment modeling to loss modeling.

3.2) Preserve Capital.
Investors’ primary concern should be the preservation of their capital and therefore a realistic strategy for the preservation of capital is the high LTV capital structure.

3.3) Liquid Assets.
TIC are really illiquid and all things being equal, CMBS AAA bonds might have been a better investment, in that one would probably not have lost $7 million. Google results on TICs.

3.4) Optimism Can Be Misplaced.
With hindsight, the use of TICs with low LTVs would suggest investors with an optimistic perspective on the economy and that there was probably insufficient downside risk assessment. But then we never really know until things are too late, right?

3.5) Sophisticated Investors.
The concept that investors are ‘sophisticated’ based on their net worth needs some rethinking.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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2 Comments

  1. Ben,

    Excellent observations. If we think of the ABX as a proxxy for mortgage credit, then the natural conclusion is that the ABX is an average over possible “HPA” scenarios. An “HPA” probability distribution that fits ABX Index pricing can be used to price the credit risk of individual bonds as well. That’s why we have seen the recent rise in the ABX.

  2. Great blog post, articles and astute observations. Commercial Property owners that are underwater would benefit greatly from cost segregation and/or loan restructuring programs, moving forward. My hope is that people seek solutions more quickly to stay on the other side of “hindsight”! Thanks for sharing.


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  1. By Quantum Risk Management « Ddoingit1's Blog on 08 Apr 2010 at 9:21 am

    […] « Some Lessons from RMBS & CMBS Defaults The Most Incisive Statement in 30 Months […]

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