Friday, June 20, 2008

Why don't people buy AAA strips at 80c in the dollar? Top five reasons by request

Peter - whoever he may be - but I would like an email - made the following comment:

Do a post of the top five reasons why people aren't buying this stuff. I don't fully believe the we-can't-get-financing argument, or at least I question how important it is here. What are the actual yields at 80 cents on the dollar? The i-banks are financing sales of this stuff, too.

I think there is also fear about fraud, chaos (the servicers can't compile the true delinquency data) and political/legal fears connected to loan-mods etc.

What think you?
Peter is right of course. There are several bits of paper which can't be trusted because the servicing sucks. I once had a big short on MTG - and part of the reason was that they owned C-Bass and its terrible Litton loan servicing business. Litton simply could not keep records of who owed them what.

In the days before Litton blew up I used to speak to consumer lawyers/bankruptcy lawyers about Litton. They would tell me that clients could prove Litton had their money - they had banked checks (cheques if you are an Australian) and Litton would be asserting it was still owed money. Litton was as nasty and reprehensible as they come. You can find out plenty here. And here is a not-atypical story.

Yes Litton/CBass paper - which was "scratch-and-dent" in the first place - could - and probably will default to a 50c in the dollar range.

So yes - some due diligence is required buying the non-standard paper.

But take a look at some companies who are not bankrupt and whose paper is very bad (such as Washington Mutual). Does anyone really believe that WaMus systems are as bad as Litton? How about Countrywide?

Long Beach Mortgage (ie WaMu) sucked as a credit originator - but I suspect they can collect the loans quite effectively.

So reason 1 why people don't buy this paper: the servicing sucks. But not in all instances. You need to be selective. Maybe that is beyond the skill of most people. This should not apply to banks who have to mark their books to market because quite often they control the servicing anyway.

Reason 2 is that there might be legislative change to let people out of their mortgages if sold to them at a predatory level. That is a pretty big statement - and it seems to me unlikely. If it happened then pretty well every bank in America would also go bust. Making the paper accross the board worth less than say 68c in the dollar (12 % credit protection and a 20% discount) just does not seem likely. So I will dismiss that.

Reason 3 is more subtle. Some of these loans will fail now - but at the moment the BBB strips and others are receiving coupons. The money that really should be for the AAA strips is being used to support BBB strips. A legislative change which forces interest holidays or forbearance will keep loans technically current for longer and increase the payments to the BBB strips at the expense of the AAA strips. Given you can buy BBB strips for pennies at the moment if you believed that you should be doing the trade. Its a real possibility and its one I can't discount. I mentioned it obliquely in the original post.

Reason 4 that people are not buying this stuff is that those people with the expertise burnt their wallet out eight months ago at worse prices. I know some people who were very good at assessing scratch-and-dint loans. They still are. But they spent all their money at 85c in the dollar where if they waited they could have purchased the merchandise at 65c in the dollar. They will make a profit - but a small one - and they could have made a motza. They were precisely the sort of people who should be buying now - but can't. I think this is in fact one of the major reasons why this stuff is hard to move. There is so much of it - and the people who do this are either full-up or have problems of their own.

Reason 5: This is the main reason. Its just not that attractive. If you take a AAA strip that originally yielded treasuries plus 30bps. You buy it at 80c in the dollar you will get treasuries plus 30bps times 1.25 for it. Oh, your yield goes from 5 to 6 and a bit. That is not much fun. You will however make back say another 10% over time because the loans will repay at 90c in the dollar and you purchased them for 80c in the dollar. Oh - so you get 8-9% if the loans last five years. And they could last much longer.

That is just not attractive for an unlevered player. I am a sophisticated sort of guy and I want returns above that. Those returns are fine if you can lever them 5 times and borrow at 50bps over treasuries. But try and buy a bunch of distresses mortgage securitisations and lever them 5 times. Can't be done. It used to be easy - but it can't be done now. Leverage is absolutely required at these prices to make the investment attractive.

The prices fall until the yields are attractive enough for an unlevered buyer. That is not me at these prices. It is however me at the right price.

I really think that is the end of the story.


Huntington Hartford said...

Great answers to a question I didn't ask!

I liked your quote on the other page about not being able to borrow to buy the paper anymore. I wonder if that partially explains one market that I've been tinkering in lately, municipal auction resets.

Peter Eavis said...

Peter is Peter Eavis. Nice post.

John Hempton said...

I will - following emails from readers - add one more reason. The collateral is often all mixed up. For instance second liens should have severity of over 100 in the midwest - as you only have liquidation costs and the property price has gone to zero.

Some stuff was originated as just Alt-A - meaning the person had a reasonable credit record in advance and maybe bought some collateral to the table - but didn't qualify for a Fannie loan. Some borrowed closing costs. The Alt-A collateral can still default - but a severity of 50 would be surprising. The person that borrowed the closing costs would have diabolical severity. If they bought no money to the table it is likely they overpaid for the house by 20% too at the top of the market...

So score a sixth reason... all mixed up collateral on some paper...


General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.