Risk Mananging Asset Backed Securitization

GGP Q2 Results
General Growth Properties Q2 results were better than the markets expected. When you strip out exceptionals, many of which are related to Chapter 11 costs, the fundamentals are encouraging, and have rightly been reflected in a significant rise in the share price.

Taking a look at the breakdown, the immediate comparisons appear poor: Funds From Operation (FFO) are down by 73.8% year on year, Core FFO is also down 43.9%. However of much great importance is GGP's Net Operating Income (NOI) - down a much more modest 11% in total, and a very good figure both in comparison to GGP's major peers and market expectations. In fact, excluding the main drag from the MPC's (Master Planned Communities) - with those stripped out we reach the headline figure reported for the main Retail businesses, with NOI down a mere 2.1% on the previous year.

Relatively strong fundamentals adds further credibility to the GGP business model. The increasing market capitalization of the firm is a direct reflection of growing confidence across the market in its ability to successfully restructure without excessive equity dilution.

Bubbles & Risk Management
I fully admit to not seeing the credit crunch coming until it was too late, and if most people are honest they did not either. In fact, nor did most of the noted commentators - it was a rare few who warned of the dire effects of a credit withdrawal with the years in advance required to avoid these problems.

I thought the dot com and recent housing bubbles were both glaringly obvious, and stayed well out of both. However as I discovered with the credit crunch, bubbles are not always so clear - they have to be hard to spot to enable them to build up.

Risk management was a dirty word on the Street a few years ago. On a few occasions, I remember sneering with the best of them, as calls from risk management about positions being taken were viewed as unnecessarily cautionary. And consistently unnecessary as the high earners and income generators within my former bank confidently dismissed them as overly conservative. I was naively a believer in the pure capitalist argument that too much collateral tied up money that could and should be actively and productively used as part of the development of the 'new economy'. The financial instruments now in use were different; these managed risk as inherent in their design.

Whenever anybody starts justifying practices that generate extraordinary profits and inserts the word 'new' in the context of economics, it is time to beware. Things really weren't different this time of course, just as recessions and crises have occurred with startling regularity throughout the last century. My take on this is that it is the different generation of investors ultimately ensures that reoccurrence. Much like investment, few take the time to research before jumping in, and hence do not learn the lessons of history.

Additionally throw in the less sophisticated consumers in the emerging markets and bubbles in India and China in particular are a virtual certainty – that means the potential to exploit significant, quick profit in the coming years ahead for those willing to take the time to invest in these markets and not play safe at home (much more on this theme another time).

Risk Management of Asset Backed Securities
The one plus of this learning process for our generation is that the regulators have been taking a hard look at the woeful risk management practices in many of the large banks - particularly in the context of asset backed securitization.

The US government is proposing several key legislative changes, which are worth understanding for those inside and outside the industry:

1. Any bank, non-bank issuer or underwriter of an asset-backed security must retain at least a 5% interest of the credit risk in such assets for an as-yet unspecified period or form. Crucially that would be without hedging - the theory being that if firms are themselves exposed to what they are trading, they as shareholders and owners of the banks will take the issue of risk a great deal more seriously.
   
2. Requirement to continue reporting by issuers of asset-backed securities even if the number of holders falls below 300 - this has relevance to the low level issuance/ownership of Structured Purpose Entities (SPE's) that we have seen in General Growth Properties bankruptcy, whereby some creditors have effectively been the sole lender. At present these structures escape under the reporting radar, but soon no longer.


3. Requirement to disclose standardised asset-level or loan-level data and standardised compensation and risk retention information. This really does not have much bearing on risk management, and seems to have been inserted to placate those wishing to have some disclosure of bankers compensation.
   
4. Regulations on the use of representations and warranties in the asset-backed securities market that would require credit rating agencies to include additional analysis in their reports - this would require disclosure permitting investors to identify originators with clear underwriting deficiencies.


5. Elimination of the offering exemption for certain real estate mortgage notes and related participation interests.

If these proposals are adopted, the impact on the securitisation market will depend on the nature and scope of the regulations that are ultimately developed. However it is that first proposal relating to forced exposure which knowing the banks will be the most effective means of ensuring responsible behaviour.

As the cocky young traders I describe in my last entry have long proven, it is easy to play dice with other people's money – and in the right period for the economy a total muppet can make money. However put your own money on the table, and you think about the risk far more seriously. This links back to what bonuses are meant to be about - a performance linked assessment that incentivises traders to trade as effectively as possible – it is that glaring short-termist flaw in them that has been exposed and is rightly attracting criticism.

Bonus reforms remain another vital change that needs to be imposed on the sector, and if I can recognise that then you know there is no excuse for those disagreeing.

Credit Markets and Rating Agency 'Refinement'

This is a follow on from my analysis in May into the credit markets and rating agencies, when Fitch assured that it would continue to monitor GGP assets in the context of bankruptcy proceedings (although the implication was for further downgrades).

Rating Agency Antics Fuel Uncertainty
This process continued last month when Standard & Poor's began to tighten their criteria for rating CMBS, with figures quoted as high as $235bn worth of commercial bonds under threat of losing their AAA status.  Now in the WSJ today, Standard & Poor announced that it has just reversed "its evaluation of a clutch of mortgage bonds backed by commercial property." It has re-rated a number which are part of the GG-10 benchmark securitization back to the crucial AAA status required for TALF legacy eligibility - and all just a week after downgrading them.

GG-10 is a large $8bn commercial mortgage backed security bond, that has large numbers of loans resecuritized each year across the market by dealers - so ratings on this baby serve as a bellwether for the health (or problems) of the wider commercial credit market. Looking into S&P's published methodology refinement in more detail, the Fed's desire to support commercial real estate is certainly a possible factor in this turnaround.

If so then that should come as no surprise - the impartiality of rating agencies has always been questionable. Note: for more on this, I highly recommend reviewing this great commentary by Linda Lowell of Housing Wire, on the ratings agencies and their impact on CMBS markets (particularly how S&P could not provide any meaningful backing to JP Morgan analysts regarding their previous change that lead to the downgrades). 

Suffice to say that the late June rally in CMBS resecuritizations was impacted by the ratings downgrade rumours and counter-rumours, as dealers were unable to price with certainty, unsure that triple-A paper classes at the time still would be so for much longer.

What Are S&P Changing?
So behind all this, quoting from the S&P methodology changes announced, the following key aspects are being amended:

• Amending how losses and recoveries resulting from 'AAA' rating scenarios for super-senior classes in US conduit/fusion CMBS are assessed.
• Differentiating the timing of losses from 'AAA' term and maturity default tests when cash flow modelling transactions.
• Spreading out losses that are applied to a transaction's certificates over a longer period of time.
  
  

The latter is the most meaningful change, since it allows for exceptional short-term losses to be effectively averaged, and hence to smooth out rating changes and thus reduce the occurrence of short term rating changes that are subsequently reversed.

S&P Methodology Outlined
For those interested, from Standard & Poor's own paper is the refined 3-step approach that they will be using for rating conduit and fusion transactions:

1. Aggregate recoveries from defaults in the 'AAA' scenario and credit impaired assets up to the crossover date. [NB Crossover date is the time where allocation of principal and losses to the super seniors change to pro rata from sequential]
2. For cash flow modelling, assume loans will not default for 3yrs and apply a 24mth recovery period before losses up to 30% would be applied (at the end of the fifth year). Any additional losses applied the following month, expect losses due to maturity.
3. Use Trepp's cash flow model to apply recoveries through the capital structure of the transaction to determine which certificates had an ending balance of $0, and would therefore retain their 'AAA' ratings.

Credit Market Evolution
This report on Sribd from Deutsche entitled 'The Future Refinancing Crisis in CRE' is another one worth reviewing, to understand the refinancing challenges within CRE right now. 

On a side note, the markets have been changing the structuring of resecuritisation in the last few years, in order to juice up tranches and create more AAA-rated bonds as assets became distressed.  How?  By moving away from the much maligned CDO to re-REMIC's (REsecuritization of Real Estate Mortgage Investment Conduits).

To see how these can be misused, take a look at this crap published by Fannie Mae back in December 2007 - see page 2 for the re-REMIC's section in which they state:

"Market participants know that almost any type of MBS can be used as collateral for Fannie Mae REMICs."

I think we're starting to see part of the problem Fannie, when you openly state almost any MBS will do. How to mortgage the future of the next generation in America through incompetence in one easy step. Let's take a look back at how the process used to work for the banks in the good old days...

"So, if I offer you this enormous stash of our sub-prime mortgage backed securities, you'll give me REMIC's in exchange?", asks the disbelieving banker.

"Sure, we luuurve you guys - you're one of our biggest clients, and we just keep on buying these.. cos.. hell, I don't know but we do. Anyway, the government wants us to buy 'em." replies the Fannie Mae redneck employee.

"I love this job.. ok fine in that case here's $50bn of our worst shit we couldn't sell to Bernie Madoff, and in exchange we'll have those nice AAA-rated Fannie re-REMIC's and sell them onto clients. As a sweetener, we'll even throw in vouchers for you and your family to have a 3 course meal at Cracker Barrel." 

"HELL YES!" replies the Fannie Mae redneck. "If there's Cracker Barrel in the deal, then you've got yourself one."

However back to reality, and re-REMIC tranches are attained in a different way to the particularly special blend of bullshit that the banks came up with previously to produce AAA-grade paper from sub-prime toxicity. Rating levels now are attained with a heavy emphasis on collateralisation - hence why rating changes like today increase uncertainty and problems.

For example, triple-A paper in recent offerings has had the most extraordinary 50% subordination levels; in English that means these would still be AAA rated if half the underlying properties burned down and none of them were insured (which they are). At least in theory, these CMBS are almost unnecessarily safe, thus should not ever be downgraded.

A trader is quoted in a Commercial Mortgage journal as stating that: "The life insurance companies are driving this. For regulatory capital reasons, they benefit from holding bonds that have more ratings stability."

Credit Future
This activity had lead to tighter spreads in the resecuritization market for super-senior bonds, leading to increases in their prices on the market and a general upturn in activity at last. However the junior tranche CMBS going out onto the market still have a significantly higher 30% subordination rate, which is a lot better than the triple-A class deals of old.

To me that is a sign that the quality of the bonds is improving to instill genuine confidence in the AAA-rating once again, and rightly so. Going back to the rating agencies, these sorts of problems then derail such progress by increasing the spreads.

GGP
Despite this, looking back at GGP, this is all part of wider series of moves by the government towards improving the credit markets and is to be welcomed by shareholders as a further means of assisting the firm in restructuring.

Indications continue to be reported that the government is open to reassessing TALF terms and conditions, but these mostly are around an extension to the scheme time frame, not a meaningful change to the criteria. Talking of GGP, there has been little going on besides some arguing between GGP and Hugo Boss relating to the latter wishing to terminate a signed lease early due to delays. Boss are likely to have that dismissed and are just trying their luck with a filing like this.

Otherwise the rulings today are largely unimportant, or have already been made (e.g. around the Success Fee). Somebody needs to slip a bottle of whisky to the good judge and tell him to hurry up and make his decision on the SPE inclusion issue…

Greed Guarantees It Will Happen Again

It is interesting how everything in life is cyclical. You're born a disgusting, wrinkly ball akin to the stomach parasite from Alien, unable to speak or wipe your own bottom - and if lucky you end up that way again by your late-80's.

On the subject of cycles, do we truly learn from mistakes? Perhaps on a generational level, but surely not beyond that, which is why so many of the problems we are seeing now have happened before. It is the same point raised in the book 'The Millionaire Next Door', which observes how the wealth acquired by self-made millionaires through frugality is usually lost within a couple of generations, as their offspring piss it all away pursuing a materialistic utopia.

Anyway my point was actually around the whole Bernard Madoff fraud, and the absolute certainty that it will happen again in the future. I don't care what politicians and others in the press state about controls to prevent it, that is simply not the case. Wherever there are naive and/or lazy investors, there will be largely unregulated, opaque funds promising fabulous returns that seem too good to be true

In one sense everything is legal until you are caught - something that Enron illustrated impressively - although not a position I agree with, despite notions of 'right' and 'wrong' being grounded solely in perspective.

So it was with some interest that I got some perspective when I chanced upon a CMBS securitization dealer from another bank over at a Corney & Barrow champagne reception last Friday. It was completely random, at a wedding drinks bash: not mine, and sadly and not corporate - the days of charging everything back are sadly not yet there again.

I was most surprised to find out the trader worked for RBS, who having notched up losses to rival Citibank, and really are a basket case in the world of banking these days. My first question to him of course, apart from the standard piss-take "what's it like to work in the public sector these days?", was what he was still doing there with a job?

He confirmed my suspicions by admitting to being the only one left of a team of 25 a year ago. An interesting illustration of another factor reducing the CMBS transactions taking place, given the headcount reductions to support the transactions. In effect though, he is minding the shop with respect to their existing CMBS portfolio - but did add he is still an originator.

Obviously I had to bring up the subject of General Growth, more to see if he knew anything about it and the potential impact of the SPE ruling. He knew enough for me to have some fun ripping his industry apart, as I reminded him what a joke the previous contracts and sales processes had been.

He did not disagree, but gave the inside perspective - namely that it was really for the clients to complete the due diligence as they were the ones impacted. That is fair enough, but as I reminded him that is not really a valid view given the $50bn loss RBS took last year - it might just be arguable that they were impacted as well. He also confirmed the rumours I have heard that the industry is busy co-ordinating a complete re-structuring of SPE's and associated contracts that will supersede what is currently on the market.

Hardly a surprise, but what that does suggest is that when we finally receive a ruling it will not have nearly the ramifications that some would suggest. There is otherwise little news on the GGP front besides some minor legal applications ahead of future hearings.

Good news for me is that the functional spec will (at last!) be finished by the weekend. It has taken me about 2.5mths due to work, and after drafting up a high level technical spec next, I could in theory get it built in the next couple of weeks. However I will be moving onto the biggest job of all next - populating the site content. Rather more important at this stage, and given the site will provide industry grade investment research papers to registered users (for free), that is going to take time to get ready. I will be covering everything from corporate finance to investment products, market psychology and all trading products on the market, whether investors have access to them or not.

The key to successful investing, particularly for those aspiring to reach high net worth status, is building strong foundations - and that goes beyond simply building knowledge. Either way this site is going to be a more intelligent alternative to the main investment tabloids.