Could Re-Remics break the liquidity logjam in Mortgage REITs? It’s a distinct possibility, and quants all over Wall Street are dutifully burning up their computer processors with souped-up excel files in an attempt to make it happen.
In October of 2006, the IPO for Industrial and Commercial Bank of China on the Shanghai and Hong Kong markets was so oversubscribed that the amount of money committed to the deal was said to have been half a trillion dollars. All for a dodgy bank run by a bunch of communists.
We now know that these gushers of almost indiscriminate liquidity, which the Wall Street Journal then referred to as “rapids of cash”, had been stoked by financial structures which allowed the same obligations to be sold again and again and again, in slightly different forms, and distributed to the far corners of the globe. This distribution of risk was what gave comfort to the mildly concerned, and as a result even Alan Greenspan said it was “different this time”.
It wasn’t, and just as in past investment bubbles, opportunists have already swooped in, attempting to profit from the calamity before the dust has even settled. Now, in what amounts to a witness protection program for certain structured finance products, the same collateralized debt obligations (“CDOs”) that helped fuel the bubble and eventually drove investors to record $400 billion of writedowns and credit losses are being repackaged and sold under a different name: Re-Remics.
This is intriguing for a number of reasons, and it may at least partially explain the $750 million shelf offering filed by RAIT Financial Trust (RAS) on July 18th, and an earlier $500 million shelf filed by Anthracite Capital (AHR).
But first, a bit of background: the commercial mortgage bonds we lovingly refer to as “CMBS”, are actually more formally known as Real Estate Mortgage Investment Conduits, or REMICs. This legal distinction allows the bonds to achieve tax-free status at the trustee level, such that taxable income and losses flow through to the actual investors, much like a partnership.
When tranches of existing REMIC-issued securities (e.g., residential mortgage-backed securities, commercial mortgage-backed securities) are combined and used to collateralize new securities, the new instruments that result from this securitization exercise are called Re-Remics (short for “resecuritization of Remics”).
While the old CDOs were backed by more than a hundred bonds, these Re-Remics typically combine fewer than a dozen, allowing holders to more easily analyze the debt. They also hold only the highest rated debt; no broken single-B rated credit default swaps may apply.
Holders of mortgage bonds are now using Re-Remics to separate better quality A-rated debt from riskier A-rated debt. If that all sounds familiar, it is. Except that Re-Remics can take advantage of hindsight: they can be applied to bonds with valuations that are more clearly known as a result of months or even years of seasoning. Indeed, as Warren Buffet once said “in the business world, the rearview mirror is always clearer than the windshield.”
Looking through the rearview mirror eliminates most of the guesswork, and this allows a Re-Remic to increase the total value of a depressed CMBS or RMBS mortgage pool. Re-Remics do this by splitting anew an existing “scratch and dent” bond trading at say, 60 cents on the dollar into two brand new and even shinier pieces: one highly-rated, low-yielding piece now worth 80 cents and another piece worth only 20 cents but carrying a much higher yield.
And investors, believe it or not, are buying into this sequel. According to a June 27 report by JPMorgan, the riskier Re-Remic mortgage tranches are a “natural fit” for hedge funds. The debt offers higher potential yields at a time when it’s difficult to borrow to boost returns, the report noted.
While hedge funds are buying the higher-yielding “B” pieces, the more highly rated A tranches are being sold to insurers and pension funds, such as Transamerica Life Insurance Co., a unit of Netherlands-based Aegon NV. Transamerica is among holders of Re-Remics created this year by Lehman Brothers, according to Bloomberg. Reliance Standard Life, a unit of Delphi Financial Group, owns a Re-Remic created by Countrywide Financial (CFC).
One huge advantage of Re-Remics is that they can allow existing bond holders to more easily dump portfolios of RMBS and CMBS, thus freeing up the additional debt capacity. This will be critical to avoiding a wider meltdown in 2009. A case in point: according to the Federal Deposit Insurance Corp., commercial banks and savings and loan institutions held more than $370 billion of non-agency mortgage bonds at the end of March.
These are the very institutions that have been stepping up to refinance existing CMBS debt (see “Is Commercial Real Estate Really Dead?”). However, these instituitiosn must also turn over their portfolios fairly regularly in order to keep lending. Nevertheless, in the current environment much of their portfolios have turned to frozen molasses and can can only be sold at fire-sale prices, if they can be sold at all. Re-Remics could help these banks get liquidity and keep lending, and by retaining the more highly-rated tranches, their capital adequacy ratios can also be strengthened.
All Mortage REITs should benefit indirectly from the increased liquidity Re-Remics will provide, but some will undoubtedly benefit even more directly by adapting their business model to participate in the growing Re-Remic market. On the one hand REITs like Northstar (NRF) that have cash to deploy could find attractive new investment opportunities in the “B” pieces. However, since the Northstars of the world are the rarity, the most obvious benefit of Re-Remic structures would be to replace CDOs as the primary source of funding for Mortgage REITs.
For the right issuer, Re-Remics have the potential to make two plus two add up to five. REITs like AHR and RAS, which have both cash and borrowing capacity, could use their warehouse lines to buy distressed CMBS trading at a discount. They could then (1) slice this CMBS into more senior and junior pieces, (2) sell the senior piece and (3) retain the junior piece, almost exactly like a CDO. The resulting bond, enhanced with this additional structuring, would be worth more than the original purchase price. Mortgage REITs would capture the difference via increased yield on the retained “B” piece.
Re-securitizations of REMICs are not completely new. Indeed, re-securitizations of agency mortgage bonds were first executed under First Boston’s Laurence Fink in the mid-1980s. Fink is now chief executive officer of BlackRock, which would seem to position Anthracite as one of the first-mover beneficiaries of Re-Remics. Among other obvious candidates candidates is Petra, run by Salomon alum Andrew Stone. In addition to these commercial mortgage REIT players, strong residential mortgage REITs such as Redwood Trust (RWT) and newfangled American Capital (AGNC) will also be looking at the structure.
If this asset structuring were to be combined with the re-engineering of existing financial liabilities such as that recently highlighted in the Mortgage REIT Journal, the result would be total transformation and much longer term viability for many (but not all) Mortgage REITs. Not only would it permanently put to bed the ridiculously academic arguments surrounding FAS 159, but it would also fill the significant business plan void created by the demise of the CDO market.
In the Darwinistic world of Wall Street capitalism, only the strong would survive. REITs like AFN and CRZ would still have a hard time overcoming their disastrous rush to deploy assets at the height of the bubble in 2006.
Putting aside these true REITwrecks for just a moment, it is also important to recognize that those best equipped to restart the Re-Remic market also have much to gain from it. According to Bloomberg, both Goldman Sachs and Lehman had about $15 billion of residential-mortgage securities, respectively, on their books as of May 31. Meanhwhile, JPMorgan had $12.8 billion of prime and Alt-A securities as of March 31. In the current market, all of these bonds are more or less illiquid.
Not surpringly then, Bloomberg has also reported that Goldman Sachs, JPMorgan and at least six other firms are now repackaging unwanted mortgage bonds into Re-Remics. As a result, more than $9.3 billion of Re-Remics were created in the first five months of 2008, almost triple a year ago, according to Inside MBS & ABS. That volume represented 47 percent of mortgage bonds issued in the period, excluding those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.
When these investment banks finish wiping their arses with their own Re-Remics, look for them to resume their never-ending quest for fee income by applying the technology to other big bond holders: the Mortgage REITs. This time however, they may actually create some value along the way rather than destroy it.
Click here for an updated Mortgage REIT list, including current yields