Anthracite Post Generates Some Heat!

by REIT Wrecks on August 14, 2008

You know, it takes a bit of grip to host this pig. Even though the code sits on some server quietly doing its thing somewhere in American Samoa, they hit my credit card every month for at least a topped-off tank of California gas. And I only get about a mile per million clicks, if you know what I mean just push that index finger once, it won’t hurt.

Trust me, anonymously spitting up some new interesting REIT story on an almost daily basis while the stock market (and my own net worth) spirals into nothing less than an investment migraine in a closet of full of credit vertigo must be about as bad as making a spot the Chinese midget tag team wrestling squad but still better than being a vegan.

So when I get comments on this turgid, loss-ridden subject matter, it’s a bit of a triumph when you only have a hammer, everything looks like a nail, or something like that. The comments help me to be an even better real estate sleuth, and hopefully all of us to become better investors. So when I saw this particular comment (below) appear on the August 10th Anthracite post, I decided I had to re-post it on its own page. I have been looking into ways to make this a more open site, with the ability to post available to more than just me, so what better way to start than with this, which definitely took some time and effort to write. Thanks for the comment 42. (Comment follows)

Not to take exception with some of your other points later in the piece, but when you start out your blog by quite incorrectly identifying the controlling class as BB rated, I must then only deduce that the content which will follow must be subjected to a high degree of scrutiny. (Update: REITwrecks responds). Typical of the CMBS market (RIP) the BB bonds are publicly offered, the B bonds are privately offered and the NR piece (aka first loss or Controlling Class Certificates) are also privately offered. Why? Because these two classifications (B and NR) of risk are so high, the investors require analytical access to non-public loan files in order to create cash flow models used to predict returns and therefore to price bonds.

First of all, the controlling class certificates (CCC) (otherwise known as the first loss piece) are UNRATED. That is clearly NOT to be confused with any bond that IS rated (including C, B, BB etc.). The CCC/first loss piece of a structured transaction are essentially the “Equity” piece with absolutely no financially secure guarantee of the return of any of the face amount of principal on the certificates themselves.

Therefore, because there is quite literally almost no hope of principal return, these assets trade at deep, deep discounts to the par face amount. Typically these ‘bonds’ trade in the new issue market (i.e. when the deal is initially structured and sold to investors) at prices nearing 17-25% of par. This practice of pricing is essentially driven by a Timing-And-Severity-Of-Losses Model to calculate a projected yield.

AHR assumes ON THE DAY THEY BUY THESE that $0.00 of principal will be recouped from these assets. So who cares about loss rates of 50% when the assumption from day one is 100% losses on principal?

Why would any ‘bond’ investor ever buy a bond and then immediately write the principal down to $0.00? Seems like financial suicide, right? Here’s why: The loans will pay the stated interest on the 100% face amount of the loans for some period of time prior to experiencing any credit deterioration. The Art & Science of the investment process in these CCC/first loss pieces is accurately estimating how long the loan will pay the full interest before it begins delinquency as well as the depth of the deterioration of the credit in that time frame.

Because the CCC investor is paying 17-25% of par and receiving the ‘bond’ coupon (interest) on the full 100% of the par (face) amount, the income from the bond will eventually return a fat profit….as long as it keeps paying. There is a breakeven point in time at which the initial investment (17-25% of par) is surpassed by the interest payments on the full par amount of the bond and it becomes a profitable investment.

So the key to a successful analysis and therefore a successful investment in these assets is BOTH a TIMING OF LOSSES and LOSS SEVERITY prediction (model). Professionals in the structured markets will recognize this as the SDA (Standard Default Assumption). This is a mechanical-standardized-time-ramp model, which describes the historically experienced credit default curve of loans of similar ilk. This model is coupled by investors with a loss severity model which incorporates various timing of workout/recovery amount/period assumptions in order to present a cash flow projection of a given loan/deal/structure.

Combining these models with the cash flow calculator of a specific loan file (which by the way is ONLY MADE AVAILABLE TO THE FIRST LOSS AND B INVESTORS) in order to predict the cash flow, while accurately adjusting the percentages of these models (up or down) to reflect market conditions is where the Math PhDs make their money.

If losses occur earlier than predicted but are of a mild severity, the investment can workout fine. If the losses occur earlier than anticipated and are of a severity equal to or greater than anticipated, the interest stream will obviously be cut off by the losses (losses take the bond face amount down toward $0 by the amount of the realized loss) and the investment can incur a negative yield.


The ‘controlling’ classes are so named because they provide to the investor in the most disadvantageous position with respect to losses (caused by poor performing loans) with the authority to direct the actions of the special servicer. The special servicer is essentially a loss mitigation function provider, which is activated at the command of and for the benefit of the controlling class investor upon the recognition of a loan performance snag.

The CCC holder has the right to control the special servicer to take action on their behalf to mitigate losses. They get to dictate the actions of the special servicer as their agent and for their economic benefit. Thus the class is tagged “Controlling Class”. This bondholder gets to call the shots; they are IN CONTROL. And they are in control because they are taking the most risk…AND THAT IS WHY THESE BONDS ARE NOT RATED. They are typically not registered (i.e. Private securities) and are refered to as NR (non-rated) classes in the prospectus.

The annual and the quarterly reports both take a few paragraphs to explain the loss assumptions on the controlling class interests. I suggest that you take some time and read the explanation of these securities, how they work, what factors affect the return and how they are booked on the balance sheet.

The scenarios you shared could be destructive or they could be irrelevant. You have not provided the depth of analysis necessary to provide much other than speculation. Your points might be accurate and have absolutely no effect OR they might have a big effect. Your post fails in its lack of depth of analysis or even an understanding of what these bonds are that you are primarily discussing. What it seems may have become a little obscure to you is that the return of principal is IRRELEVANT.

The Fitch report could be right and losses could mount to 50% over the life a of a deal AND IT COULD PROVE TO BE A COMPLETELY IRRELEVANT ASPECT OF THE RETURN CALCULATIONS FOR THESE BONDS DEPENDING ON THE TIME FRAME FOR THE LOSSES TO BE REALIZED. It is the timing and severity of losses, which are all important.

Your work is widely read and you are to be commended for the valuable service you provide to the market at large. No offense intended because I do respect your work…but, you are just a little out of your league with your last post. It is therefore likely that the net result is that your readers, whom I dare say have not been exposed to the specific nature of these arcane classes within the structured securities realm, will be frightened not enlightened.


Mortgage REITs
Disclosure: I assume 42 is long AHR

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