Private Label RMBS: Opportunity of a Lifetime?

With recent prices for typical senior private label residential mortgage backed securities (subprime, Alt-A, and prime jumbo) now 25%-40% higher than two months ago, it would be a stretch to call them an opportunity of a lifetime. They are not even the opportunity of the past two months. Nevertheless, even with the increases, the prices of many of these securities remain at levels that should generate annualized returns in the 20%-25%+ range so long as we do not see another much more severe leg to the recent recession. Class A-2D of GSAMP 2006-HE5 (one of the securities referenced in Markit's ABX 07-1 AAA index), for which Reuters has provided recent price quotes in the ballpark of 20 cents on the dollar, provides an example.

There are differences between GSAMP 2006-HE5 and other subprime pools, but the risk-reward trade-offs on these securities are more similar than different. Therefore, examining a single security from this pool provides useful insights into the return potential for other subprime securities, and to a lesser extent, Alt-A and prime jumbo securities.

As of August 2009, the outstanding principal balance of the mortgages in GSAMP 2006-HE5 was $482 million, 46.5% of the original principal balance when the deal was originated in 2006. The other 53.5% has been repaid or charged off. Of the remaining mortgages, $252 million, or 52% of the outstanding balance, is at least one payment past due, is in the process of foreclosure or bankruptcy, or has been foreclosed.

GSAMP 2006-HE5 is divided into two groups. Losses on either group can erode the subordinate M-1 through M-5 certificates (losses have already wiped out the M-6 and junior certificates). Principal and interest payments on the Group 2 certificates (including A-2D) depend on underlying principal and interest payments on the Group 2 loans.

Class A-2D is the “last-to-pay” Group 2 senior security. This means that class A-2D will receive principal before any of the subordinate certificates, but after the A-2B and A-2C certificates are paid in full, unless the subordinate certificates are wiped out. If the subordinate certificates are completely written down, principal payments will be made to the senior certificates (including A-2D) in proportion to their outstanding principal balances. This means that the cash flows on the remaining Group 2 senior certificates (including class A-2D) should mirror the cash flows on the remaining Group 2 loans outstanding at the time, after adjusting for administrative expenses and hedges. Delinquency rates for each group are currently within 1% of the overall average for both pools combined, so the future performance of Group 2 should be relatively similar to the overall pool.

The table below (a slightly modified version of a table from an August 25, 2009 Wells Fargo monthly report for this pool), provides a snapshot of the certificates, excluding classes X, B-1, B-2, M-9, M-8, M-7, and M-6. The $102 million original principal of these certificates has been wiped out by losses.

Class	Pass-Through Rate	Beginning Certificate Balance	Interest Distrib.	Principal Distribution	Current Realized Loss	Ending Certificate Balance
A-1	0.425%	91,808,763	31,432	1,583,203	0	90,225,560
A-2A	0.325%	0	0	0	0	0
A-2B	0.385%	91,206,448	28,287	4,877,032	0	86,329,416
A-2C	0.435%	115,439,000	40,452	0	0	115,439,000
A-2D	0.525%	48,975,000	20,712	0	0	48,975,000
M-1	0.585%	41,491,000	19,553	0	0	41,491,000
M-2	0.595%	38,379,000	18,395	0	0	38,379,000
M-3	0.605%	22,820,000	11,122	0	0	22,820,000
M-4	0.655%	19,190,000	10,125	0	0	19,190,000
M-5	0.685%	19,190,000	10,589	0	5,297	19,184,703
M-6	0.765%	4,391,550	2,706	0	4,391,550	0
Total		492,890,762	193,373	6,460,235	4,396,847	482,033,679

Since origination, the pool has experienced $151 million of loan losses, 14.6% of the original principal balance of the pool, including $58 million since January 2009, or 10.2% of the outstanding principal balance as of January 2009. The $58 million of losses on the mortgages has resulted in $42 million of losses on the subordinated certificates. This $42 million has accounted for about 50% of the total principal reduction since January 2009. The $42 million of certificate losses is lower than the $58 million of mortgage loan losses because the average interest rate on the underlying mortgages is higher than the average interest rate on the securities, and this excess interest offsets losses.

click to enlarge

The chart below illustrates certificate losses expressed in dollars and as a percentage of monthly principal reductions since January. The difference between the purple and blue bars is the amount of total certificate principal repaid each month. Recent certificate interest payments (not shown in the graph) have averaged around 5% of principal payments.

The amount that investors ultimately recover depends on the future path of the yellow line in the chart above. If this line remains at levels similar to the 50% average since January, then investors will ultimately be repaid about 50 cents per dollar of principal. (Actually, the path of the yellow line will begin to diverge from investor cash flows if the subordinate certificates are wiped out. If the loans continue to perform as they have for the past six months, the overall performance of the certificates will be similar to the recent past, but class A-2D will receive significantly less than 50 cents on the dollar of principal. This is because the principal balance of the senior certificates cannot be written down, and interest will continue to accrue on the full principal balance on the notes. Therefore, investors will receive more interest but less principal than if the certificate principal were written down, but the net cash flows would be about the same.)

The yellow line peaked at almost 62% in March, and has decreased to just over 40% in August. On the surface, this is encouraging. However, the graph below shows that total delinquencies plus bankruptcies, foreclosures, and real estate owned have increased as a percentage of the outstanding principal balance over the past few months. This suggests that losses should grow in relation to principal and interest payments on the loans, unless foreclosures result in better net recoveries than they have so far in 2009.

It is illustrative to consider investor returns in three different scenarios assuming the class A-2D certificates are purchased at 20 cents on the dollar.

1. The relationship between loan losses and net cash flows on the certificates remains similar to the performance so far this year. In this case, the certificates pay interest at an effective rate of five times one month LIBOR plus 1.2% (interest accrues at LIBOR plus 0.24% of the face amount, but this is multiplied by five if the securities are purchased at one-fifth of their face amount). Principal is likely to begin being repaid in about three years when the principal of the subordinate certificates is written down to zero. The subsequent cash flows would be roughly equivalent to principal repayments at 50 cents on the dollar (250% of the original investment), plus interest at an average rate around LIBOR plus 2%. Overall, the investment should generate an average annualized return around 25%.

2. Loan performance improves enough that the class A-2D certificates are repaid in full. In this case, it will probably take about four or five years until any principal is repaid to class A-2D, after classes A-2B and A-2C are repaid in full. Nominal returns in this scenario would probably be about twice the previous scenario, but over a longer duration, so average annualized returns should also be in the rough ball park of 25%.

3. Loan performance worsens to the point where the mortgage loans experience average principal losses of 80%-85%. This would imply that almost all loans foreclose and recovery rates on foreclosed loans are low (less than 15-20 cents on the dollar). In this case, the investment should pay interest at five times one month LIBOR plus 1.2% for the next two or three years until losses eliminate the subordinate certificates. After this, investors would receive cash flows roughly equal to the original principal investment (20% of par).

The first of the three scenarios above would correspond to lifetime loan losses of 42%-45% of the original principal balance of this pool, roughly 15% higher than recent projections by Standard and Poors for similar pools. Loan losses for 2009 and 2010 would be around 30% of the January 2009 pool balance, higher than the 21%-28% range for the “More Adverse” scenario from the Fed’s Supervisory Capital Assessment Program (SCAP) stress tests. In addition, losses on legacy residential mortgages in 2011and 2012 would be similar to losses for 2009 and 2010. In this case, banks would probably require another round of large capital raises.

The second (most favorable) scenario would result in lifetime loan losses of around 32%, roughly 15% lower than Standard and Poors’ projections for similar pools. Loan losses for 2009 and 2010 would be around 25%, the middle of the “More Adverse” SCAP stress test scenario.

In the third (worst) scenario, lifetime loan losses would exceed 50%, much worse than Standard and Poors’ and SCAP stress test projections. This scenario is consistent with a very severe environment where most banks (including large banks like Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC)) could only survive as independent entities via massive capital raises.

If you believe that an outcome similar to the first two scenarios is much more likely than the third, then class A-2D at 20 cents on the dollar represents an excellent value. Unfortunately, it is not possible for the average retail investor to purchase this type of security, and there are problems with the few publicly-traded funds that have launched recently to purchase distressed mortgage assets. Here are a couple of examples.

1. Invesco Mortgage Capital (IVR) has purchased Alt-A, prime jumbo, and commercial mortgage-backed securities (presumably at very attractive prices), but about half of the company’s equity capital has been allocated to leveraged purchases of agency securities supported by short-term repurchase agreements. About half of the interest rate risk is hedged via interest rate swaps, but the remaining cash flows remain exposed to interest rate risk. This would hurt returns and possibly require securities to be sold at a capital loss if interest rates spike. Given the massive recent expansion of the Fed’s balance sheet, and the potential for inflation if a recovery takes hold, betting that interest rates will remain near or below current levels seems like a poor strategy.

2. PennyMac Mortgage Investment Trust (PMT) was established to purchase distressed mortgage loans (rather than mortgage-backed securities), and maximize investor value by handling the mortgages efficiently, modifying mortgages when appropriate. Unless prices increase precipitously compared with recent lows, purchasing distressed whole loans is a good strategy, but it would be better to also have the option to purchase mortgage-backed securities if they offer better returns.

It would be ideal if retail investors could take direct positions in mortgage-backed securities or indices of mortgage-backed securities. Taxpayers are being asked to fund potential losses on legacy mortgage-backed securities, so it seems fair that they should also be allowed to make direct investments, without paying high investment management fees. This could be achieved by creating versions of Markit’s ABX and CMBX indices (as well indices for Alt-A and prime jumbo mortgage-backed securities) to be traded on a public exchange. Hopefully, Markit or another entity will move forward with this strategy, perhaps at the encouragement of banks and other market participants who would benefit from increased liquidity, before prices increase to less attractive levels.

Disclosure: Long PMT

Comments

[Brent Forsland:]

Good walk-through of the cashflow structure of this deal but you whole rich/cheap analysis of this bond is predicated on some bad information. This security may have traded near 20 cents on the dollar but this would trade closer to 30 the buck today. Reuters is not a good source for this type of non-agency pricing information. Try re-runing your analysis at this level and you'll be less bullish

Sep 01 09:09 AM

[MutantCapit...:]

In any analysis of a RMBS, it's appropriate to look at pooling and servicing agreement {PSA] to determine mortgage servicers
involved in the deal, who owns these servicers, what the servicers' track records are, what legal action has been brought against them and what settlements have they participated in, among other details of all involved parties.
Per SEC filings for GSAMP 2006-HE5, servicers are:
Wells Fargo, Litton Loan Servicing, Avelo and Select Portfolio
Servicing. Litton and Avelo are owned by Goldman Sachs.
Select Portfolio Servicing is owned by Credit Suisse.
Wells Fargo, Goldman Sachs and Credit Suisse all hold
ownership positions in Markit. No conflict of interest here!

These four servicers each have an egregious track record of mortgage servicing fraud of which their parent companies are fully aware, taking full advantage of insider knowledge of bogus manufactured defaults so they can short ABX indices for obscene profit. Despite FTC, class action settlements and ongoing litigation, these four servicers continue to engage in servicing fraud, at behest of their masters who continue to place these rigged short bets while trying to interest investors in RMBS detritus of their own making.
Hopefully investors will take note of numerous Material Instances of
Noncompliance per 10k filings of which these bad actors have many for GSAMP 2006-HE5.
Just the tip of this iceberg:
www.consumeraffairs.co...
ml-implode.com/ailing/...
www.ftc.gov/opa/2007/0...
seekingalpha.com/user/...
If GSAMP 2006-HE5 is such a good bet, why not go short for the long haul and then you too can be participating in the biggest insider trading scheme of all time.

Sep 01 07:06 PM

[Mark Alexander:]

Thanks for the comments.

Brent,

After looking more closely at the pricing information, I see your point. Reuters information looks very inconsistent to the point where one wonders why they bother. Perhaps the reliability will improve over time. Is there a centralized source for pricing information that you consider reliable, or does one need to obtain individual dealer quotes?

At 20 cents on the dollar, GSAMP 2006-HE5 would be an outlier. At 30 cents on the dollar, it is less attractively priced than the overall ABX 07-1 AAA index, which I estimate is priced to earn average annual returns around 18%

I think that the underlying thesis remains valid based on these returns (though not quite so compelling as if GSAMP 2006-HE5 could be purchased at 20 cents on the dollar): sub-prime securities are priced to generate healthy returns under economic conditions that would produce large losses for banks and other financial companies. The losses would probably be large enough to trigger significant declines in US equities in general.

Can you suggest any publicly-traded equities (or other assets) that you believe will generate returns superior to sub-prime securities? I have a couple of ideas, but not many.


Mutant,

Conceptually, bungled servicing seems like the perhaps the largest risk for sub-prime RMBS investors. However, aside from gross mismanagement (worse than what has happened to date), I do not understand how servicing issues will have a major impact on investor returns. Perhaps you can explain.

Sep 14 11:07 PM

[iflyjetzzz:]

Mark, you wrote: "The table below (a slightly modified version of a table from an August 25, 2009 Wells Fargo monthly report for this pool)"

How do I find that data? Can you supply a link? It'd be much appreciated.


As far as the content of your article, I think that scenario 3 (or worse) is going to be the likely outcome. The number of foreclosures for the last year has been reduced/slowed down due to foreclosure moratoriums and legislation. The foreclosures will continue. And GSAMP Trusts are loaded to the gills with mortgages that don't make sense.

On a personal note, the house that I 'm renting was foreclosed on. It was part of GSAMP Trust 2006-HE5. It was a garbage loan by Southstar Funding (now out of business), the mortgage was 0 down and a 10.025% interest rate, which after a short period adjusted to libor plus 7.025% (readjusted every 6 months).
In the end, the Trust will recover $0 from the house I'm renting. I already see how the trustees and lawyers are self-dealing to jack up their fees and wipe out any eventual equity in the house.

Oct 18 07:46 AM

[iflyjetzzz:]

I'd like to add some data about the house I'm renting. It's in San Antonio, a 3BR 2300sf built/bought in 2006. The note on the house is $137K but I see that the bank's listed it at $140K.
The property taxes are due on it - ~$4K/yr.
There is a HOA lien on it for ~$1.5K.
The house was sold in foreclosure on 5 Oct. The lawyer for the trust immediately filed to evict me before I had a chance to send him a copy of my lease. Thank god for the Protecting Tenants at Foreclosure Act; it will allow me to live there until April 2011.
For tax purposes, the house was appraised at $150K (down from $165K in 2008). Realistically, it would take a price of $135K to move the house within a reasonable timeframe. And the home value is deteriorating daily, as foreclosures are popping up like weeds in my subdivision.

I do not plan on trashing the house prior to moving out, but I certainly understand why a large percentage of houses are trashed. The trust's lawyer is an absolute total jerk.

Oct 18 10:30 AM

[Mark Alexander:]

ifl,

Thanks for sharing your story.

You can find performance data at ctslink.com . You need to establish a user name and password, but this should be relatively painless. You can enter a CUSIP (362437AE5 for class A-2D) or click on the link at the left for a list of residential mortgage pools. A prospectus can be found at secinfo.com.

Do you really think the trust will not recover anything on the house? If it sells for $125,000 and the trust incurs $50,000 in expenses, the recovery would be around 50 cents on the dollar. It would bode very poorly for the remainder of the pool if the trust does not recover anything on your place.

I am not quite as pessimistic as you, but I am growing increasingly worried about something like “scenario 3”. Asset prices and shares of financial companies keep escalating while delinquencies and nonperforming assets continue to increase swiftly. Total delinquencies for GSAMP 2006-HE5 increased from 52% to 54.5% from August to September. Similar private label deals that report data early (around the 20th of each month) show continued deterioration for October (worse than September). I had expected performance to gradually stabilize or improve, so this surprised me. If I had invested in private label RMBS at the beginning of September, when this article was written, I would now take my 15% or so gain and walk away.

Oct 21 07:59 PM

[iflyjetzzz:]

Mark,
Thank you very much for the reference information; I have been reviewing the data.
On my particular house, I doubt that the trust will recover much more $50,000 after all fees are paid, representing an ~38% recovery. That is a best case scenario. And please keep in mind that my particular house is very much a best case scenario for the trust. The home is in excellent shape and I have no intentions of trashing it before I leave. However, I can tell you that there have been several foreclosed houses in my subdivision that have had substantial repairs made after foreclosure. You can pretty much write those off to 0% (or more likely, negative) recovery.
We have no idea of the shape of the remaining REOs that are sitting on the trust's books. I'm sure that they sell the best houses very quickly and are stuck with the bad ones. Although the bulk of REOs on the trust's books are 2009 foreclosures, there are still quite a few 2008s and even a 2007 on the books. I think that you can write those down to zero; they are probably in such bad shape that the trust is unable to sell them.

I see no abatement in delinquencies; the October data showed a 56.5% delinquency rate.
The lower tranches are rapidly becoming worthless and based on trend data, I would expect class M-5 to be a 100% loss before the end of 2009. By this time next year, I expect to see class M-2 taking losses, as I expect M-3 and M-4 to be 100% losses within the next year.
Good call on your part for taking any gain and walking away.

Again, thanks much for the link. That's some great data that will likely serve me well in future court appearances.
... and to fill you in on the latest in my saga, I went to court last week to fight the eviction notice. The trust's lawyer rambled for ~30 minutes trying to evict me. The judge dismissed the case.
To date, there has been no request for rent.

Nov 07 03:41 AM

[Mark Alexander:]

iffy,

Thanks for the response and the update.

I see losses at least through 2010 similar to you, and the examples you provide do not bode well for last-to-pay tranches like A-2D after 2010.

If the trustees for this and similar deals are smart, they will accelerate forecllosures and/or short sales over the next six months to take advantage of the home purchase tax credit.

Good luck with the battles. Keep me posted if anything interesting happens and you find time.

On Nov 07 03:41 AM iflyjetzzz wrote:

> Mark,
> Thank you very much for the reference information; I have been reviewing
> the data.
> On my particular house, I doubt that the trust will recover much
> more $50,000 after all fees are paid, representing an ~38% recovery.
> That is a best case scenario. And please keep in mind that my particular
> house is very much a best case scenario for the trust. The home is
> in excellent shape and I have no intentions of trashing it before
> I leave. However, I can tell you that there have been several foreclosed
> houses in my subdivision that have had substantial repairs made after
> foreclosure. You can pretty much write those off to 0% (or more likely,
> negative) recovery.
> We have no idea of the shape of the remaining REOs that are sitting
> on the trust's books. I'm sure that they sell the best houses very
> quickly and are stuck with the bad ones. Although the bulk of REOs
> on the trust's books are 2009 foreclosures, there are still quite
> a few 2008s and even a 2007 on the books. I think that you can write
> those down to zero; they are probably in such bad shape that the
> trust is unable to sell them.
>
> I see no abatement in delinquencies; the October data showed a 56.5%
> delinquency rate.
> The lower tranches are rapidly becoming worthless and based on trend
> data, I would expect class M-5 to be a 100% loss before the end of
> 2009. By this time next year, I expect to see class M-2 taking losses,
> as I expect M-3 and M-4 to be 100% losses within the next year.<br/>Good
> call on your part for taking any gain and walking away.
>
> Again, thanks much for the link. That's some great data that will
> likely serve me well in future court appearances.
> ... and to fill you in on the latest in my saga, I went to court
> last week to fight the eviction notice. The trust's lawyer rambled
> for ~30 minutes trying to evict me. The judge dismissed the case.
>
> To date, there has been no request for rent.

Nov 10 10:06 PM