Recent residential mortgage-backed securitization deals are carrying a few structural features similar to transactions from the pre-crisis days, posing potential challenges of absolute levels of losses and timing of prepayments.
To be clear, the mortgage bonds under surveillance will only incur losses in low-probability scenarios. However, in these unlikely events, and the securities take a turn for the worst, the severity of the transaction produces monumental consequences, according to Moody’s Investor Service (MCO). The extent of which would bear remarkable resemblance to the same extent experienced when the Great Recession first began to unfold. In other words: Big losses for investors.
Moody's is sounding the warning because, even though the risk is small, they felt it is important to highlight the highly technical structure of recent RMBS. Investors may overlook, or not even be aware of, these risks, no matter how unlikely to materialize.
SMALLER SUPPORT, BIGGER LOSS
In the report, Moody's cites deals where super senior support bonds can incur vastly high losses when compared to the super senior bonds they support.
Support bonds are typically small relative to the super senior bonds, these securities could incur a very high loss severity because any losses that support bonds will constitute a large percentage of the support bond’s balance.
Given that a deal’s rating reflects not only the profitability of a bond’s default, but also the severity of the loss in the event of the default, a support bond’s small size means that it might need more enhancements than a larger bond would to achieve a particular rating at a given pool expected loss, Moody’s concluded.
In an example, Moody's lays out two deal scenarios, citing the second structure as the more favorable:
A $10 loss on a $100 single-tranche senior bond results in a loss severity of 10% for that bond. A structure that splits that bond into an $80 super senior bond and a $20 support bond, however, will produce a stronger bond that would realize no losses and a weaker bond with a loss severity that is much higher than what the original bond’s would have been.
In the first scenario, the support bond is sliced too thin to provide meaningful senior support. The support bond risks depletion with a 10% loss severity. Going forward, Moody's suggest that the loans need more insurance compared to collateralization to avoid such severe measures within these transactions.
"Super senior/support bond combinations were common in RMBS transactions before the financial crisis because they added extra protection to the senior bond at the top of the structure, although this protection came at the expense of the support bond," the report states.
EXCHANGE ONE FOR THE OTHER
Exchangeable securities are also another common feature in pre-2008 RMBS. Again, the feature is popping up in recent transactions as well. An exchange option allows an investor to exchange multiple bonds for one bond or one bond for multiple bonds. Ideally, such a structure will leave the holder of the post-exchange securities in the same credit position as before the exchange.
The overall issue is that the initial exchangeable bonds do not hold the same overall credit quality. Pro-rata loss allocations should equally split the support bond.
For example, in the above (bad) scenario, say a bond uses 10% loss severity. According to Moody’s analysts, if split into two, post-exchange bond, each should get 5%. Some transactions bundled the entire 10% into only one of the new post-exchange bonds, depleting support in the other and leaving those investors at much higher risk.
Another factor within these transactions is that principal-only bonds are vulnerable to back-end losses from slow paying discount loans.
PO bonds can also be sensitive to prepayments and losses on bonds within the RMBS transaction.
"Because their cash flows come only from the discount mortgage loans, these PO bonds are vulnerable to tail risk that the transaction’s conventional principal and interest senior bonds aren’t in scenarios in which the non-discount portion of the pool pays off more quickly than the discount loans and losses are back-ended," Moody’s analysts explained.
Simply put, the discount loans are inherently more susceptible to slower prepays because their interest rates are lower than the rates on non-discount loans.
WHAT CAN BE DONE
Moody's is not suggesting investors head for cover and exit the private-label market. Actually, the tone of the research indicates the opposite. Surveillance such as this was not as widely available in the run-up to the crisis. Presumably, investors are doing their homework on their holdings and the production of such a piece of research says as much.
The structural nuances are also a product of the investor community, according to Moody's.
"Some RMBS issuers have in recent transactions re-introduced structural features from precrisis transactions that allow them to offer senior bonds with a variety of cash flow allocations to match different risk appetites and yield requirements," the research states.
If such is the case, then there is little more to be done. Investors need to be aware of any and all risks, in other words, but not to be frightened by the prospect.