The New Exotica on Wall Street, 3: Re-REMIC's

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Like the legendary snake that swallows its own tail, “Re-REMIC’s draw their collateral from old REMIC’s. In this final installment of our series on financial innovations, we will discuss how Wall Street chefs prepare this exotic new dish for investors.

Before there were re-REMIC’s, there were REMIC’s. The acronym stands for Real Estate Mortgage Investment Conduit. The Tax Reform Act of 1986 provided that such vehicles, if they follow strict rules, are not subject to taxation at the entity level; instead, the government taxes only the distributions to investors. Eligible REMIC collateral includes federally backed securities, such as those backed by Ginnie-Mae, Freddie Mac and Fannie Mae, as well as unguaranteed mortgage “whole loans.” These whole loans might be, for example, subprime or “Alt-A” mortgages, or high quality “jumbo” size mortgage loans.

REMIC’s typically comprise a series of sequential pay “tranches.” Investment banks seek an “arbitrage” (versus the cost of buying the collateral) by matching these tranches carefully to the investment preferences of investors—including maturity, credit rating and bullish or bearish characteristics. REMIC’s typically include a bottom class, the “residual,” with the highest potential for gain (or loss).

In a whole loan collateralized REMIC, the early tranches face less credit risk as well as less duration risk. Issuers and sponsors seek to get these tranches favorably rated. The highest attainable rating is AAA from Standard & Poor’s or Aaa from Moody’s Investors Services (traditionally, the two most prestigious rating agencies). Often, the top tranche of REMIC’s received the coveted AAA, while lower priority tranches might receive lower ratings, but generally all “investment grade” (at least BBB-/Baa). Credit rating agencies based such high scores on complex probabilistic models that contained many assumptions derived from historical experience. One approach, called “Monte Carlo analysis,” tested investment results against a very large series of possible scenarios. A prevailing assumption, whether modeled directly or implicity, was that US residential housing values would not experience sharp losses.

Some investors have a special reason to seek highly rated securities. If they are banks or insurance companies, they will need less regulatory capital to hold them. If the investors are fixed income mutual funds, their trust indenture may restrict them to a certain minimum bond rating. But if securities plummet in rating, such investors may feel compelled to sell suddenly at a severe loss.

Neither the Wall Street firms nor the credit rating agencies expected the extreme increase in mortgage delinquency and default ratios that struck the US residential market first, starting in 2008, but is now reaching the commercial market. The potential losses far outdistanced anything in their models. As a result of earlier faulty assumptions, plus, in come cases, sloppiness and even venality at the rating agencies, risk evaluations frequently turned out to be unrealistic. Numerous formerly investment-grade tranches have fallen deeply into “junk bond” status.

The “re” in “re-REMIC” stands for “re-securitization.” One use of the re-REMIC’s has been to slice and dice the downgraded first tranche into a further sub-set of sequential pay tranches, of which at least the first one or two have high investment grade ratings. FT Alphaville » Blog Archive » The Re-Remic gimmick? The “residual” can encompass formerly rated tranches. (For the cognoscenti, a re-REMIC is a form of Collateralized Debt Obligation (CDO), more specifically a Collateralized Bond Obligation (CBO), in that its assets are themselves fixed income securities. A CDO of a CDO is called CDO², and we have even seen CDO³. Each new generation raises the complexity of modeling performance.)

Strictly speaking, re-REMIC’s are not a new thing. First Boston and Salomon Brothers first introduced these structures some fifteen years ago. Toxic CDOs Given Up for Dead Coming to Life With Pension Funds - Bloomberg.com. But investment banks have revived them under current conditions to extract value and liquidity from existing REMIC’s stagnating in the inventories of investment dealers and their clients.

Investment banks bringing re-REMIC’s include Goldman Sachs, JP Morgan Chase, Morgan Stanley and Banc of America (“round up the usual suspects,” some jaded observers of this financial panic may say). Investors in re-REMIC’s include traditional investors in mortgage-backed securities, plus (for the riskier tranches) some of the bold new players formed to seek opportunity amid the distress. Whether these Re-REMIC’s will pan out for particular investors depends on a number of variables, but particularly on default rates and credit loss ratios and the priority status of the selected tranche.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.