The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!I would like to thank all of you for all the knowledge you so generously share. I have enjoyed your posts for several years now. So it's past time that I give something back. I hesitate to write because my writing skills are so lacking and you get murdered on these boards for miss spelling or grammatical errors.What brings me to write is I have gained by chance some information about credit risks that may be useful to you. Namely “who really gets left holding the bag when mortgages default and just how risky are Mortgage Backed Securities”.My wife and I was guest this weekend with a couple whose husband works in the commercial capital markets (not the residential capital markets but both are structured in the same way.) After a polite amount of time I asked “What do you do in the capital markets”? He said we securitize commercial mortgages. Wow! I never dreamed I would talk one on one with some one who could explain in detail how the MBS system and tranches work.So I put the question to him “who really get left holding the bag when these MBS bonds default?”He, being a patient type, first explained how the pool of mortgages is assembled from portfolios of mortgages that they buy from originators and later securitize.The process: A skilled clerk examines each mortgage in a portfolio of mortgages and makes a notation of the quality of each mortgage then puts it in a pile that is now referred to as The Pool. The next step is to mentally divide the Pool into tranches. Tranches are a concept of risk and not a physical division of the mortgages in the pool.The securitizer, sometimes with the help of software, calculates how many bonds are to be issued for each of the tranches. The different tranches represent different degrees of risk. The top tranch has very little risk and pays the least interest of all the tranches where as the lowest tranch has considerable risk but pays the most interest...in the range of 18% or better. The interest rates paid on the tranches is based on the 10 yr treasure bond plus a varying number of basis points added depending on the risk of the tranch.Bonds are then issued on each tranch. Fewer bonds are issued on the lowest tranch than the other tranches and all the tranches are backed by the very same pool!My next question was to define what is considerable risk? How is risk assigned?Now no one really signs an affidavit but if they did it would make it very easy to explain the meaning and significance of a tranch and how risks are dristributed.. Let's pretend all the people in the lowest tranch had signed an affidavit or agreement that said “we the members of the lowest tranch are willing to stand good for all the grief (non payments of loans, early repayments of loans and all costs associated with foreclosures) coming from any and all loans in the entire pool if you will pay us 18% interest”. Let's further pretend all the people in the tranches above the lowest have signed similar affidavits but demanded a lower rate of interest than the bond holders in the tranches below them. Now no one really signs such an agreement but it comes very close to explaining the way risks are assigned. The lowest tranch assumes 100% of the risks until they are wiped out! The honor is then past to the next tranch above. (No one in the upper tranches is ever out one penny until the tranch below is wiped out.)The people designing the securitization assume there will be 1 -2 % defaults in a typical pool in a normal times and take this into consideration when deciding how many bonds to issue for each tranch. (I think this process is called pricing the pool).In concept the bottom tranch is acting as an insurance company. (We will pay them 18% on the money they put into “C” tranch bonds if they will stand for all losses until they are wiped out and then the “B” tranch takes over the insurance duties).I'll bet not many people have ever had tranches explained to them in this fashion. I had no idea that the risks were assigned in this manner. Having a difficult time accepting this as fact, I asked my neighbor who also works in the capital markets if the above is an accurate description and she said “Yes…it's sort of like the last man standing”.I have known both of my sources for over 10 years.Here is what happens when the grief starts to come in from the loans as the lowest tranch starts to get hammered.All monies coming into the treasury of the pool manager come from borrowers making their monthly mortgage payments. Normally the pool manager takes part of this income stream and makes the coupon payments to the bond holders of each tranch at their promised coupon rate. However if the incoming revenue is short because of non payment of loans or other grief, this shortage is deducted from the amount set aside for coupon payments to the lowest tranch and they receive less than expected, but the higher tranches continue to receive their full coupon.If revenue shortfalls continue long enough the lowest tranch can go into default.After the lowest tranch gets wiped out, the tranch above drops down a notch to become the new lowest tranch and the process of whoever is the lowest tranch continues to accept all the grief from the entire pool of mortgages.After this explanation I said “It must be very risky to buy a bond in the lowest tranch.” He calmly replied: Mind you these people are making 18% and they have had a string of good years since 2000 in the commercial real-estate. Besides that they don't loose everything when a loan goes bad, the securitizer starts foreclosure on be half of the tranch and in the process if they find any fraud in the loan it gets kicked back to the originator for a full refund of capital. So if times are good and the grief is not over the assumed 1% of the pool, the high risk takers are well rewarded for their risk by making 18%, almost 4 times what they would make on Treasuries.Who are the buyers of the lowest tranch? They tend to be Hedge funds who are betting with other people's money and are willing to take high risk for high returns. So who gets wiped out first when the loans start to default? The people who bought the highest interest paying bonds in the pool are the first to go.. You can tell what tranch you are in by how much interest they are paying you.Before you flame me and you have sources in the capital markets, please see if you can confirm the above description of equity tranches.Alfred4
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