Mortgage Bond Rout

The slow deterioration of the low end tranches spilled over into a big decline in the more secure tranches today. This is an incredibly screwed up mess. Check out the carnage:

http://www.eurobondonline.com/abx-HE-AAA-06-2.Htm

http://www.eurobondonline.com/abx-HE-AA-07-1.Htm

http://www.eurobondonline.com/abx-HE-A-07-1.Htm

http://www.eurobondonline.com/abx-HE-BBB-07-1.Htm

http://www.eurobondonline.com/abx-HE-BB-07-1.Htm

This is confusing. How can there be such a thing as a "AAA" sub-prime mortgage security? Are they just segmenting sub-prime mortgages based on the credit score of the borrowers, with the least of the bad scores being labelled "AAA"?

Are there any indexes that track that Alt-A or prime mortgage securities? It would be interesting how they are performing these days what with all the chaos in real-estate. Are Alt-A securities still trading at par?

"This is confusing. How can there be such a thing as a "AAA" sub-prime mortgage security?"

If you are a fund manager and you want to buy a mortgage backed security based on a pool of mortgages you get to choose your level of risk.
You can buy the AAA rated stuff that has the highest guarantee of payment with the lowest yields, or
you can buy the lowest rated stuff that is the first to stop paying when borrowers start defaulting but has the highest yields, or
you can buy one of the grades in between.

Usually only the stupidest of fund managers (or the most unscrupulous) are duped into buying the "equity" tranches of an MBS offering.

So what criteria are used to determine which sub-prime mortgages are BBB and which are AAA? Or is the difference related to the kinds of insurance protection offered for the various issues (i.e. with AAA having some sort of insurance policy to cover losses)?

The way it works is as follows:

The various tranches are not based on individual mortgages. They are based on the pool. Some of the tranches have first claim on the cash flows coming in, so that it is the lower (higher risk) tranches that lose money first.

Imagine a pile of 100 mortgages. All of these generate monthly cash flows in interest an principal. These cash flows, less a servicing fee, are passed on to whoever owns the CMOs, CDOs, CLOs, and whatever other "C" securities you would care to come up with that are based on underlying fixed income assets.

Say that 500 shares of CMOs were issued, backed by these 100 mortgages. Each CMO share would get 1/500 of the cash flow coming in each month. Now if 10% of the mortgages default and stop paying, the so-called equity tranche is penalized first until its value goes to zero. The next tranche (so-called "BBB") is penalized next, and so forth. The theory was that, based on historical experience on mortgage payment, that the risk to the "AAA" tranche was minimal. The problem came from the fact that the mortgages being used to create these securities were not being issued under the same conditions as the historical experience was drawn from. Those creating the CMOs ignored (probably deliberately due to the profit potential) the oft-repeated mantra: "Past experience is no indicator of future performance"

 

Clear as mud?
Graham.

Thanks for the clearification. I was wondering how it all worked.

I have not heard of any indexs that track that sort of thing.