The following two documents show two descriptions of the subprime mortgage disaster. The first from BrasscheckTV, showing how those involved were victims of a scam, and the second from EIM Group (chairman Arpad Busson) demonstrating how this scam was orchestrated.

____________________________________________________________________

After the Fall

Contrary to anti-social, right wing propaganda, "sub-prime" loans were not made to help poor people get their first homes.

They were created to help new home builders, especially in states like California, Nevada, and Florida, sell out their new home inventory at super-inflated prices.

Home buyers were told by the Fed chairman...by the President...by Fox News...by every idiot financial reporter on TV...that the loans they were taking out were a "good deal."

The loans were very simple:

Very little down, very low payments and then, a few years out - when theoretically the property would be worth much more - the monthly payments would rise dramatically.

The idea was that long before then the home buyer would have sold out at a handsome profit and moved onto their next home.

Free enterprise at work.

It's easy to call these people foolish, but what they really are are the victims of a scam.

The home builders got paid lavish premiums for their inventory...real estate companies and loan brokers got rich from these sales...the Wall Street banks that packaged these scam loans and sold them throughout the world made hundreds of billions of dollars...and the psychopathic Bush administration got to fund its wars without raising taxes based on the illusion that the economy was good and could afford it.

Now the chickens are coming home to roost.

This is EXACTLY the same scam that Bush Sr. ran in the 1980s using the Savings and Loans real estate fraud bubble to pay for the Contra war and God only knows how many billions he and his fellow crooks siphoned off on the side.

Bush Sr. even had the same Fed Chairman Alan Greenspan running the central bank.

The only difference is this disaster is 100 (1000x) larger.

____________________________________________________________________

The company EIM Group and its analyses of Subprime Mortgages:

 http://www.eimgroup.com/jahia/webdav/site/eim/shared/Sub%20Prime%20Mor tgages%20May%202007%20(4).pdf

Text below:

NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
May 2007 | Subprime Mortgages
E.I.M. S.A.
2, Chemin de Chantavril | 1260 Nyon | Switzerland
Tel +41 22 363 6464 | Fax +41 22 363 6465 | Email  info@eim.ch
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
2
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Contents
I. Overview of Subprime Mortgages
1.1. Subprime Mortgages
1.2. Subprime Profiles and Characteristics
1.3. Size
II. Origination and Securitization of Subprime Mortgages
2.1. Evolution of Subprime Lending
2.2. Origination
2.3. Securitization
III. Fallouts in the Subprime Market
3.1. Sequence of Evens
3.2. Government Related News
IV. Effect on Market Constituencies
4.1. Effect on Subprime Originators
4.2. Effect on Wall Street Firms
4.3. Effect on Housing Market
4.4. Effect on Economy
4.5. Conclusions
V. Servicing Subprime Mortgages
5.1. Various Stages of Delinquent Mortgages
5.2. Loss Mitigation
5.3. Conclusions
VI. ABS CDS and ABX Indexes
6.1. ABS CDS Basics
6.2. Differences between Corporate CDS and ABS CDS
6.3. Applications of ABS CDS
6.4. ABX Indexes
6.5. Trading of ABX—Upfront Exchange of Cash
VII. EIM’s Views and Strategy
7.1. A World of Polarization
7.2. Synthetics as a Means of Shorting
7.3. EIM’s Strategy
7.4. Conclusions
References
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
3
Overview of Subprime Mortgages
I. Overview of Subprime Mortgages
Lenders’ definitions of a subprime borrower vary, but they generally accept that a
borrower with a credit score of less than 620 falls into the subprime category.
Certain criteria and weights are used to calculate an individual’s credit score. For
example, Fair, Isaac & Co1. calculates FICO, one of the most common credit
scores, by assigning values and weights to five factors: payment history,
outstanding balances, length of credit history, new credit and types of credit.
FICO scores range from 300 to 850. The higher the score, the better the chances
for getting loans at lower rates. Besides the subprime category, there are two
other major credit categories: prime and near prime. A credit score of 720 and
above is considered excellent and would qualify a borrower as prime. A borrower
with a credit score between 720 and 620 is typically considered as near prime.
Subprime borrowers can have loans on credit cards, autos, mortgages etc.
1.1. Subprime Mortgages
The majority of subprime mortgages are taken out as cash-out refinancing loans2 ,
so they are often referred to as home equity loans (HELs). The subprime market
consists of the following sub-sectors:
1) First-Lien Subprime Loans
The lender takes a preferred first mortgage interest on the property. The
borrowers (obligors) have a 20%–25% equity in the property and select
repayment terms of up to 30 years. The interest on the mortgage can be fixed or
floating. The interest rate exceeds the interest rate available under agency
programs3 , because the borrower’s credit is impaired. First-liens now comprise
more than 80% of subprime securitizations.
2) Second Liens
The second lien has a perfected security interest in the property, but it is junior to
the first mortgage lien. Second liens can be taken out at the same time as the first
lien, for the purpose of purchasing a home with little down payment, or they can
be taken out separately to refinance credit card debt, finance home
improvements, etc. Second liens are about 10% of subprime securitizations.
3) High Loan-to-Value Mortgages
Some lenders make loans that exceed the value of the property (called high-loanto-
value, or HLTV loans). These loans generally do not exceed 125% of the
property’s appraised value. The interest on the amount of the mortgage that
exceeds the property value is not tax deductible. In addition, these assets are
generally treated as unsecured investments by regulators for capital purposes.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
4
First-lien HLTVs have a typical LTV of 102%–103%, while second-lien HLTVs have
a typical combined LTV of 110%–115%. First-lien HLTVs are issued for home
purchase with no down payment. The amount in excess of 100% is used to
finance the closing costs. Second-lien HLTVs are primarily consumer loans. The
borrowers taking out first- and second-lien HLTVs have much stronger credit
profiles than the borrowers taking out low-LTV first-lien subprime loans. HLTVs
have declined in popularity, and today they are a small percentage of subprime
securitizations.
4) “Scratch and Dent” Mortgages
The “scratch and dent” term encompasses loans that do not fall into the
underwriting categories of lenders, but have some additional features that make
them reasonably risky. For example, the borrower’s debt-to-income ratio may be
too high, but the combination of disposable income and LTV make the loan
attractive. These loans are also called “program exceptions.”
Other reasons for loans to be classified as scratch-and-dent include the following:
(1) the loans have been removed from sale to a third-party purchaser; (2) they are
delinquent loans (not in bankruptcy or forbearance4) up to three-months past due;
(3) the loans are in bankruptcy; (4) the loans had prior multiple delinquencies that
are now cured; and (5) the loans are subject to certain appraisal, credit
documentation and/or other deficiencies.
5) Reperforming Loans
Reperforming mortgages include the following (a) rewritten loans where the prior
loan may have been in default and the new loan was originated in a workout
situation; (b) loans where the original loan terms have been modified pursuant to
the Service Members Relief Act of 1940 (Relief Act loans); and (c) modified loans
where the original loan terms have been subject to a material modification
pursuant to a written agreement.
1 Like Standard &Poor’s or Moody’s, which rates corporate bonds, Fair, Isaac rates individual consumers’ credit
worthiness and provides credit reports to lenders such as credit card companies.
2 Cash-out refinancing is a way for a homeowner to access the equity built in the house. By taking out a larger
mortgage to refinance an existing smaller one, the homeowner receives extra cash to pay off other debt.
3 Agency programs refer to the mortgages from the Fannie Mae, Freddie Mac and Ginnie Mae, which are all
“quasi” government agencies.
4 Forbearance refers to that the lender agrees to defer payments of currently or previously owed amount to a
later date when the borrower is capable of paying again.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
5
1.2. Subprime Profiles and Characteristics
Based on several lenders’ reports, the typical subprime borrower has a relatively
stable employment history, with some years in his job and profession. The home is
generally a single-family dwelling typical of an average American home - 1,500
square feet, 3 bedrooms, and 1.5 bathrooms. The average home price is
US$220,000. These collective borrower traits portray a picture of economically stable
consumers with a home that has benefited from the strong housing market, but is
typically not located in one of the highest growth areas.
As discussed in the table below, firstlien
subprime loans are mostly taken
as cash-out refinancing (60% of
floating rate loans and 75% of fixedrate
loans). The cash-out is used for
home improvements, paying off
consumer debt, medical expenses
and other consumer purposes. Other
characteristics include:
1) Virtually all floating-rate subprime
loans are hybrids. The fixed-rate term
is either two years (80%) or three
years (20%), after which the loans
reset every six months, indexed to sixmonth
LIBOR.
2) Historically, about 90% of the loans are taken out on borrower-occupied
properties. There are very few investor properties in subprime pools, although
their percentage has risen in the recent years.
3) More than 75% of the subprime loans are backed by single-family properties.
For the majority of subprime loans (60% of floating-rate and 70% of fixed-rate),
the borrower has submitted full documentation, which typically includes two
years of income tax returns, pay stubs with verification of employment, and a full
documentation of assets.
4) The majority of loans carry prepayment penalties, which slow down prepayments
and contribute to lasting cash flows. The amount of penalty varies, though the
most common penalty is six months’ interest on 80% of the unpaid principal
balance.
5) About half of hybrids have two-year penalties, 20% have three-year penalties,
and 30% have no penalties.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Age 43 years
Monthly Income US$5,780
Time in Property 5 years
Time in Job 8 years
Time in Profession 11 years
Property Type 84% single-family
Year Built 1960
Size 1,500 sq. ft.
No. of bedrooms 3.0
No. of bathrooms 1.5
Property value US$220,000
Subprime Borrower Profile
Source: Citigroup
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
6
Therefore, the typical subprime loan is clearly differentiated from the other nonprime
and non-agency category, namely, the alt-A loan. Alt-A loans are considered
as near prime loans with higher credit scores and higher loan balances, but also
have significantly higher concentrations of investor borrowers and loans with
limited documentation (for example, no tax returns for years and/or limited
income verification)
1.3. Size
Whole Loans5 and Cash RMBS
There is no precise measure of the size of
subprime whole loans as the older vintages
have most likely been paid off and the
recent vintages may not be captured by the
major loan databases. Based on
LoanPerformance, a database that covers a
large majority of subprime loans by an
estimated 70%, the total outstanding
amount of subprime loans could be close to
US$1 trillion.
The amount of the whole loans originated before 2000 is insignificant—they have
been paid off, refinanced or fallen into default.
But not all the whole loans are securitized. On average, the historical
securitization rate has been about 60%--with roughly US$600 billion subprime
loans securitized, sliced and diced into different tranches of RMBS and sold to the
public market.
Of the US$600 billion RMBS backed by subprime loans, less than 8-9% or about
US$50 billion are non-investment grade rated (BBB- and below), which are of
immediate concerns to investors in the event of massive defaults. Over 90% of
securities issued are rated BBB and above due to the subordinations provided by
the non-investment grade tranches.
By contrast, the total size of residential mortgage debt is estimated to be about
US$9.5 trillion (agency, prime, near prime and subprime), of which about US$5.5
trillion are securitized into MBS. Therefore, subprime mortgages account for
10.5% (1/9.5) and 10.9% (0.6/5.5) of the total residential mortgage debt
and securitized MBS, respectively—not exactly dominant by any measure.
5Whole loans are the same as mortgages. The use of the word “whole” simply means that the loan has not been
securitized (or sliced and diced into various tranches of different credit ratings).
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
2006 500
2005 350
2004 180
2003 48
2002 15
2001 8
2000 4
Total 1,057
Year Current Outstanding
Loan Amount (US$ bn)
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
7
Related Markets
The cash subprime RMBS market has spawned other related markets, namely ABS
CDOs and CDS on ABS (both single name ABCDS and the ABX indexes). It is even
harder to put numbers on these markets.
According to BIS and ISDA6 , the notional amount of the entire CDS market,
including Corporate and ABS was about US$26 trillion as of the end of 2006. A
report by Fitch7 put the notional amount of ABS CDS at US$500 billion at the
beginning of 2006. Given the rapid expansion of synthetic ABS trading in 2006 and
early 2007, the outstanding notional must have grown to a much larger number by
now. By some estimates, it is over US$1 trillion, including both longs and shorts.
As for the subprime ABS CDO8 market, it is an estimated 40% of the US$600 billion
CDOs issued in the last three years or about US$240 billion in size.
Summary
Between loans, cash bonds and derivatives, there are over US$2.2 trillion worth of
instruments traded in the various markets (it would be double counting to include the
loans and the RMBS deals backed by these same loans).
II. Origination and Securitization of Subprime Mortgages
2.1. Evolution of Subprime Lending
The subprime mortgage market did not take off until mid- to late-1990s. Since then,
growth has been phenomenal—the total volume of subprime loan origination has
risen from US$65 billion in 1995 to over US$500 billion in 2004 (before paying off,
prepayment and defaults). The last couple of years saw even stronger volumes—over
$600 billion subprime loans were originated in 2006 alone.
6Bank for International Settlements and International Swaps and Derivatives Association.
7Similar to S&P’s and Moody’s, Fitch is another major credit rating agency.
8ABS CDOs are CDOs issued with ABS as collateral, which could include subprime ABS or prime ABS.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Size of subprime whole loans: US$1 trillion
Size of cash RMBS backed by subprime: US$600 billion
Size of non-investment grade cash RMBS: US$50 billion
Size of ABS CDS and ABX Indexes: US$1 trillion
Size of ABS CDO: US$240 billion
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
8
Many factors have contributed to this growth:
1) Lending institutions were not able to charge high interest rates and fees until the
Depository Institutions Deregulation and Monetary Control Act (DIDMCA) came
into effect in 1980. The market was only available to homebuyers in the prime
category.
2) In 1982, the Alternative Mortgage Transaction Parity Act made it possible to
charge variable rates and allow balloon payments.
3) In 1986, the Tax Reform Act of 1986 increased demand for mortgage debt as it
allowed interest deductions from income, making even high cost loans more
affordable.
4) In 1994, interest rates unexpectedly rose and the volume of originations in the
prime market dropped precipitously. Mortgage brokers and originators
responded by increasing subprime loan originations in order to maintain volume.
5) The development of RMBS market and the acceptance by investors in the 1990s
provided funding to subprime originators as they could securitize the loans, sell
them in the public market and move on to originating new loans.
6) In the late 1990s, housing price appreciation (HPA) was high, while interest rates
declined to some of the lowest levels in decades, thus providing low-cost access
to the equity in homes. Of the total subprime loans originated, over 50% were
for cash-out refinancing, whereas about 30% were for home purchases.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
0
100
200
300
400
500
600
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Subprime Mortgage Orginations ($ Billion)
Source: Inside B&C Lending
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
9
As the subprime market has evolved over the past decade, many firms that started
the subprime industry have either failed or been purchased by larger institutions.
The subprime meltdown of 2007 will undoubtedly prove as a catalyst to more
consolidation.
2.2. Origination
Subprime lenders create loans in three ways: retail, correspondent and broker
network. Most lenders employ a combination of the methods. For the investor, the
origination channel is relevant because it affects the performance of the loan. Loans
from brokers and correspondents tend to see faster prepayments. In addition,
investors typically scrutinize the re-underwriting practices of subprime issuers to
ensure that bulk purchases do not result in lower credit quality of the loans.
Retail originators work directly with the borrower, either through retail branches or
calling centers. Many customers are referred to the lender through affiliates, such as
credit card companies, insurers, or related mortgage lenders. Retail originations are
more expensive than other origination channels, but they provide the lender with
points and loan origination fees, which are significant sources of income. Retail
originations provide an opportunity for best loan selection and pricing.
Correspondent lenders (correspondents) are banks and finance companies that are
typically too small or regionalized to warrant retaining and servicing the loans.
Correspondents sell their originations to larger lenders in packages. Most final
lenders re-underwrite the correspondent loans to make sure they meet the lender’s
credit criteria.
Mortgage brokers match borrowers with mortgage lenders. They act as an
intermediary, trying to get the best match between the borrower and the lender.
Brokers typically offer a loan to several lenders and act on the most competitive
offer. The lenders, in turn, underwrite each loan before offering the loan terms.
Broker channels have consistently dominated subprime loan production. In 2004
they accounted for more than 50% of subprime originations.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Money Store Associated First Household Ameriquest
Beneficial Household CitiFinancial New Century
Household ContiMortgage Bank of America CitiFinancial
Guardian Savings & Loan IMC Washington Mutual Household
LongBeach Savings Money Store Option One Option One
Green Tree GMAC-RFC First Franklin
Advanta Countrywide Washington Mutual
GMAC-RFC First Franklin Countrywide
New Century GMAC-RFC
Ameriquest Wells Fargo
Pre- 1996 1996-1998 1999-2001 2002-2006
Source: Inside Mortgage Finance
Major Subprime Lenders Across Various Market Phases
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
10
2.3. Securitization
Securitization is the process of pooling subprime mortgage loans and converting
them into packages of securities with various credit ratings. The process could
include the following steps:
1) Originators sell whole loans (packages via a flow program) to a Wall Street
Dealer or directly into a trust,
2) Trust issues rated, registered securities, which the dealer distributes to investors
acting as securities underwriter,
3) AAA rating is achieved through senior/subordinate structure, whereby a portion
of the pool is subordinated to the rest with respect to realized losses,
4) Dealer works with investors to structure various cash-flows to meet investor
needs and requirements (reverse inquiry),
5) Trust receives cash flows from underlying loans and distributes monthly to
investors according to distribution rules,
6) Dealers provide secondary trading liquidity, valuation and analysis.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Source: Citigroup
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
11
The senior/sub structure is currently the most common means of enhancing the
credit in subprime deals. It accounts for more than 95% of current issuance. The
senior/sub structure provides credit enhancement through three mechanisms:
1) Subordination;
2) Overcollateralization (OC); and
3) Excess spread.
All three mechanisms coexist in a deal, and the size of each one changes from
month to month and deal to deal.
Definition of Subordination
Subordination means that payments of interest and principal on the classes are
ordered according to some priority. If in a given month the amount of available cash
is insufficient to cover the full interest and principal payments on all the classes, the
classes with higher priority get paid in full, while some of the classes with a lower
priority experience an interest or principal shortfall. Bonds that have higher priority of
payments carry a higher credit rating.
Definition of Overcollateralization (OC)
OC is the excess of collateral balance in a deal over the face amount of the bonds.
Deals can either be issued with an initial OC, or the OC can be built up to some
target level by using excess spread to accelerate the paydown of bonds.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Source: Citigroup
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
12
Definition of Excess Spread
Excess spread is the difference between the gross coupon on the loans, adjusted for
servicing and other fees, and the average coupon on the bonds. A typical servicing
fee is 50bp per year and the trustee and other administrative fees are generally less
than 2bp. Excess spread is the first line of credit protection in any subprime deal.
Please see below for a typical subprime RMBS structure (the current OC level,
however, is much higher depending on the quality of the pool).
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Source: Citigroup
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
13
III. Problems in the Subprime Market
A barrage of negative news about the subprime market has dominated headlines in
recent months. We highlight some dates below.
3.1. Sequence of Events
March 14th
• National City reports that it might increase reserves US$50 million after one of its
mortgage insurance companies covering its HEQ portfolio rejected claims related
to its mortgage losses. National City believes the reasons for rejecting the claims
were “inappropriate”. National City also announces that they would write down
US$11 million in subprime loans.
March 15th
• ACC Capital Holdings fires an unspecified number of workers. This affects
workers in Ameriquest (provider of subprime loans), Argent Mortgage (provider
of loans via independent brokers), and AMC Mortgage Services (servicer of
loans).
• GE agrees to purchase PHH Corp. for US$1.8 billion, and upon closing the
transaction sells PHH Mortgage (retail originator/servicer of residential mortgages)
to Blackstone Group, the private equity firm.
March 16th
• Accredited Home Lenders puts up US$2.7 billion of loans in its held-for-sale
portfolio for sale, so it can enhance liquidity. The loans are being sold at a deep
discount, and Accredited takes a US$150 million hit on the sale.
• Credit Suisse doubles Fremont’s credit line to US$1 billion. In addition, Fremont
announces that it is unable to meet its extended (March 16) annual report filing
deadline.
• Novastar cuts 17% (350 jobs) of its staff, primarily within the firm’s wholesale
loan origination group and related functions.
March 19th
• Connecticut, Maryland, Rhode Island, and Tennessee issue cease-and-desist
orders to New Century regarding taking new loan applications (Ohio issued a
temporary restraining order). These states join Massachusetts, New Hampshire,
New Jersey, and New York in similar orders after New Century failed to fund the
mortgage loans after closing.
• Accredited faces expulsion from the NASDAQ Stock Exchange, after failing to file
its 10-K by March 15.
• C-Bass will pay 28% less for Fieldstone under an amended purchase agreement.
• Fremont tells staff they may be dismissed in 2 months; employees will receive pay
and benefits through May 18 unless they find other jobs.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
14
March 20th
• Accredited receives a US$200 million loan from Farallon Capital Management,
the hedge fund manager. The 5-year loan may be used to fund new mortgages,
general working capital, or other corporate needs.
• People’s Choice Home Loan Inc., a mortgage lender based in California, files for
Chapter 11 bankruptcy protection.
• Wells Fargo will eliminate over 500 subprime mortgage division jobs.
March 21st
• Fremont agrees to sell US$4 billion in subprime loans, and estimates a US$140
million pre-tax loss on the deal (the sale reflects 3.5% discount to face value).
Fremont receives US$950 million cash from the 1st sale installment. Remaining
sales are expected to be completed over the next few weeks.
• Citadel, after purchasing ResMae for US$180 million on 3/5, acquires a 4.5%
ownership interest in Accredited.
• Bank of America cuts Option One’s (H&R Block’s mortgage lending unit) credit
line from US$4 billion to US$2 billion.
• PHH Corp (acquired by GE; Blackstone Group owns PHH Mortgage) delays its 10-
K filing for 2006.
March 22nd
• Barclays drops demands that New Century buy back US$900 million in
mortgages. In return, New Century agrees to transfer the mortgages it financed
with Barclays “as is” and “without any representation or warranties”, and will
realize a US$46 million loss on this deal.
March 23rd
• In its 2006 financial results, Freddie Mac discloses that it held US$124 billion of
non-Agency securities backed by subprime loans at year-end 2006, or about 18%
of the US$704 billion portfolio (nearly all of which were AAA rated).
March 26th
• Morgan Stanley announces it will publicly auction US$2.48 billion of mortgages
originated by New Century.
March 27th
• Merrill Lynch-owned First Franklin cuts an unspecified number of jobs relating to
loan processors, as well as other jobs with similar functions.
March 28th
• Fulton Financial Corp. reports it will take a US$5.5mm pre-tax charge in Q1
2007, due to EPDs9 on 80/20 piggyback10 and stated income loans.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
15
March 29th
• HSBC chairman Stephen Green says the bank will cut back its subprime division
“significantly”. Mr. Green adds: “Whether or not we’ll write it off completely I’m
not sure.” HSBC had bought subprime lender Household International in 2003.
• Homebuilder Beazer Homes, currently under investigation by the FBI, receives a
federal grand jury subpoena for documents related to its mortgage origination
business.
March 30th
• First NLC (owned by Friedman, Billings, Ramsey Group, Inc.), a subprime
originator based in Florida, announces it will close several of its wholesale
operations centers, and will lay off employees.
April 2nd
• Barclays completes its US$76 million acquisition of EquiFirst (subprime origination
business unit of Regions Financial Corporation).
• To avoid foreclosures, EMC Mortgage (owned by Bear Stearns) sets up a 50-
member team that will be responsible for meeting with homeowners having
difficulty in making their mortgage payments.
• New Century files for Chapter 11 bankruptcy (no surprise for market
participants!). New Century also enters into an agreement to sell its servicing
assets and servicing platform for US$139 million to Carrington Capital
Management, and to sell certain loans and residual interests for US$50 million to
Greenwich Capital (both agreements are subject to the approval under the
bankruptcy code). New Century will also reduce its workforce by 3,200 or 54%.
• News emerges of Grant Thornton’s resignation as auditors to Fremont and
Accredited. The auditor states that the two companies “no longer meet our
requirements for clients acceptance.”
April 3rd
• New Century’s US$150 million loan is approved by the bankruptcy judge,
enabling it to stay open while it auctions off assets.
April 9th
• Mortgage lender American Home Mortgage Investment Corp cuts its dividend,
and reports that earnings would miss analysts’ estimates. Its shares fall nearly
20% on this news.
• The Bankruptcy Trustee oppose New Century’s proposed sale of US$50 million
mortgages to RBS.
9EPDs or Early Payment Defaults are delinquencies within the first few months (3-6 months) after taking out a loan.
1080/20 piggyback are second liens. Instead of taking one loan with a Loan-to-Value (LTV) of 95%, which requires
mortgage insurance and is costly, the borrower takes out a first lien for 80% LTV and a second lien for the remainder
20%. The presence of the second lien does not affect the legal priority of the first lien in case of borrower default.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
16
April 10th
• Accredited Home Lenders hired new auditors to replace Grant Thornton, the
second firm it has parted ways with in the course of a year.
April 11th
• NovaStar announces that it received a commitment for an additional financing
facility of up to US$100 million, arranged by Wachovia. This facility is part of
NovaStar’s efforts to enhance liquidity. The firm also announces it is exploring
strategic alternatives which may include a sale. NovaStar says originations of
nonconforming loans (including subprime) fell 58% in Q1 2007 versus last year.
April 12th
• Wells Fargo files a complaint against New Century’s auction of its mortgage
service unit, stating that the auction process used shuts out competitors. C-Bass
also says the auction rules make it too expensive to challenge the initial bidder
(Carrington). Both Wells and C-Bass complain that New Century has not released
enough information about the Carrington offer.
• New Century wins permission to sell about 2,000 mortgages to a RBS subsidiary
unless a competitor exceeds the US$47.3 million bid (face value of loans =
US$170 million). The auction ends April 30th. New Century also wins approval
for US$7.34 million worth of incentive payments to loan division employees.
April 13th
• First Horizon, based in Irving, Texas, shuts down its nonprime wholesale lending
unit.
• Homefield Financial, based in Irvine California, shuts its wholesale lending
division.
April 16th
• Fremont General Corp agrees to sell US$2.9 billion of subprime home loans to an
unidentified buyer, and expects to record a US$100 million pretax loss on this
sale. This follows a sale of $4 billion worth of subprime loans announced last
month.
April 17th
• Fannie Mae and Freddie Mac plan to help subprime borrowers avoid foreclosure
by helping them refinance into more affordable mortgages. Fannie Mae plans to
encourage 2,000 lenders to help subprime borrowers refinance their ARMs to 40-
year fixed rate loans. Freddie Mac proposes offering fixed rate loans with as long
as 40-year terms and ARMs with longer fixed rate periods.
• Credit Suisse agrees to buy nonprime residential lender, Lime Financial Services.
Lime (founded in 1999) funded about US$2.1 billion of loans in 2006.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
17
April 18th
• Ellington Management Group, a Connecticut-based hedge fund, announces its
plans to buy Fremont’s real estate business and US$2.9 billion of subprime loans.
• Washington Mutual announces its commitment to refinance up to US$2 billion in
subprime loans at discounted mortgage rates, to help homeowners (with
subprime mortgages) avoid foreclosures.
• Freddie Mac announces to purchase as much as US$20 billion fixed and
adjustable rate mortgages to provide lenders with more options to offer subprime
borrowers.
April 19th
• New Century receives permission to sell its loan service division to Carrington
Capital Management (unless the US$133.3 million bid is topped).
• GE’s WMC mortgage unit will lay off 771 employees (50% of their workforce)
and will also close 3 service centers.
April 20th
• H&R Block announces its plan to sell Option One to Cerberus Capital
Management. Cerberus will pay [cash value of tangible net assets when the deal
closes less US$300 million]. H&R Block also shut its mortgage retail division
3.2. Government Related News
Regulators and politicians have stepped up their discussions over possible remedies
as the flow of “bad” news continues. This included plans to tighten the
underwriting standards and some form of federal “aid.” At this stage, it is unclear
how the different proposals (see below) might proceed and potentially affect the
subprime market.
• Governor Ted Strickland said Ohio (with the highest foreclosure rate at the end of
2006) might have to expand its initial plans to raise $100 million from municipal
bonds to help homeowners refinance their mortgages.
• Senator Ronald Rice, who represents New Jersey, proposes a program similar to
Ohio’s, helping homeowners refinance their mortgages. Senator Ronald Rice
wants a plan in which the state housing agency could borrow at least US$100
million to offer 30-year fixed rate loans to borrowers facing foreclosure.
• Senator Chuck Schumer, a New York Democrat, calls for the federal government
to bail out troubled borrowers. The Senator also proposes a bill that creates a
national system regulating mortgage brokers. The legislation would also establish
a “suitability” standard aimed at shielding borrowers from unaffordable loans.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
18
Overall speaking, more and stricter subprime regulations seem extremely likely to
happen in the near future, which should strengthen the underwriting standards and
reduce delinquencies for the loans of 2007 vintage. Any bail out programs at tax
payers’ expense, however, are unlikely to pass.
IV. Effect on Market Constituencies
We should not underestimate the extent of problems in subprime. Negative news
flow will continue and we will probably see more subprime bankruptcies in the
future. So far we have heard reassuring words from Treasury Secretary Henry
Paulson and Fed Chairman Ben Bernanke about the limited impact of the fallouts
from subprime,
What are the repercussions? And how are the various market participants being
affected by the meltdown?
4.1. Effect on Subprime Originators
The following shows the top 25 originators in 2006. Four of the originators (Ownit,
ResMae, Mortgage Lenders Network and New Century) have already filed for
bankruptcy, and several others are on the verge. A fair number of subprime
originators could shut over the coming months, as they are currently unprofitable.
Few independent subprime issuers are expected to have the capital necessary to
support such a business for any prolonged period. Most independent subprime
originators will seek “deeper pocketed” parents or they will be forced to declare
bankruptcy.
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( )
1 HSBC Finance, IL $52,800.00 8.30% -9.90% HSBC Household Finance (rumored to be up for sale); Decision
One [owned by HSBC (rumored to be up for sale)
2 New Century Financial, CA $51,600.00 8.10% -2.10% In breach of debt covenants; restating '06 earnings
downwards; major shareholder lawsuits; blanket national
layoffs beginning; stopped accepting loan applications,
speculation of bankruptcy, stock de-listed from NYSE, SEC
starts investigation; 5 additiona
3 Countrywide Financial, CA $40,596.00 6.30% -9.10% Countrywide stopped offering no money down loans.
4 CitiMortgage, NY $38,040.00 5.90% 85.50%
Rank Lender 2006 Volume Mkt % Change Notes
Vol. (US$ mil) share Vol 05-06
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
19
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5 WMC Mortgage, CA $33,157.00 5.20% 4.30% WMC (subsidiary of GE) stopped offering hi CLTV loans
and announced to lay off 460 workers on the loan
production front
6 Fremont Investment & Loan, CA $32,300.00 5.00% -10.90% 3/2/07 Fremont announced shut down of subprime
business; Credit Suisse doubled Fremont's line of credit
to $1bb.
7 Ameriquest Mortgage, CA $29,500.00 4.60% -61.00% Ameriquest (On life support from Citigroup; may end up
acquired. Owned by ACC); Recently shut most offices
and settled with 30 states over predatory lending; laid
off workers.
8 Option One Mortgage, CA $28,792.00 4.50% -28.60% Owned by H&R Block; up for sale; stopped funding
loans for subprime/alt-a with CLTVs>95%; H&R Block
reduced the value of Option One's residuals by
$29.2mm.
9 Wells Fargo Home Mortgage, IA* $27,869.00 4.40% -8.10% Wells announced staff reductions for their subprime
operations
10 First Franklin Financial Corp, CA $27,665.50 4.30% -5.70% First Franklin (acquired by Merrill Lynch from National
City for $1.3bln)
11 Washington Mutual, WA $26,600.00 4.20% -21.50% Washington Mutual's Long Beach Mortgage cut 50 jobs
in response to problems in subprime mkt.
12 Residential Funding Corp., MN $21,200.00 3.30% -16.10% GMAC-RFC (Major layoffs in ResCap; Reports 4th qtr
loss due to losses on subprime loans)
13 Aegis Mortgage Corp., TX $17,000.00 2.70% -4.70% Aegis (recently closed two subprime operations centers)
14 American General Finance, IN $15,070.00 2.40% -2.40%
15 Accredited Home Lenders, CA $15,766.80 2.50% -4.90% Accredited Home is delaying earnings filing; announced
sale of $2.7bb of its loans in HFS portfolio, will take
$150mm hit on sale; may cut jobs; received $200mm
loan from Farallon Capital Mgt (hedge fund manager).
16 BNC Mortgage, CA $14,500.00 2.30% -3.30% Lehman subsidiary
17 Chase Home Finance, NJ $11,550.00 1.80% 19.70%
18 Equifirst, NC $10,750.00 1.70% 21.60% Acquired by Barclays
19 NovaStar Financial, KS $10,232.70 1.60% 10.20% Novastar (serious impairments; likely no dividends in
2007, no taxable income through 2011, shareholder
lawsuits, stopped offering high CLTV loans; cuts 17% of
its staff)
20 Ownit Mortgage Solutions, CA $9,500.00 1.50% 14.60% 12/7/06 Ownit (partially-owned by Merrill and BofA)
filed for bankruptcy
Rank Lender 2006 Volume Mkt % Change Notes
Vol. (US$ mil) share Vol 05-06
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
20
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21 ResMae Mortgage Corp., CA $7,659.00 1.20% 11.60% 2/13/07 ResMAE filed for bankruptcy -- acquired by
Citadel
22 Mortgage Lenders Network USA, C $6,000.00 0.90% 100.00% 2/5/07 - filed for bankruptcy
23 ECC Capital Corp., CA $5,484.50 0.90% 291.20% ECC/Encore (fire-sale bought out by Bear-Stearns);
trading of ECC stock has been suspended
24 Fieldstone Mortgage Company, MD $4,991.30 0.80% -33.70% Fieldstone (2007-02-16, bought by C-Bass); C-Bass will
pay 28% less for Fieldstone under an amended purchase
25 Nationstar Mortgage (Centex), TX $4,619.00 0.70% -23.00% Owned by Fortress Investment Group
Total for Top 25 Lenders: $543,243 84.90% -10.20%
Total B&C Originations: $640,000 100.00% -3.80%
Source: Inside B&C Lending
According to the UBS mortgage strategy team headed by Laurie Goodman, the
origination model in place for most of 2005-2006 followed this structure: the all-in cost
of origination was US$101.5, and the loans were sold at US$102.5. The only other
expense item was the “hit” from early pay defaults (EPDs). Typically in the subprime
arena, EPD protection is provided for the first payment. In other words, if a loan misses
the first payment, the loan is labeled an EPD and can be “put back” to the originator.
(EPD protection is typically for the first 3 months for Alt-A paper). Thus, for most of
2005, the cost to the originator of the EPDs was 20 bps. That is, EPDs were 2% of the
pool balance, and the originator lost 10 points on each loan put back to them (the
loans could be resold at US$90). Thus the originator was clearing ~US$0.80 per US$100
of loan origination (100 bps - 20 bps EPD “hit”).
At this point, origination is a very unprofitable business. The all-in cost of origination is
higher (US$102, rather than US$101.5), as fixed costs must be spread over a smaller
number of loans. In addition, the loans are selling at a loss, and EPDs are higher. In the
current market, the sale price on a clean package of loans is in the US$98-99 range.
The last clean package traded at US$99, and prices have dropped since then (we’ll use
US$98.5 as the sale price). Thus, origination is now a money-losing business—a loan is
originated at US$102, sells at US$98.5—locking in a US$3.50 loss/US$100 originated.
EPDs have been running ~6% of the pool balance on the very weak 2006 origination.
Two months ago, these loans were trading at a price of US$80, suggesting that the cost
of the EPDs was 120 bps (20 points on 6% of the pool balance). More recently, the
liquidation value of the delinquent loans was US$65, suggesting that the cost of the
EPDs is 210 bps (35 points on 6% of the pool balance). Thus, the loss on very low
quality recent origination approaches US$5.60 per US$100 par.
Rank Lender 2006 Volume Mkt % Change Notes
Vol. (US$ mil) share Vol 05-06
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
21
This analysis indicates that it is now unprofitable to run a subprime business, and it
will remain so for the near future. Even originators currently in good shape will be
running down their capital for months to come, and most of those without deep
pockets are likely to be acquired or exit the business. It should be noted that the first
round of bankruptcies stemmed from lenders’ lack of capital to meet EPDs. The
second round of bankruptcies will come form originators’ capital being eaten away.
To make matters even more problematic, many originators are relying on warehouse
lines with the dealer community to finance themselves. As loan values decline, these
positions are subject to margin calls. These lines also contain warehouse lending
covenants regarding their financial condition; a number of originators are in violation
of such. These lines are often renewable yearly (some every 6 months, some at will),
thus rollover risk is a concern. If covenants are breached, payments can be
accelerated.
According to Goodman’s team, the business will eventually be profitable again.
Fewer loans will get made. Volume will fall by a minimum of 30%, maybe more.
Loans that will be made will be of higher quality. We are already seeing that
subprime originators are unwilling to offer the popular 80/20 piggy-back loan; they
are more generally steering away from high LTV lending. With more limited supply
and better quality product, we would expect EPDs to fall and prices to rise. That
reversal, however, will take a while. We expect some signs of stabilization later this
year. However, by then, it will be too late for many current market participants.
4.2. Effect on Wall Street Firms
Wall Street firms’ exposure to subprime is limited, making up just a small part of
their overall business. For example, Bear Stearns has noted that only 3% of total
mortgage revenue has historically come from sub-prime. Similarly, Lehman noted
that U.S. subprime–related revenues (originations, securitizations, trading) has
averaged less than 3% of total firm revenues in the past six quarters.
There has been considerable speculation by market participants about the direct
exposure of major dealers to sub-prime originators. Investor concerns center on
warehouse lines to finance sub-prime originators and ramp up CDO deals. It is
expected that the losses from both activities will be rather limited. A bigger concern
is that the largest impact will be on future revenues (albeit such revenues will remain
a relatively small part of large operations).
Financing for sub-prime originators takes two forms—either Single-seller Asset
Backed Commercial Paper (ABCP) programs or warehouse line (repo financing). In
the former, the A1/P1 commercial paper is extendable, and a large bank steps in
behind the investor to provide a market value swap. In 2006, originators funded
about 25% of their needs through ABCP. However, this has become prohibitive from
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
22
a liquidity point of view; these programs require more cash to fund the same amount
of loans than do warehouse lines. Thus a number of originators have closed these
programs. The ABCP conduits now account for only 10% of total loan financing,
and do not represent a large risk to institutions.
Originators have turned increasingly to warehouse lines (repo lines) for financing. The
dealer community has built in a variety of protections. The most important protection
is that in the event of bankruptcy, the warehouse line provider (dealer) is exempt
from the automatic stay and can liquidate the assets as if they own them. In
addition, warehouse lines initially provide financing to the originator with a 2%
haircut, and the dealer providing the financing has the right to make margin calls as
needed, based solely on the dealer’s determination of market value. Clearly, if the
originator is unable to meet the margin calls, the dealer could liquate the collateral.
An additional dealer protection is the use of warehouse lending covenants, which
require the originator to provide up-to-date financials and to meet debt coverage
ratios and profitability targets. If the originator is unable to meet these covenants,
the dealer could accelerate the required payments. Finally, the lines are generally
renewable.
The net result, according to UBS’ mortgage strategy team, is that subprime
originators are obliged to work very closely with the dealer, who is in the stronger
position. A number of originators have breached their covenants. Collateral from at
least one major originator has been liquidated to free up warehouse lines (the loans
sold at 92-93). In that particular case, all dealers were made whole as enough preemptive
margin calls were made to bring the cost below liquidation price. More
generally, assuming the collateral was purchased at par, sold at 92.5, had a 2-point
haircut and some early margin calls were made—the loss to the dealers would be
about 3 points.
In the event of bankruptcy, any losses on the warehouse lines not covered by
collateral liquidation would be unsecured claims. In short, given the 2% haircut and
margin calls—Wall Street’s losses on warehouse lines are likely to be relatively small.
It is important to realize that the warehouse lines are not fully utilized, as new
production has been very light. It is true that many of the loans on warehouse lines
are getting increasingly stale, and are apt to sell at lower dollar prices the longer they
sit on warehouse lines. This “stale” collateral is estimated to be about US$30 billion.
Even so, with protections in place, the impact on the dealer community is apt to be
muted.
A second source of concern is CDO warehouse lines. Generally, when a CDO is
ramping, the dealer takes spread widening risk and receives the carry. However, that
risk can be hedged, since the dealer is essentially long credit risks through single
name CDS, and can short the ABX against it. In fact, with the ABX11 selling wider
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
23
than single name CDS, dealers that consistently hedged CDO warehouse lines have
not lost money. Most of the Mezzanine Structured Finance CDOs12 that were over
50% ramped have been distributed, albeit at much wider spreads. In many cases,
the deals were downsized. A number of the high grade CDOs that were mostly
ramped were unwound, as the liabilities widened to the point where it was
economic to liquidate the deals. The Mezz and high grade SF CDOs that were very
minimally ramped are basically on hold.
The third source of direct risk is originators who cannot honor their early pay
defaults. There is no way to hedge this risk, but again, the magnitude is small.
All told, according to UBS, there are three direct risks from the current situation.
Collectively, these risks are small relative to revenue from the mortgage business.
Actually, the largest effects on mortgage revenues will be revenue loss from a
reduction of new issue activity in sub-prime and Alt-A markets. Moreover, the
amount of SF CDO deals is apt to be much lower going forward, again impacting
dealer revenues. Even so, revenues from subprime and Alt-A are a small percentage
of the overall flows of a well-diversified Wall Street firm.
4.3. Effect On the Housing Market
The meltdown in the subprime market impacts the broad housing market in several
ways. The higher number of defaults over the years to come will cause even more
houses to come onto the weakened market. Already the housing slowdown has
created a historically high number of non-occupied homes for sale. The problems
could be compounded during periods with large amounts of mortgage rate resets.
This will put further downward pressures on home prices.
Due to the loose underwriting standards, a large number of recent years’ subprime
loans went to individuals who probably do not have incomes or jobs allowing them
to manage the financial burdens associated with owning a home. The shakeout in
subprime lending (and to a lesser extent, Alt-A) will force these people back into the
rental market. Overall birth rates and immigration data point to a need for increased
housing in coming years, but the subprime meltdown will reduce the number of
Americans owning homes.
11For detailed information on ABX, please refer to chapter “VI. ABS CDS and ABX Indexes.”
12 Mezz SF CDOs are backed by mezz ABS bonds, typically of lower credit qualities than AAA/AA/A.
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
24
Even more important to the housing market is the reduction in the number of
affordable loans that mortgage lenders will offer. In both subprime and Alt-A, the
most egregious loans will no longer be made. Between the push back from the
capital markets and the new lending rules likely to be put in place by federal and
state banking regulators—many of the “new” loans of recent years will be history, at
least for as long as it takes us to forget that the immediate benefits of loose lending
standards (more people can afford homes now) will be offset later by rising default
rates.
The problems in subprime will cause home prices to be flat-to-slightly negative for
the next 1-2 years. After that, there could be a long period of flattish price
appreciation and recovering from the subprime debacle could take years.
One mitigating factor—the longer home prices remain stagnant while incomes rise—
the more affordable housing will become. When home price appreciation has leveled
off, family incomes have continued to rise, and interest rates have declined, making
homes much more affordable over the past year. The National Association of
Realtors Housing Affordability Index had fallen from 146 in February 1999 to 99.6 in
July 2006. As of January 2007, it had rebounded to 116, and it’s reasonable to
expect that it is even more favorable currently.
4.4. Effect On the Economy
These events will clearly drag on economic growth. Will this be sufficient to cause
an economy- wide credit crunch or recession? Most economists would say “no”. At
the margin, however, events in the sub-prime arena clearly make the Fed more
willing to ease than to tighten.
As we mentioned earlier, subprime mortgages account for roughly 11% of the total
residential mortgage debt and securitized MBS, not exactly dominant by any
measure.
2005 and earlier sub-prime origination has some home price appreciation already
built in. Let’s assume that 50% of outstandings were originated in 2006, many with
little or no equity in their homes. This particular group cannot afford to pay the
increased rate, and a borrower lacking equity in his home must write a check to
refinance though he doesn’t have sufficient funds to do so. Let’s further assume that
50% of these loans are problem loans13 (likely to experience default or have trouble
refinancing), many of which are 2/28loans resetting in 2008. Thus, the “problem”
subprime loans could total 3.0% of mortgage debt (12% sub-prime x 50% 2006
origination x 50% problem loans).
132/28 loans are loans with fixed rates for the first two years and reset afterwards
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
25
By early 2008, some new loan structures will have evolved which will allow some of
the problem borrowers to remain in their homes. Moreover, originators have some
flexibility to modify loans due to a more benign environment possibly reducing the
number of problematic loans.
Clearly problems are compounded if home prices decline significantly. Then we could
face a scenario where borrowers with 85-90% LTV would also be unable to
refinance without writing a check. Assuming all 2006 loans do default at some
point, “bad” loans could make up 6.0% of total mortgage debt (12% subprime x
50% 2006 origination x 100% problem loans)—still a relatively small percentage.
In addition to the direct effects of the housing market overhang (which include the
dampening effect on employment in housing construction and the real estate
industry in general), the fallout from subprime is likely to have two indirect effects:
First, the tightening of credit standards is likely to further weaken home sales and
housing construction. Despite this, it would still be difficult to consider credit “tight”.
Moreover, the MBA purchase index is at levels similar to mid-2006, indicating no
effect so far on home purchases.
Second, moderating house price appreciation (HPA) is likely to contribute to weaker
consumer spending through reduced home equity extraction (HEE). According to
economists at UBS, HEE fell to 2.1% of disposable income in Q4 2006 from 3.1% in
Q3 2006 and 6.9% in Q4 2005. For 2006 as a whole, HEE took up an estimated
3.5% of disposable income, down from 6.3% in 2005. HEE may continue to slow.
However, the sharp decline in HEE in the last few quarters has not been associated
with a sudden weakening in consumer spending. Market participants can argue
about the potential impact on spending; but this remains unclear as we are
experiencing a time lag.
4.5. Conclusions
As made plain by events over recent months, turmoil in the subprime sector are
proving highly problematic for the mortgage credit and the subprime origination
communities. They put a downward bias on home price appreciation, and the
housing overhang should keep prices flat for a number of years. These events are
also a drag on economic growth, but not substantial enough to throw the economy
into a recession.
Negative news on subprime may continue for years to come, but contagion will be
limited.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
26
V. Servicing Subprime Mortgages
After loans are originated, sold and securitized, they still need to be served, either by
the same originator (on a serving retained basis) or another servicer (on a servicer
released basis): collecting monthly payments, transferring the funds to the various
parties and so on. Even more importantly, servicers play a critical role in mitigating
losses on “bad” loans and everything else equal, a good servicer can significantly
lower default rates, increase recoveries and shorten the length of a workout in the
event of a bankruptcy.
There are three types of servicers: primary, special and master.
1) Primary loan servicing refers to the management of loan cash flows, including
communication with the borrower, loan reporting, and the management of initial
delinquencies.
2) Special servicing refers to the servicing of severely delinquent loans, including
foreclosure, and the subsequent management and sale of repossessed properties.
3) The Master servicer oversees the performance of primary and special servicers,
manages the servicing portfolio, and advances interest and principal on
nonperforming loans. If either servicer is unable to meet its obligations, the
master servicer takes over the servicing of the loan portfolio and therefore serves
as the ultimate guarantor of the servicing operation.
5.1. Various Stages of Delinquent Subprime Mortgages
When a subprime mortgage has gone “bad”, it typically goes through the following
stages:
Delinquency
When a loan is past due by 30 days or more, it is delinquent. However, there are
different standards counting the “past due” days. The American Mortgage Bankers
Association (MBA) states that past due days be counted from the “due date”, while
the Office of Thrift Supervision (OTS) dictates that the past due days be counted one
month after the “due date”. All subprime servicers observe the OTS standards,
while prime servicers use the MBA standards.
“Casual delinquencies” are loans that have been delinquent for 60 days or less.
These loans typically have higher chances of being “cured.” Loans that have been
delinquent for more than 60 days are seen as “serious”, as their chances of
becoming current again decrease as days go by.
Delinquency rates are calculated by dividing the total balance (or number) of loans in
delinquency by the total current balance (or number) of loans outstanding,
respectively.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
27
Foreclosure
When a loan is delinquent and the servicer is unsuccessful in collecting the
payments, the foreclosure process may start. Foreclosure is a legal process to
transfer the title of the property from the borrower (mortgagor) to the lender
(mortgagee) based on the mortgage agreement.
In the US, foreclosures are guided by
the laws in the state in which the
property is located. Some states
require a lender to obtain a court
order and the borrower be permitted
to contest the foreclosure in court.
This process is called a “judicial
foreclosure,” which is lengthy and
costly for the lender. Other states are
“non-judicial, where foreclosures are
typically faster and cheaper for the
lender. Faster foreclosures are better
because they limit legal costs and the
loss severity.
The length of a foreclosure can be affected by a servicer’s engagement in loss
mitigation. If the servicer and borrower can work out a plan to bring the loan back
to current, the foreclosure process would stop.
Foreclosure rates are calculated by dividing the total balance (or number) of loans in
foreclosure by the total current balance (or number) of loans outstanding,
respectively.
REO
REO stands for “real estate owned”. REOs are loans that have completed the
foreclosure process and the underlying property is now legally owned by the
securitization trust.
Similar to the calculation of delinquency rate, REO rate is calculated by dividing the
total balance (or number) of loans in REO by the total current balance (or number) of
loans outstanding in the pool, respectively.
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California 7.3 25.2
Florida 8.9 9.5
New York 14 5.7
Texas 6.2 5.3
Illinois 12 3.9
Michigan 7.9 3.0
Arizona 6.1 2.9
New Jersey 14 2.8
Georgia 5.9 2.7
Maryland 9.2 2.6
Weight avg all states 9.2 100%
Top 10 Subprime Outstanding :
Time in Foreclosure Varies Based on State
State Time in %
Foreclosure Outstanding
Source: LoanPerformance
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
28
5.2. Loss Mitigation
All things being equal, a servicer that is skilled at mitigating losses can significantly
alter the path of loss and maximize the loan value.
Loss Mitigation
The servicer may offer a payment plan to avoid foreclosure. The rationale of such an
offer is that by making a delinquent loan re-perform, rather than going through a
lengthy and costly foreclosure process without receiving any payment, the lender and
RMBS investors can maximize the value and minimize the loss.
The payment plan could come in many forms such as:
1) Deferring owed amount (forbearance);
2) Forgiving part of the amount owed;
3) Changing loan terms such as lowering interest rates and/or recasting maturities.
However, a failed mitigation may prove more harmful than a straight foreclosure.
Based on some estimates, re-default rates within two years post-mitigation can run
as high as 25%.
Deficiency
Assume a lender forecloses on a delinquent borrower, evicts the borrower and sells
the home. If, at the end of that process, the sale proceeds are insufficient to cover
the full amount of the unpaid mortgage loan balance, plus fees, costs, accrued
interest over the period of delinquency, then there is a “deficiency.” In so-called
“deficiency states,” the lender can then pursue the borrower personally for the
amount of the deficiency.
In a “one-action” state, notably California, the lender can choose to take back the
home or can go after the borrower personally, but not both. However, if the
borrower took out the mortgage for a purpose other than to purchase a home, then
the lender may seek recovery both out of the property and from the borrower
personally.
One generally would not expect an individual that is delinquent on their mortgage to
have significant personal assets. Often, the real value in obtaining a deficiency
judgment is to induce cooperation from the borrower. Anecdotally, a startling
number of borrowers go into foreclosure without ever returning a collector's phone
calls (in subprime, it can be as high as 50%). To a surprising extent, defaulting
borrowers often find themselves in a position of some power. They can be difficult
to evict, they can file frivolous bankruptcy filings repeatedly, they can vandalize their
home, etc. The lender's right to collect on a deficiency is arguably a bargaining tool,
perhaps more so than a financially viable source of recovery.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
29
Losses
Losses in subprime loans and RMBS are generally not realized until the underlying
REO property is sold. More likely than not, the sale proceeds will not completely
cover the sum of outstanding mortgage balance, interest and principal amount past
due (the servicer has advanced), legal expense and real estate tax etc. The difference
is the net loss. Net loss divided by the total loan amount is called “loss severity”.
One minus the loss severity ratio is called the recovery ratio.
Losses can be recognized early on even before a foreclosure’s completion for a
second lien mortgage or a junior loan. In this case, there is virtually no hope
whatsoever to recover any meaningful amount. Therefore, the loan will have to be
booked as losses when it hits the delinquency timeline.
Although documents for most home equity transactions mandate that the servicer
should advance principal and interest payments so long as they are “deemed
recoverable,” in practice the advance policies vary among servicers. Some will
automatically make the advance throughout the foreclosure and even when the loan
is in REO, as long as the loan is a first lien mortgage. Others will advance for a
particular number of months. If the servicer chooses not to advance, the eventual
realized loss will appear smaller than if advances were made to the end.
The use of mortgage insurance (“MI”) reduces the net loss amount of a loan. For
transactions that have lender-paid MI, that typically reduces the effective loan-tovalue
(LTV) ratio of the loans in the pool to 60% or even 50% (i.e., there is max
60% to lose vs. a 95% LTV loan, where 95% can be lost). The reported net loss will
be significantly lower than transactions that do not have MI.
In addition to loss severity, the constant default rate (CDR) is used in estimating total
losses. CDR equals 1- (1-monthly loss rate)^12. Simply put, CDR is the annual
default rate of all loans. CDR multiplied by loss severity is the total loss one can
expect in a pool.
Constraints on Loan Modifications
As discussed above, servicers most commonly modify the terms of the loans to
mitigate their losses. However, changes to loan terms will impact the amount of
and/or timing of cashflows to the securitization trust and RMBS investors. To prevent
that, RMBS transaction documents (specifically, Pooling and Servicing Agreement or
PSA) may limit how much can be changed.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
30
5.3. Conclusions
Servicing disruptions will likely to increase as the current credit cycle plays out and
the housing market continues to soften. While there is some standardization in
servicing and common use of systems, turmoil at the level of the servicers will
exacerbate loan deterioration. There have even been some very rare and extreme
cases where lenders who were found guilty of wrongdoing were barred from
initiating foreclosure proceedings in a given state.
Many subprime borrowers respond best to aggressive collection, even in the early
stages of delinquency. If personnel disruptions in servicing are widespread, even
some borrowers with the ability to pay may fall behind and be unable to catch up.
Moreover, in the case of a servicing transfer (due to a bankruptcy or liquidation,
etc.), the transition period is likely to cause higher delinquencies and possibly
eventual losses. In such situations, knowing who the back-up servicers are, what
their true roles are in the securitization (is it really to service, or is it just to find
another party to service?) becomes critical.
VI. ABS14 CDS and ABX Indexes
The arrival of credit default swap technology in the ABS market provides investors
with new opportunities to acquire ABS exposure and better mechanisms to manage
risk via shorting. The market for asset-backed credit default swaps (ABCDS) has
grown rapidly. Investors have jumped right in, pushing trading volumes in subprime
loan ABS beyond those of cash instruments (please see Chapter I, page 6 for
estimated size). The vast majority of swaps have been single-name contracts
referencing subprime loans.
6.1. ABS CDS Basics
In the most plain-vanilla CDS, the protection seller makes a payment to the buyer
only when a “credit event” such as issuer bankruptcy or a failure to pay principal
occurs. When a credit event does occur, the contract usually terminates in one of
two ways: physical settlement or cash settlement. In a physical settlement, the buyer
of protection delivers the defaulted bond to the seller and receives par in return. In a
cash settlement, the buyer of protection receives the net difference between par and
the market price (also known as the recovery value) of the defaulted security. In this
case, a process involving multiple dealer bids is often used to determine the market
price of the bond. Investors have similar economic exposure under either type of
settlement.
14 ABS includes RMBS and other types of ABS, but is used inter-exchangeably with RMBS throughout the paper.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
31
From a bird’s-eye view, the mechanics of ABCDS are very much in line with those of
generic CDS. There are, however, several unique features of the asset-backed
securities that CDS on ABS must handle, which make the swaps unique themselves.
Amortization and Prepayments: Most ABS have principal that is paid over time
and are subject to some amount of prepayment uncertainty. The outstanding
notional of an ABS declines with scheduled principal payments, voluntary
prepayments, and defaults. In contrast, corporate bonds do no typically amortize
and principals stay the same.
AFC Risk: Most subprime ABS securities have coupons that are capped at the net
weighted average coupon (net WAC) of the collateral. This cap, known as the
available funds cap or AFC, can result in “interest shortfalls” on the bond equal to
the difference between the “expected” coupon (i.e., LIBOR + coupon spread) and
the actual coupon received.
Timing of Principal Writedowns: Principal losses on ABS occur over time,
whenever losses on the collateral in the trust exceed the credit enhancement
available for the bond. This contrasts with corporate or sovereign debt, where a
failure to pay principal is a one-time event of default.
Reversible Writedowns and Shortfalls: In most structures, interest shortfalls and
principal writedowns in one month can be reimbursed or reversed at a later date.
The former can be repaid from excess spread in later months, usually with accrued
interest (this is known as the “interest carry-forward” feature in ABS). The latter can
be reversed if credit performance of the collateral improves, resulting in a “writeup”
of principal
Clean-up Calls: Virtually all ABS transactions have a clean-up call feature, which
gives the issuer the right to purchase the collateral remaining in the trust when the
deal balance falls to 10% or less of the original amount. If the call option is not
exercised, the coupon spread on many ABS “steps up” to 1.5-2.0 times the original
amount.
Lack of Homogeneity: No two ABS bonds are truly alike. ABS vary due to differences
in collateral, seasoning, deal structure, servicer, and a host of other factors.
Additionally, non-AAA ABS are issued in relatively small sizes; the size of the BBBtranche
of a US$2 billion subprime ABS transaction, for example, may not exceed
US$15 million. The lack of homogeneity coupled with small tranche sizes keep the
liquidity of some ABS limited.
ABS CDS address these characteristics through a combination of a “pay-as-you-go”
structure and some uniquely defined terms in the contract. For example, to address
amortizations and prepayments, the notional amount used to calculate premiums
decreases over time, in line with that of the underlying bond. As with many
derivative products, understanding the nuances of ABS CDS is critical—the devil is in
the details, as they say.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
32
There are generally four “credit events” as defined in ABS CDS:
Failure-to-pay: The reference cash bond fails to pay all principal by the legal final
maturity date.
Writedown: The balance of the reference cash bond is written down.
Distressed rating downgrade: One of the three major rating agencies downgrades
the reference cash bond to Caa2/CCC or below.
Maturity extension: The legal final maturity date of the reference cash bond is
extended.
When a credit event occurs, the protection seller is typically required to make a
payment to the protection buyer, who, as discussed below, has the right to terminate
the CDS through a physical settlement.
It is important to note that non-payment of interest is not a credit event in ABS CDS,
although it does trigger a payment to the protection buyer. Additionally, ABS CDS do
not include bankruptcy as a credit event, since ABS bonds are issued by a
bankruptcy-remote special purpose vehicle.
The Pay-As-You-Go System
To handle principal writedowns that occur over time and relatively limited liquidity in
some ABS bonds, ABS CDS are structured as “pay-as-you-go” (PAUG) contracts with
a physical settlement option. If a credit event occurs, the buyer of protection has the
option, in whole or in part, to terminate the CDS contract by physical settlement,
delivering the bond to the protection seller in exchange for par in return. This may
be an option for investors who own the bond or can find it in the secondary market,
but in practice, this will often prove challenging.
Allowing investors to use PAUG mitigates issues that can arise when many investors
(e.g., protection buyers) try to source bonds that are in short supply. As the term
implies, under PAUG, the CDS contract remains outstanding, and the protection
seller makes payments equal to the writedown amount and, to some extent, interest
shortfalls.
The buyer continues to make premium payments based on the notional of the ABS
CDS contract adjusted for writedowns and paydowns.
There are three payment “legs” to each ABCDS contract: a fixed payment leg, a
floating payment leg, and an additional fixed payment leg (Figure 3). The “fixed”
payment is simply the premium paid by the buyer of protection, a fixed percentage
of notional. The “floating” payments are made by the protection seller, representing
writedown amounts, interest shortfall amounts, and principal shortfall amounts
(principal shortfalls are defined as unpaid principal at the legal final maturity of the
reference bond). The “additional fixed” payments are made by the buyer, and consist
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
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Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
33
of any reimbursements for reversed writedowns and shortfalls. Of course, such
payments are not truly “fixed,” but are labeled as such because they flow in the
same direction as the “fixed” leg CDS premium.
Buyer is the buyer of the protection, also known as the seller of the ABX index.
6.2. Differences between Corporate CDS and ABS CDS
While ABS CDS are generally similar to corporate CDS, there are significant
differences between the two due to the unique nature and structural mechanics of
ABS products. Below we highlight these differences.
Reference Entity
In corporate CDS, the reference entity is effectively a corporate issuer, while in ABS
CDS, it is a single ABS security. The failure of a corporate issuer to pay principal or
interest on any debt obligation is typically a “credit event” for all of that issuer’s
CDS. This “cross-default” concept is absent from the ABS market.
Credit Events
Credit events in corporate CDS include bankruptcy of the reference corporation,
failure to pay principal or interest, and restructuring. Unlike corporate CDS, ABS CDS
do not include bankruptcy or restructuring as credit events. In addition, non-payment
of interest is not a credit event in ABS CDS, although it does trigger a payment to
the protection buyer under PAUG.
Maturity Date
The maturity date of corporate CDS is largely independent of the maturity of the
issuer’s bonds, and tenors are typically 1-10 years, while the effective maturity date
of ABS CDS is the earlier of the bond’s legal final maturity and the date when it is
fully paid off or written down.
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Fixed payments Buyer to Seller CDS Premium
Floating Payments Seller to Buyer Principal writedowns
Interest shortfalls
Principal shortfalls
Additional Fixed Buyer to Seller Reversed principal writedowns
Payments Reimbursements of interest shortfall payments
Reimbursements of principal shortfalls
Pay-As-You-Go Payment Mechanics
Payment To / From Amount (s)
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
34
Settlement
Most corporate CDS require physical settlement, while some contracts specify cash
settlement. In either case, the buyer does not have the option to choose one or the
other. ABS CDS are structured as “pay-as-you go” (PAUG) contracts with the buyer
retaining a physical settlement option if a credit event occurs.
Principal Writedown
Principal loss is a one-time event for corporate bonds and results in settlement (and
termination) of the CDS. Under the PAUG structure, the protection seller in an ABS
CDS must reimburse principal losses over time, until maturity of the contract.
Furthermore, if principal writedowns are later reversed, ABS CDS provide for writeup
of the CDS notional and reimbursements to the protection seller.
Non-payment of Interest
Failure to make interest payments on the underlying bond is considered a credit
event in corporate CDS but not so in ABCDS. Interest shortfalls, defined in ABCDS as
any nonpayment of expected interest, can occur due to an available funds cap (AFC),
which limits the bond coupon to the net weighted average coupon (WAC) of the
collateral. While not considered credit events in ABS CDS, they do trigger payments
from the protection seller, who may later be reimbursed.
Prepayment Uncertainty
Corporate CDS are not subject to prepayment risk, since corporate bonds usually
have bullet maturities. However, ABS CDS are exposed to prepayment uncertainty.
To handle this complication, the notional amount of ABCDS declines with reductions
in the balance of the reference cash bond.
6.3. Applications of ABS CDS
There are many ways ABS CDS can be used:
Acquire Credit Risk
ABS CDS provide investors access to credits they otherwise may not be able to gain
due to scarcity of cash bonds. For example, ABS CDS allow subordinate investors
such as CDOs ramp up their portfolios more quickly than is possible when only cash
bonds are available. CDS also allow investors to acquire more exposure to a specific
bond than is available in the cash market. An investor with a particularly strong view
or with a larger portfolio could, for example, sell protection in a US$10 million CDS
contract referencing a BBB bond that has only US$5 million outstanding.
Increase Leverage
Since CDS require no initial cash outlay (beyond any margin requirements), they
provide an efficient means of making leveraged credit investments. As discussed
earlier, investors with relatively high funding costs should find it more attractive to
sell protection through ABS CDS than to buy the cash bond and fund it on balance
sheet.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
35
Short the Market
ABS CDS have transformed ABS from languishing as a long-only cash market. ABS
CDS allow investors to express a bearish as well as bullish view on the credit quality
of ABS collateral in general. Investors seeking to profit from a housing market
slowdown, for example, may buy protection on a number of subprime bonds from a
wide range of issuers.
Hedge Exposures
ABS CDS can be used as hedging instruments for mortgage originators, banks, and
other investors. The subprime mortgage market has experienced an annualized
growth rate of 50% over the past four years. As the market has grown, bank and
originator margins have compressed, increasing their desire to hedge pipeline risk
(i.e., the risk of spread widening after loan rates are locked but before they are
closed and sold or securitized).
Relative Value Tranche, Vintage and Issuer Trades
ABS CDS can be used to reflect not only a bullish or bearish view on the market, but
also a relative value view on one issuer versus another, one part of the capital
structure versus another (e.g., BBB+ versus BBB), one vintage versus another (e.g.,
2003 versus 2005), or even one product type versus another. CDS makes such “pairs
trades,” in which an investor goes long one risk while shorting another correlated
risk, relatively easy to execute.
6.4. ABX Indexes
The ABX is a series of index products for ABS CDS. The ABX references 20 subprime
transactions and has five sub-indexes broken down by rating buckets: AAA, AA, A,
BBB and BBB-. Each sub-index will be composed of 20 equally weighted ABS CDS
referencing cash bonds, one from each deal. Thus, the same deals will be
represented in each sub-index (e.g. the 20 underlying exposures in the BBB ABX will
come from the same deals as the 20 underlyings in the AAA ABX). To ensure
liquidity, the dealer community has committed to providing daily marks on the ABX
indexes.
New ABX indexes will be introduced every six months, creating a market in which
both on-the-run indexes (the ones most recently created) and off-the-runs (earlier
vintages) trade. Unlike corporate CDX (corporate CDS indexes), which often have
the same names in old and new indexes, the new ABX will have 20 completely new
deals compared with the old ABX. Therefore, the new ABX may have a very
different risk profile than the older ones.
While ABX generally have similar mechanics as single name ABS CDS, there are some
differences that differentiate the two.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
36
Buyer is the buyer of the protection, also known as the seller of the ABX index.
6.5. Trading of ABX-Upfront Exchange of Cash
The ABX indexes are quoted on price terms rather than spread terms. Each of the
ABX indexes will have a predetermined coupon that is fixed (in percentage of
notional terms) over the life of the index. Prices on the index will be quoted as a
percentage of par, with any premium or discount representing the amount to be
exchanged upfront on a new contract. For example, assume the BBB ABX index is at
par with a fixed coupon of 150 bps and a spread duration of 4 years. If spreads
widened by 100 bps, the BBB ABX index would trade at about US$96. At this point,
to enter into a new contract, the seller of protection in the ABX would receive US$4
or 4% of the notional plus a premium of 150 bps.
Similar to single name ABS CDS, ABX provide investors with a multitude of new
opportunities for investment and risk management. A few of these are listed below:
1) Acquire broad exposure to subprime market in a single contract
2) Increase leverage by taking exposure synthetically rather than in the cash
market
3) Reduce funding costs by taking exposure synthetically rather than in the cash
market
4) Express macro views on the housing market
5) Hedge portfolio risk against losses or systematic spread widening
6) Hedge CDO pipeline or CDO equity risk against losses or spread widening
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Settlement Option Physical settlement option No other settlement option
if a credit event occurs
Interest Shortfall No cap, variable cap, fixed cap Fixed cap
Clean-up Call Treatment Option to terminate the CDS contract No option to terminate the
if the deal is not called CDS premium the option contract
to step up if CDS remains in effect No step up in ABX premium
Key Differences between Single-Name ABCDS and ABX
Contract Term Single-name ABS CDS ABX
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
37
VII. EIM’s Views and Strategy
What would be the best strategy to first protect us from being “hit” by the subprime
woes and secondly, benefit from higher volatilities and potential opportunities?
7.1.A World of Polarization
The debate over the state of the housing market is not clear-cut. Views are polarized
between the housing bears that fear a prolonged meltdown, and the bulls that
believe that the correction is already overdone. The bears could not have been more
outspoken with their views frequently aired in the media.
Where does this leave housing-related credits? One word springs to mind:
uncertainty. Some argue that BBB- rated ABX 06-2, trading at 1,150 bps over Libor
or about US$71 on April 12th, should widen by another 900 bps and trade below
US$50 to justify the weak fundamentals, while others, believing that the “fair” value
is around high US$70s and will see any such widening as buying opportunities.
Fundamentals vs. Technicals
Economic data cited by housing bears may well be pointing to a “doomsday”
scenario. Assuming a flat home price appreciation (HPA), losses on sub-prime pools
are estimated to be 8% and if HPA is negative, for example, -3%, losses could reach
12%. Since BBB- rated sub-prime ABS will be hit at the 8-10% loss level, it has
become popular to put on shorts, primarily via ABS synthetics such as ABX, single
name ABS and mezzanine tranches of ABS CDOs.
Macro funds, dedicated short credit funds and even long/short equity funds’
relentless appetite for protection has pushed spreads wider, particularly in the
synthetic index market (e.g., ABX). In addition to the systemic spread widening,
tiering has increased between high and low quality ABS within the same credit
ratings.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
100
300
500
700
900
1100
1300
1500
19/01/06
19/02/06
19/03/06
19/04/06
19/05/06
19/06/06
19/07/06
19/08/06
19/09/06
19/10/06
19/11/06
19/12/06
19/01/07
19/02/07
19/03/07
Spread (bps)
Cash ABS
ABX 06-2
Single Name CDS
Spreads of BBB- Rated ABX, Single Name ABCDS and Cash ABS
Source: UBS
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
38
On the other side of the bearish trade, demand from outright long accounts and
CDOs, albeit much lighter recently, keeps the widening somewhat in check, but thus
far not enough to offset the widening.
BBB- rated cash bonds, single name CDS and ABX have behaved very differently,
with the former two widening much less, at 350 bps and 450 bps tighter than ABX,
as of mid-April. Spreads between the three had not been much apart until mid-
2006. What has caused the large divergence? It would be hard to blame it all on
the fundamentals as all three are BBB- rated referencing the same 20 deals.
Technicals provide a much better explanation. The holders of ABX are mostly hedge
funds that have not been historically known for picking individual credits. Moreover,
after a 40% drop in the S&P 500 Home Building Index in the first half of 2006, it
looked like a much better idea to short the housing market by buying protection on
BBB- ABX (then 250 bps over Libor).
By contrast, the clientele of cash and single name CDS are outright accounts and
CDOs, which do not typically go short. In November of 2006, a few large OWICs
(Offers Wanted in Competition, or widely distributed lists of individual bonds to be
shorted) from hedge funds surprised the market and finally pushed cash and single
name CDS spreads wider, albeit to a much lesser degree than ABX. In December,
cash ABS spreads narrowed while others continued to widen, which fundamentals
alone fell short to explain.
It is surprising that the wide divergence between spreads of cash bonds, single name
CDS and ABX has not been arbitraged away. Inhibitive transaction costs might be
the reason (ABX bid/offers are 4-5 bps, while cash ABS bid/offers could be 25 bps on
weak names). Nevertheless, the arbitrage for CDOs has become much more
attractive—equity IRRs of synthetic ABS CDOs have increased to over 30% due to
wide spreads. CDO liabilities have widened too, but more than compensated by the
higher spreads in assets. Relative to the previous 13%-15% IRR, the increase in
return will be enough to entice many to step up buying once the dust settles. For
example, a number of hedge funds have been busy working on launching ABS CDO
equity funds.
In summary, weak housing fundamentals mean losses, and many that have shorted
the subprime sector have made a killing. However, liquidity is gradually coming back
from CDOs and long accounts, which can ensure that a greater percentage of
borrowers stay in their homes (rather than default). As long as the technicals
improve and fundamentals do not fall precipitously and unexpectedly, shorting the
housing market via synthetics at the current “stressed” levels no longer seems to be
the best trade in town.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
39
7.2. Synthetics as a Means of Shorting
Since their debut about two years ago, single name ABS CDS and ABX have quickly
become liquid ways of going long or short housing credits. Unlike corporate CDS,
the pay-as-you-go (PAUG) structure of ABS derivatives is something new and among
the various risks, some are:
1) Basis risk. The "one credit two spreads" phenomenon is more pronounced in
ABS, as shown in Chart 1. As technicals come and go, P&Ls fluctuate randomly
with no apparent fundamental reason, which we do not believe is a risk well
compensated for.
2) Structure risk. When GM and Ford were downgraded in early 2005, funds that
were long CDO equities and short mezzanine debt (or selling protection on
equities and buying protection on mezzanines), seemingly hedged against
downgrades, were caught by surprise. CDO equities sold off while mezzanine
debt rallied despite sharing the same collaterals—the structures of the bespoke
deals put no pressure on mezzanines. And the fact that most mezzanine
investors were buy-and-hold investors further increased mark-to-market values of
mezzanine debt.
Many short-biased funds are long CDO equities to offset negative carry. Could a
"double whammy" happen again to the “long equity and short mezzanine”
trades? Although many argue that ABS are different than corporate credits
when it comes to default correlation, we are yet to be convinced.
3) Negative carry. The negative carry is substantial before any final pay-off. A 10x
levered short credit fund that started trading in mid-2006 could spend Libor +
250 bps on BBB- ABX Index and easily incur 25% negative carry (as leverage
levels vary, so does the corresponding negative carry). The actual carry will be
smaller due to cash and other returns, but will likely exceed 20% per annum
after management fees.
4) At the current spread levels, the negative carry is much higher--for a similar 10x
levered fund, the negative carry could exceed 100% a year (again, at a lower
leverage level, the negative carry could be less). Unless the deals are completely
wiped out, shorting at the current levels would be hard to justify—it would be a
large bet based on an unusually bearish view on the housing market and even
entire economy.
5) Individual deal performance has diverged significantly in ABX 06-2, as indicated
by the 60-day plus delinquencies ranging from 0.80% to 10%. Buying
protection on a diverse pool is a blind bet against weak, but also solid credits,
which are the majority of the index. This is a sub-optimal way to invest at best.
Some may argue that all stocks are not equally unattractive, but people short S&P
500 futures all the time. However, there is no negative carry associated with
shorting S&P futures.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
40
Potential Upside
The potential upside to the bearish trade, given the current “stressed” levels, is
limited. If the waiting period is one year, and the second year is up 120% (assuming
10x leverage and the price of the BBB- ABX declines by 12% to US$61, which is
middle point between the high US$70s “fair” value that many fundamental ABS
credit funds believe and the high US$40s that the “bears” adhere to), an investor
would gain about 20% in total (120% minus 100% cost in the first year) or 10%
per year. Some claim the upside is 200%, which is difficult to believe (when was the
last time you came across a trade that is nearly as crowded as this one?)
Whether or not to pay for the negative carry is one issue, quite another is when and
how large the payoff can be. While the debate continues, let’s not miss out on the
opportunities that can return 10% or more at lower volatilities.
7.3. EIM’s Strategy
Several funds we are invested in profited from short positions on subprime. These
funds played the theme in a variety of ways and benefited tremendously from the
widening out of spreads.
Going forward, however, we think that there will be more money to be made from
stressed or distressed opportunities than simply being short. Whether it is in two
months or six months, the distressed opportunities are emerging in whole loans, ABS
and potentially ABS CDO tranches. In capturing these potential opportunities, we
will be “bottom-up” with a focus on the primary market at the individual loan level.
Funds with servicer and REO workout experience are preferable.
In 2005, we developed a "bar-bell" approach to credit investing given our cautious
views. Following that approach, we saw returns of 12% net at 3.0% volatility in our
credit portfolios in 2006.
The same approach can be readily applicable to subprime ABS credit investing—what
we find exciting is not only the bearish trades, some of which may still have
attractive upside on a very selective basis, but also longs in stressed and distressed
situations arising from an increasing number of delinquencies, defaults and
downgrades.
Stressed/Distressed Opportunities
There has been a strong supply of stressed/distressed whole loans as the subprime
originators have gone out business and loans are being sold at deep discounts to
meet liquidity demands. Use New Century as an example. Its “Scratch and Dent”
loans15 are now selling at low US$90s or even lower prices. In January, the same
loans were sold at above par or high US$90s.
15Loans that have been put back to the originators due to Early Payment Defaults (EPDs). Typically, these loans are
still paying and have not gone into delinquency.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
41
However, are the prices low enough to compensate for the defaults and losses? What if
Housing Price Appreciation (HPA) is flat or even negative?
The following table shows a scenario analysis for performing loans based on the
following assumptions:
1) Loan purchase price of US$92;
2) -10% HPA (house prices drop by 10% per year for the life of the loans (over
4 years);
3) Loss severity of over 62% (only 38 cents recovered on the dollar vs. a historical
average of 60 cents recovery) and;
4) 2.61x of the base default curves (for example, 2.61 x 9% = 23.50% default rate at
the 37th month for 2/28 loans vs. historical highs of mid-teens)
The expected return of selective “Scratch and Dent” loans (after being securitized) could
be running at 14.4% gross, despite the extremely high assumptions on default rate and
loss severity. In the base case, assuming 2.06x of base default curves and a loss severity
of 54%, the yield can be as high as 31% gross.
Source: EIM and an anonymous hedge fund
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Class Size % of Collat Fixed / Float Rating (M/S/F) Bench DM Price WAL Mdur
SNR 247,686,000 66.25% Floating Aaa/AAA/AAA 1M LIBOR 27 100.00 1.15 1.07
M1 28,040,000 7.50% Floating Aa1/AA+/AA+ 1M LIBOR 65 100.00 4.02 3.43
M2 23,180,000 6.20% Floating Aa3/AA-/AA- 1M LIBOR 100 100.00 5.39 4.43
M3 15,702,000 4.20% Floating A2/A/A 1M LIBOR 150 100.00 4.68 3.87
M4 6,356,000 1.70% Floating A3/A-/A- 1M LIBOR 225 100.00 4.45 3.63
M5 13,085,000 3.50% Floating Baa2/BBB/BBB 1M LIBOR 550 88.76 4.32 3.42
M6 5,982,000 1.60% Floating Baa3/BBB-/BBB- 1M LIBOR 850 80.05 4.23 3.24
Collat 373,866,173 WAC = 9.132% / 19.77% IO / 29.49% Balloon / LTV2 = 87.59% / FICO = 622 / 2nd = 20.18%
(1) 3/28 ARM = 35 CPR AAA Spread 27.0
(1) 2/28 ARM = 35 CPR Sub Spread 207.4
(1) FIX = 30 CPR Total 129.3
(2) Swap Rate = 4.97% (150 PPC on Bonds; no drop)
Base Case HPA Decreased by 10%
Target Yield 31.00% Whole Loan Price 92.00
Base Case Default Freq. 205.74 Default Freq. 261.16
Base Case Loss Severity 54.21 Loss Severity 62.19
Whole Loan Price @ Base 92.00 Yield @ HPA Decreased 14.40%
Base Prepay Curves
0
20
40
60
80
1 9 17 25 33 41 49 57
Period
CPR (%)
228_Low
327_Low
FIX_Low
2nd_Low
Base Default Curves
0
2
4
6
8
10
1 9 17 25 33 41 49 57
Period
CDR (%)
228_Dflt_High
327_Dflt_High
FIX_Dflt_High
2nd_Dflt_High
In adjusting HPA, loss severity was increased 10 percentage points for each loan, while the HPA in each state was
decreased by 10 percentage points, increasing foreclosure frequency
New Century Scratch and Dent - HPA Analysis
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
42
Non-Performing Loans
Non-performing Loans are generally defined as mortgage loans that have stopped
paying monthly payments and are currently in late-stage delinquency, including
foreclosure or bankruptcy, where the borrower has demonstrated either an
unwillingness or inability to make mortgage loan payments. These loans may also
have been reclaimed by lenders as real estate owned (“REO”).
Given the nature of these loans, the primary exit strategy will be foreclosure and sale
of the underlying property at a price in excess of the cost basis. In certain instances
it may be possible to arrive at an arrangement, either through loan modifications or
some form of forbearance plan, which will allow the borrower to begin making
monthly payments. In these circumstances, and to the extent the borrower is able to
demonstrate both a willingness and ability to make timely mortgage payments, the
“re-performing” loans can be sold to a 3rd party at substantial gains relative to the
initial cost basis.
The “home runs” for an investor would be buying non-performing loans at discount
prices (for example, at mid-60s in mid-April 2007), making the loans re-perform and
then selling them at higher prices (around mid-80s or higher at the time of writing),
generating 30% gross return on an unlevered basis.
However, the percentage of non-performing loans that can become re-performing is
generally small. Although it varies across pools depending on pool specifics, on
average less than 20% of outstanding loans are ever expected to re-perform.
Therefore, over 80% of non-performing loans will go through the REO process and
end up being liquidated (underlying houses are sold). Assuming a loss severity of
54% (the base case in the above table, which is a severe loss by historical standards),
the cumulative loss could be 44% of the total unpaid principal balance. As long as
the purchase price of the loans is 1- 44% = 56% (or 56 cents on the dollar), there
will be no expected principal loss for the investment16. For an experienced “bottom
fishing” investor that can source loans at “fire sale” prices (e.g. from “distressed”
originators that are desperate for liquidity), the potential upside can be very
attractive even without leverage.
Rarely is leverage applied to non-performing loans in the funds that we have
invested or considering investing. However, up to 100% of financing can be readily
obtained from Wall Street dealers in the current environment. If conviction on the
quality of loans is high enough and a certain level of leverage is deployed, the
expected return will be further enhanced.
16The real break-even price can be quite a bit higher than 56 cents because loans are not liquidated at the same
time—the later a non-performing loan is liquidated, the higher the chance for it to re-perform.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
43
The following shows a scenario analysis for non-performing loans given certain
“base case” assumptions:
1. Loan purchase price of US$63;
2. 82% of loans end up being REO and liquidated;
3. Loss severity of 40%;
4. 1 x leverage
Source: EIM and an anonymous hedge fund
In the worst scenario, where 85% of loans are “hopeless” and have to be liquidated
at a loss severity of 48%, 20% worse than the “base case,” the annualized gross
yield is still close to 15%. In the best scenario, where loss severity is 20% better
than the “base case,” annual yield could exceed 40%.17
Other Long Opportunities
There has been limited supply of distressed cash RMBS bonds, as the cash market is
inherently small in size. It was estimated that there were only US$3 billion "fallen
angel" ABS in 2006 and distressed ABS paper may still be hard to come by despite
the recent sell-off, leaving funds struggling to find attractive deals. Synthetically,
however, investors can go long the single name RMBS or ABX indexes by selling
protection on the names.
Given the difficulty in sourcing and investing in distressed ABS, it makes sense to
consider CDO Equity, ABS Residuals and Credit Opportunity Funds on a selective
basis once the dust settles. The timing of it is for anyone to debate. Nevertheless,
the following table compares the three investment options.
17 Loan pools vary in quality and prices and leverage levels may not be the same. Therefore, expected returns can be
different from those shown.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Sensitivities (Market Down) Sensitivities (Market Up)
Non-Performing Loans & REO Base Case
+10% Dflt Crv
+10% Severity
+20% Dflt Crv
+20% Severity
-10% Dflt Crv
-10% Severity
-20% Dflt Crv
-20% Severity
Unpaid Principal Balance 400,000,000 400,000,000 400,000,000 400,000,000 400,000,000
Base Case Gross Defaults 81.83% 327,320,000 83.45% 333,800,000 84.92% 339,680,000 80.00% 320,000,000 77.87% 311,480,000
Base Case Cumulative Loss 33.20% 132,800,000 36.81% 147,240,000 40.42% 161,680,000 29.24% 116,960,000 25.30% 101,200,000
Purchase Price 62.95 251,800,000 62.95 251,800,000 62.95 251,800,000 62.95 251,800,000 62.95 251,800,000
Note Financing (Liquidating Trust) 53.00% 212,000,000 212,000,000 212,000,000 212,000,000 212,000,000
Trust Equity 47.00% 188,000,000 188,000,000 188,000,000 188,000,000 188,000,000
Bond Discounts 0.22% 866,226 866,226 866,226 866,226 866,226
Expenses 0.62% 2,482,268 2,482,268 2,482,268 2,482,268 2,482,268
Basis before Purchase Px Discount 191,348,494 191,348,494 191,348,494 191,348,494 191,348,494
Purchase Px Discount 37.05 -148,200,000 -148,200,000 -148,200,000 -148,200,000 -148,200,000
Net Basis in Residual 43,148,494 43,148,494 43,148,494 43,148,494 43,148,494
Residual Cash Flow 26.47% 105,898,596 21.68% 86,726,169 17.00% 68,009,682 31.81% 127,225,103 37.37% 149,462,509
Cash-on-Cash Return 145.43% 100.99% 57.62% 194.85% 246.39%
MV of Resid @ 30.0% Yield 10.79% 43,148,496 8.99% 35,969,100 7.13% 28,531,674 12.62% 50,483,796 14.28% 57,105,109
Yield at Base Price (62.95) 30.00% 23.19% 14.88% 36.02% 40.70%
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
44
Source: EIM, Bear Stearns, Morgan Stanley
ABS Residuals are the "equity" or "first-loss” tranche in home-equity ABS deals that
receive the excess cash flows after covering losses. Equivalent to CDO equity in capital
structures but much more under-followed, residuals from the primary market could
present favorable risk-adjusted returns. Although liquidity in residuals is scarce, it has
been improving. For example, Amaranth sold US$500 million of residuals in two days at
cheap but not distressed levels to JP Morgan and Citadel. Both firms profited to the
tune of hundreds of millions of dollars when they disposed of the trades just weeks
later.
One or a combination of the choices in the above table could help offset the negative
carry if one indeed decides to go short on selective subprime deals. With a 25/75 split
between short-biased funds and Residuals/Opportunity Funds (feel free to twist the
weights based on your views and available managers), the resulting portfolio exhibits a
long convexity profile—attractive returns can be achieved regardless of the direction of
the housing market, while a positive return is retained in the “status quo” scenario.
Note: Assuming 4x leverage for a short biased fund focusing on BBB flat subprime RMBS.
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Investments Residential mortgage security residuals Cash and synthetic ABS bonds, Leveraged loans, high yield bonds
and soon, ABS
Investment Goals Primary: Income from Excess Spread Primary: Income Income and Capital Growth
Secondary: Capital Growth Secondary: Capital Growth
Targeted Returns 20% Gross IRR 15%-22% Gross IRR depending on assets 15%-18% Gross IRR
High current yield High current yield Medium to high current yield
Target Volatility Very Low (<3%) Very Low (<3%) Low to Medium (5-6%)
Cash Flow Profile Immediate and front-end loaded Immediate and front-end loaded More evenly spread but at manager's
discretion
Duration of Returns 2 to 3 years 3 to 6 years 2-3 years for loans and ABS,
longer for high yield bonds
Asset Diversification Medium. Higher if self-originated Medium Medium to High
Primary Risks Defaults, prepayments. Risk mitigants: Defaults, prepayments. Defaults, prepayments,
servicer and REO workout experience valuation financing, valuation and illiquidity
Use of Leverage Yes, term non-recourse financing Yes, term non-recourse financing Yes, combination of term funding
with no margin calls with no margin calls and traditinal financing (Repo)
Liquidity Improving and better than CDO equities Limited Quarterly after first year lock-up
Transparency Extremely high, monthly loan level data High, monthly portfolio report Limited
ABS Residuals vs. ABS CDO Equities and Credit Opportunity Funds
ABS Residuals ABS CDO Equities Credit Opportunity Funds
Short-Biased +40.0% - 20.0% - 30.0%
Residuals/Opps Funds + 9.0% +16.0% +25.0%
25/75 Split +16.8% +7.0% +11.3%
Housing Meltdown Status Quo Housing Rally
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
45
Even more appealing, Credit Opportunities Funds/ABS Residuals will benefit from the
distressed opportunities and wider spreads and produce even higher returns.
Manager Selection
Funds that could meet the following criteria have better odds to succeed in capturing
the aforementioned opportunities:
1) With direct access to a servicing platform or better yet, own a servicing platform;
2) With dedicated REO team and deep loan workout experience;
3) Analytics that process loan level information and value distressed and nonperforming
loans;
4) Experience in loan sourcing and bidding;
5) Experience in securitization or in obtaining non-recourse term financing
Criterion 1alone will eliminate many funds from consideration as only a handful of
hedge funds have the capital or mandate to own a servicing platform. In contrast,
private equity firms have been busy snapping up servicers in the recent crisis.
However, it would be virtually impossible for a regular hedge fund investor to benefit
from such a servicing platform, unless the investor can invest in a private equity fund
that does not mark to market.
7.4. Conclusions
After the recent sell-off, liquidity has all but disappeared, pushing subprime prices
down to levels that are hardly justified by fundamentals alone. The lack of liquidity
has continued into May as we are finishing up this paper. Cognizant of the poor
fundamentals, we believe that even “bad” deals can be attractive at certain
distressed price levels. Through careful selection, potential upside of these distressed
opportunities can be very attractive for the discerning investors.
With thorough due diligence processes and right execution platforms (such as
servicing), a few funds that we have invested or will be investing are well positioned
to benefit from the distressed opportunities in subprime loans, RMBS and potentially
in the near future, CDO tranches.
Realizing that we are incapable of calling the timing of the market, a “bar-bell”
approach with primarily long distressed and some selective short exposures; hence
being long convexity18 is our preferred approach to investing in subprime credits.
18 The distressed nature of the loans or securities means that any further price declines will come at a decelerating
speed before the price and the value “floor,” which is determined by the liquidation value of the underlying property,
finally converge. The positive convexity comes from: 1) deceleration of price declines and/or 2) convergence of prices
and value “floor,” at which point volatility can only help barring a downward move of the value “floor.”
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
Any statements of opinion constitute only current opinions of EIM, which are subject to change and which EIM does not undertake to update. Nothing herein constitutes advice or an offer, solicitation of endorsement with respect to any investment area or
vehicle. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. Parties should independently investigate any investment area or manager, and should consult with
qualified investment, legal and tax professionals before making any investment. Past performance is not necessarily indicative of future results.
46
References:
Chomsisengphet S. and Pennington-Cross A., 2006, “The Evolution of the Subprime
Mortgage Market,” Federal Reserve Bank of St Louis Review
Goodman L. and Zimmerman T. et al., March 20 2006, “Mortgage Strategist,” UBS
Investment Research
Goodman L., Zimmerman T. et al., March 27 2006, “Mortgage Strategist,” UBS
Investment Research
Heike D. and Mago A., December 2004, “The ABCs of HELs,” Lehman Brothers
Fixed Income Research
Covey D., Koss M. et al., January 2006, “Introduction to the ABX,” Lehman Brothers
Fixed Income Research
Gjaja I., Kane M. and Carnahan M., December 2005, “Introduction to the Home
Equity Loan Market,” Citigroup Fixed Income Research
Weaker K. and Reeves K., March 2007, “Servicing Seriously Delinquent Subprime
RMBS,” Deutsche Bank Global Market Research
MBS Week, March 2007, Countrywide Securities Corporation
Anonymous Hedge Funds, March and April 2007
NYON (GENEVA) ZURICH NEW YORK LONDON PARIS SINGAPORE MONACO GIBRALTAR
www.eimgroup.com
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