Wednesday, September 22, 2010

Commercial mortgage-backed securities are doing very well

This is a chart (source here) of the price of a AAA-rated basket of commercial mortgage-backed securities, most of which were originated in the heydays of 2007. Issued at par, this issue (which was assumed by almost everyone to be bullet-proof because of its AAA rating) fell to an unbelievable low of 55, but it has now rallied back to 92.7. You can check the prices of other AAA- and AA-rated securities issued earlier, and the story is basically the same—there has been a stunning recovery.

What this means is that in the depths of the depression and deflation fears, the market was priced to the expectation that almost half of the mortgages backing this security would default (or more likely, that 70% of the securities would default with a recovery value of 35%). It's not necessarily the case that the market was actually expecting a catastrophic default rate, but more likely, that the market's liquidity had evaporated at a time when many banks, and institutional investors were forced to sell at the height of the financial panic. Prices collapsed since lots of people wanted/needed to sell, and there were precious few buyers willing to buy.

Those institutions that decided to hold the securities were forced to write them down—with the losses going straight to their bottom line—because they were considered to be "impaired" according to accounting rules. But now the securities have almost doubled in value, yet the value recovered has in most cases not been recognized. This means there are lots of unrecognized profits on the books of institutional investors who were brave enough to hold these securities when everyone thought the sky was falling. I assume this is also good news for a lot of banks. And it's a vivid example of how illiquid and/or panicked markets can price securities to extremely unreasonable and even absurd assumptions. Markets are not perfect, and they can make huge mistakes. For an in-depth explanation of how this worked, I should once again recommend the book "Panic" by Redleaf and Vigilante.

In a similar vein, high-yield securities at the end of 2008 were priced to the expectation that an incredibly large percentage (as much as 50%) of companies would default on their obligations over the following 3-5 years. Yet we learn today that the default rate for high-yield securities will be less than 3% by the end of this year, according to Moody's.

Again, markets can and do make huge mistakes, especially when emotions are running high.

And, as should be obvious, conditions today are not nearly as bad as most people thought they would be.


septizoniom said...

does musical chairs mean the chairs are more valuable intrinsicly than before the manufactured shortage?

Frozen in the North said...

I think everyone gets your point. However, when the Sh&t hit the fan in 2008, no one could trust any securitization pool or any asset valuation provided by banks.

Of course at times some babies were thrown out with the bathwater, but it remained that investors had zero confidence on rating agencies, investment banks, and third party asset selectors.

So this pool was good after all, so what, how many turned out to be total garbage?

You think its bad, up here in Canada where commercial real estate never dropped and where our recession was a fraction of what you are experiencing in the U.S. commercial real estate trust and all kinds of securitization deals where hit badly. Moreover, the argument that the holders were wrong to MTM their books is incorrect, because they could not sell the assets at the then prevailing market.

For once I think you missed the boat. Frankly, to still rely on Moody's or S&P for anything (including tell you what's today weather like) is just plain foolish.

(sorry for the rant)

Charles said...

Gorton's analysis of what happened to the shadow banking system is very helpful here. AAA-rated mortgage backed securities were used as collateral for short term investments. This worked fine as long as they had a stable value that could easily be supported, that is, as long as they were liquid. As soon as they became questionable, they could not serve as collateral and had to be dumped. They became illiquid because there was no one to buy them.

These securities collapsed in price because they couldn't be valued and no one would buy the huge quantities being dumped on the markets.

They have mostly recovered, which is what we should expect to happen, as the financial markets stabilized. But they remain speculative debt.

Benjamin said...

I noticed this too. Excellent commentary by Scott Grannis. Maybe we are seeing the end of the tunnel.