Why the triple-A subprime bond is bad news

By Felix Salmon
September 2, 2011
broke that a subprime mortgage bond called Springleaf Mortgage Loan Trust 2011-1 was being priced with a triple-A rating from S&P.

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There was a flurry of predictable coverage on Wednesday when the news broke that a subprime mortgage bond called Springleaf Mortgage Loan Trust 2011-1 was being priced with a triple-A rating from S&P. The WSJ’s Al Yoon has the best detail on how the bond is structured; basically, 5,629 performing subprime loans are being put into a pool, and holders of triple-A bonds get the first 48.85% of the cash flowing from that pool. Because you can be pretty sure that at least 48.85% of the mortgages will be making their payments, the triple-A tranche is considered ultra-safe; Daniel Indiviglio has attempted to defend the deal and its rating on those grounds.

But as Bloomberg reports, it’s not as simple as that. There are at least five main arguments for subprime bonds not to have a triple-A rating when the US is only double-A:

  1. The US is not revenue-constrained in the way that a structured product is: the US can raise taxes, but Springleaf can’t raise mortgage rates. In extremis, the US can act to avert a default; the Springleaf deal can’t.
  2. If the US were to default, the repercussions would be so huge and unpredictable that it’s very hard to see how anybody can have faith in the Springleaf deal continuing to pay out in full. That’s the thinking behind the institution of the sovereign ceiling: you can’t really have more faith in an American bond deal than you can in America itself.
  3. A triple-A rating is pretty useless if there’s a good chance that it’s just going to get downgraded in the near future. S&P downgraded $30 billion of re-remics shortly after giving them post-crisis triple-A ratings; there’s no good reason to believe the same thing won’t happen here.
  4. The reason for the triple-A is that mortgage payments are uncorrelated: even if some people default, they won’t all default at the same time. But as we learned so painfully in 2008, correlations tend to spike dramatically during a crisis, and the whole point of a triple-A bond is that it’s meant to be crisis-proof.
  5. Rating structured bonds is impossible. These things are simply too complex and unpredictable to be able to apply a triple-A rating to. Haven’t we learned anything from the financial crisis?

And even putting all those arguments aside, the very existence of this bond is depressing, for a couple of reasons.

Firstly there’s that 48.85% number — much, much lower than the kind of numbers we saw during the subprime boom, when well over 90% of a subprime pool would regularly receive a triple-A rating. S&P is putting up unprecedented barriers to structured products getting a triple-A rating — and companies like Fortress Capital, which owns Springleaf, are still going through all the hoops they need to go through to get one. What that says to me is that we really haven’t learned one of the main lessons of the financial crisis — that triple-A ratings are treacherous and largely meaningless things, and that it’s silly to go to great lengths to get one, or to confine yourself to investing only in bonds with that particular seal of ratings-agency approval.

Secondly, there’s the fact that the Springleaf deal is made up of old, seasoned loans, rather than new mortgages. It’s financial engineering, in other words, and isn’t driving any capital to the housing market. During the bubble, there was too much money going from structured finance into the housing market; right now, however, the market needs all the help it can get, and it’s getting none at all from that quarter.

Finally, it’s worth noting what people are buying, in terms of bonds backed by brand-new mortgages. They’re buying agency bonds, issued by Fannie Mae and Freddie Mac, which carry a double-A credit rating. (And which yield much less than the 4% on the Springleaf deal.) If we ever want to transition to a world where the private sector is funding American mortgages and the federal government is getting out of it — if we ever want to realize the stated aim of politicians on both sides of the aisle to make Frannie much smaller — then we’re going to have to find some kind of palatable alternative to agency bonds. But there’s no indication that any such alternative exists.

There’s no way that the Springleaf model can be extended to new mortgages. The overcollateralization in Springleaf is too great: it would be uneconomic to put such a deal together with new mortgages, since it would be impossible to find investors to take the other 51.15% of the deal. And of course investors would demand even more overcollateralization with new mortgages than they do with seasoned ones.

The story of Springleaf, then is ultimately a depressing one. It shows that people still care about triple-A ratings when they shouldn’t; it shows that mortgage finance is not going to move to the private sector any time soon; and it shows that the paradigm of ratings agencies needing to ratify structured products and give them a triple-A rating is alive and well. Whether you think this particular rating is justified or not, there’s no good news in its existence.


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I see the shaved monkeys at Bloomberg have been allowed to randomly hit a typewriter again.

1) US can raise taxes? Really? So how come Obama hasnt just eliminated the deficit with his magic revenue generation wand?
2) Again for the people who have difficulty reading, S&P downgraded the US long-term debt. This bond is – from recollection – a seven year deal, which S&P hasn’t downgraded the US on.
3) These are bonds backed by the cashflow of subprime loans that survived the crash. Using the same idiotic logic, dot.coms who made it through 2000-2002 are just as likely to flame out as those that crashed. This is before we repeat yet again that the rating is a measure of likelihood of default not anything else.
4) Not true, it is rated AAA because it is unlikely that the underlying cashflows will ever be less than 48.85%. That includes any excess interest rate cover and overcollateralisation in the bond and recovery on any defaulted loan.
5) Why would mortgages be so impossible to rate but debt from say $BAC or $C is not? or the US?

People are buying agency bonds because they are credit-wrapped and so easier to analyse.

Posted by Danny_Black | Report as abusive

I can’t believe this. Have they learned nothing? I’ll not be putting any of my clients anywhere near this, nor anything remotely like this so long as I can identify such things – and if I can’t see what’s in it, I won’t buy it for that reason either. Who exactly were the loans given to initially, irrespective of liability or likelihoods?

Posted by FifthDecade | Report as abusive

FifthDecade – but presumably had it been rated B- you’d have told your clients to pile in?
The bloomberg arguments are pretty weak:
2) That might be true – should no bond in the world be AAA anymore? Or can we accept that a US default is still v unlikely, that this would not necessarily lead to long term losses for bond holders, and that regardless, this would not lead automatically to losses on this bond.
3) So S&P can’t give AAA ratings because they downgrade bonds? Surely what’s important is what the “right” rating is now, not what it might be if things change in 6 months.
4)Yes, but 48% seems to me to give plenty of headroom
5) Rubbish. What (I hope) we have learnt is that a AAA bond rating doesn’t mean investors should buy without doing their own diligence.

Posted by NickC | Report as abusive

Now that I’ve learned, in the past month, the difference between Moody’s ratings and S&P ratings, I can see where Moody’s ratings would be subject to a sovereign ceiling more than S&P ratings. If treasuries pay out three days late for what are commonly known to be temporary technical reasons, I don’t see that dramatically affecting the value of these mortgage bonds.

In re this being old mortgages, so that new money is not going into mortgage lending: The way I read this, Springleaf itself made these loans, and it sounds like Springleaf is likely to take the proceeds of the security sales and turn around and look to make mortgage loans with them. Perhaps Springleaf is intermediating the process because it believes that the premium return demanded by investors on new (vs. seasoned) loans is too high, and it’s happy to draw the premium.

Posted by dWj | Report as abusive

One of the issues for me is while cashflow is assessed, the return of principal is not mentioned. What happens if the people who took out these seasoned loans NOW lose their jobs and can no longer pay, yes, the cashflow is affected, but so is the principal. As we saw in 2008, likelihood is no guarantee while AAA is seen as being one.

As for what I’d recommend if they were classed as B, no I wouldn’t pile into them then either. I still wouldn’t touch them: I’m not in the mortgage lending business, and nor are my clients. Call me old fashioned, but securitisation of mortgage debt to me is smoke and mirrors for one way to get more money out of consumers they can’t afford to lose.

Posted by FifthDecade | Report as abusive

FifthDecade, I wouldn’t call you old fashioned, merely clueless which apparently is par for the course for investment advisors.

Principal is also assessed in giving a rating and it depends on how the deal is structured but either the interest and principal are separate waterfalls – in which case for you to lose principal not only would 100% of the people have to default but you’d also need to have all their homes be sold for less than 48.5% of the mortgage. Or more likely it is some blend where the excess spread from the underlying mortgages goes into a pot to pay off the coupons and principal of the bonds.

Did we see that in 2008? How many AAA bonds defaulted in 2008?

At least you get that you don’t get how these bonds actually work which puts you one step up on, say, IKB and ACA whose directors managed to get paid handsomely for being “experts” and “sophisticated investors” and then magically becoming innocents who were taken advantage of when the market turned against them.

Posted by Danny_Black | Report as abusive

Really, the essence of the argument is, “Rating structured bonds is impossible. These things are simply too complex and unpredictable to be able to apply a triple-A rating to.”

In this case, it seems likely that the rating errs on the conservative side. For “seasoned” mortgages, a default/recovery rate less than 50% would be overwhelming. Wouldn’t take more than a fraction of that to blow up every bank in the country.

That said, it is nearly impossible to analyze. If 48.85% is okay, why not 55%? Or 65%? Our models say that 75% ought to be rock-solid. Maybe 80%? At some point we end up right back where we were in 2007.

And yes, that is a slippery-slope argument. Still worth pondering how far we are along that slope.

Posted by TFF | Report as abusive

Thank you for your interesting argument Danny_Black, but it fails to convince. Without knowing more about the underlying you can’t take someone else’s word for it that the mortgages are safe just because they haven’t defaulted yet. Look at the Economy. Look at Cleveland. Default rates and ensuing capital losses there were way over 51.15%, but once upon a time they were current too. I don’t buy the AAA rating either by the way.

As for the pot paying out the principal, that’s a gamble. Those mortgages are more likely to suffer as a group en masse due to National or Global economic problems than they are because one or two individuals can’t manage their money too well or have a personal tragedy. In such cases, reliance on principal being paid in full is highly risky, a Black Swan event perhaps but by grouping them together you aren’t reducing the overall risk, you’re actually increasing it (granted of a different type).

The longer US consumers demand lowest prices at any cost, and the Big Corporates pander to these wishes by outsourcing the jobs of their customers to China, the more likely it is that mortgage shocks will be like the tide coming in by affecting everyone, not just the leaky boats. Storm surges do happen.

Posted by FifthDecade | Report as abusive

FifthDecade, you maybe don’t get this whole invesment advisor gig. You are not MEANT to “take someone else’s word for it”. You are the one who has a fiduciary responsibility to make sure these are suitable investments, not the underwriter, not S&P.

Of course, you can just buy these bonds pocket the extra yield and if they blow up get the FHFA to sue the underwriter a la Frannie. One way bet…

Posted by Danny_Black | Report as abusive

FifthDecade, also your arguments are just gibberish, worthy of Mr Taleb himself. Mortgages in Cleveland are taking a higher than 51.5% loss? Really? Maybe some very select areas are but overall? And an “unpredictable event” can happen to any company. Maybe Red Skull finally kills Captain America and nationalises GE causing it to default on all its bonds. I hope you have protected your clients against this event!

Posted by Danny_Black | Report as abusive

So, 2008 never happened huh? All those banks who bought sub-prime debt based securities that flatlined and all those governments who invested in AAA bonds based on the same oversold securities never had any problems? There aren’t areas in Cleveland where 100% of mortgages defaulted in 2007/08? Those same events weren’t repeated all over the US, but usually to one group of people, the sub-prime mortgagees? Non-recourse loans? Did you even read any of Felix’s articles on these events and what was really happening? Or were you one of those profiting from passing on this toxic debt as fast as possible before it burned your own hands? Your personal attacks on me suggest so.

As for not getting the investor advisor gig, that’d be you: there are no one way bets with investments.

Posted by FifthDecade | Report as abusive

“You are not MEANT to “take someone else’s word for it”. You are the one who has a fiduciary responsibility to make sure these are suitable investments, not the underwriter, not S&P.”

Wouldn’t that be beyond most investment advisors? It would certainly be beyond me (which is why I wouldn’t touch these bonds).

Invest in what you understand, in what you can evaluate independently…

Posted by TFF | Report as abusive

Danny Black, the only ones for whom it was an “unpredictable event” were the buyers. The sellers had been cutting the high risk crack with baby powder for a long time.

Danny Black will tell you how easy it was to sell that crack, because he was on the sell side. (Maybe even Goldman England, being he is a Goldman and banker apologist) He will tell you that everyone was addicted to the product, but that isn’t the their fault. And everyone was cutting it, so it’s the buyers fault for not testing every batch, not the banks.

Banks, mortgage brokers and servicers and S&P were alligned and had the computer data that was available to only them. The buyer didn’t have the access to the information that S$P and the seller had, so of course they are relying that the AAA meant something. If AAA doesn’t mean cream of the crop than ratings are garbage.

When you knew which loans were designed to fail, which mortgage brokers were crooked and selling to the poor and forging information, which banks didn’t give a hoot about proper collateral, securitzation, handling of the note and registering it 90 days after each sale, which used MERS which destroyed documents so there was no paper trail, which were sold 10 previous times as a hot potato, which area had the most failures you could tuck them in nicely and short the sh*tty deal.

That was data no one had available to peruse, except those banks and servicers that had access to the data streams. John Paulson made a lot of money using that data, because he had access to them. Did the banks offer that data in the prospectus? If not, why not? Why was one side of the table more “informed” then those going long? (Sorry a little fine that was a spit in a bucket of the actual revenue, doesn’t make Goldman less guilty of criminal activity)

Danny will also blame the buyers. Yes buyers signed for mortgages they knew nothing about. Many were flippers and in on the game along with mortgage servicers, brokers and assessors. But those people also specifically targeted the poor because they could barely read and had no money, collateral and sometimes no jobs. What business was a bank in that offered such loans and hired such brokers? Sounds rather like the culture of the mob than a bank…

Danny will blame the regulations as being too stiff and so have spawned intruments like CDOs. The banks greed has nothing to do with it. Suckers are born every minute. But RICO was designed to stop this financial fraud to protect the people against such fiancial fraud. So was Glass-Steagal.

CRA and subprime loans were supposed to help people who needed it and to restore neighbourhoods. On that note Danny is right. Regulations are crap if no one is enforcing them and they are so easy to skirt and take advantage of. Banks and their lobbyists have been shaping the law for sometime. Rest assured it isn’t so they can make a better America or a better life for the disadvantaged.

And now on to the actual topic. There is no way any subprime can be AAA at any time. Inflation is around the corner. The housing industry is in the toilet. These are “old” mortgages with little or no equity and less than average credit scores. They paid for the rating!

There is no way any firm whose holdings are people’s 401 k should be investing in what will be a another bubble. But they will, because it isn’t their money and the buyer loves his financial crack, right Danny?

Posted by hsvkitty | Report as abusive

I completely agree with Danny Black on this. Of course a AAA subprime mortgage bond is possible, and the US sovereign rating is irrelevant.

Here is a much more sensible article on the topic, also from Reuters:

http://www.reuters.com/article/2011/09/0 2/businesspro-us-markets-credit-idUSTRE7 8157U20110902

Posted by Marc_Bolan | Report as abusive

Danny_Black, can you not express your argument without personal attacks? You undermine your own legitimacy every time you post.

Posted by FifthDecade | Report as abusive

Weird, I thought an inability to get elementary facts right and a clear ignorance of even the most simple and basic parts of the field undermined credibility but then again I was never a “journalist” or an “investment advisor”. I am also old-fashioned enough to think it is rather important, in particular if non-specialists are relying on them for credible information. Especially in finance where idiotic reporting can have serious consequences – for example when SocGen was recently in a nose dive because a moron in the Daily Mail mistranslated a story which was then picked up by the muppets at the FT.

Posted by Danny_Black | Report as abusive

Forget that the homeowners have lower than average credit scores and little or no equity! Forget that the
AAA credit rating on past subprimes should never have been given and the whole world is still reeling from the last bubble!

An AAA rating is supposed to be based on quality of the assets and their likelihood of default. This is how S&P restores confidence in ratings and their ranking of creditworthiness?

There are those who are missing their crack…that’s all this is about. They miss the rush the risk and the heyday and all those who were not punished and still complicit, like S&P, want to jump right back in blow more bubbles.

Danny_Black, everyone but you is a moron, a muppet, a shaved monkey, an idiot and of course you consider me a retard (and have called me that 4 times even though it is absolutely unacceptable to use that term to describe anyone. At least find an acceptable term to belittle me with)

Although I am well aware that you are a specialist on how to sell junk and call it diamonds, the rest of those reading here may not know. As a former banker, Danny will be happy to take the bank’s side and tell everyone that the AAA rating is legit! After all the mortgages did ok during the last 4 years even though they were subprime! yep Danny’s says so! (and S&P was paid, dearly, to say so too!)

Posted by hsvkitty | Report as abusive

Seriously, Bloomberg has free soft drinks and fruit in the company cafeteria, you should consider it. Even they would be impressed with you complete lack of any knowledge, sub-zero IQ and inability to understand simple english, you’d probably be an editor in no time.

Posted by Danny_Black | Report as abusive

Felix has this one spot on.

This is yet another piece of garbage from the people who brought down our financial markets.

Much more important, what the hell is going on at S&P. Evidence is that the place has long been and is now even more a ship of fool.

Posted by No_Time_Flat | Report as abusive

Unfortunate that some commenters seem more interested in poo-flinging than in advancing any sort of sensible argument. I’m tempted to wonder why anyone would think all the mortgage defaults are behind us now and it’s clear sailing from here on out, so hooray for mortgage-backed securities and the top tranches are better than US Treasuries, but there seems little point, since it will just provoke more poo-flinging with no recourse to evidence.

Posted by SelenesMom | Report as abusive

“I’m tempted to wonder why anyone would think all the mortgage defaults are behind us now and it’s clear sailing from here on out”

SelenesMom, I don’t think anybody suggested that.

As I said before, it is a slippery-slope question. If you slice off the most senior 1% tranche, it is surely the safest bond on the planet. There is almost no way to end up with a 99% loss on a pool of mortgage securities! (Giant asteroid hits Kansas?)

Conversely, if your senior tranche is 99% of the pool then some of your principal will not be repaid. That would be obvious even if they were high-quality loans in boom times.

So where is the line that separates “risk free” from “not risk free”? (Please define “free”?) It might easily be above 48.85%, but I really have no way of knowing.

Posted by TFF | Report as abusive

SelenesMom, it is a shame after all the coverage that securitisation has got that people still don’t get it. The bet is not that the mortgages will not default or even that house prices will not go down. This is a bet that even if 100% of the people default the recovery will still be more than 50%. We don’t know the details but I would guess there is extra collateral in the mix and properly excess interest rate coverage so if fact they can go down even more.

Posted by Danny_Black | Report as abusive

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