Wednesday, April 22, 2009

Desecuritization: Value There for the Taking

Posted on Yahoo Finance by Jack Guttentag:

The government is betting that, by lending large amounts to private investors to purchase securities, markets will revive and security values will rise. This is a costly and risky venture; I hope it works, but I fear it won't. This article proposes another approach to the same objectives -- an approach that would cost the government nothing. I call it desecuritization. All it requires is the appropriate enabling legislation.

Desecuritization means reversing the securitization process. Securitization converts large numbers of individual loans into security issues. Descuritization converts the securities back into individual loans. The objective of both is the same: to enhance value. The first works during normal periods, the second can work during a crisis period such as the one we are in now.

Securitization enhanced value during normal periods because a single type of loan could be converted into a variety of securities with different characteristics fashioned to meet the diverse needs of investors. For example, a pool of 30-year fixed-rate mortgages could be transformed into a security issue subdivided into sub-issues that vary in their duration (how long before the investor gets his money back), their exposure to risk of default as indicated by credit quality ratings, and their sensitivity to changes in market interest rates.

Appealing to Many

Where investor demand for 30-year fixed-rate mortgages was limited, the diverse securities fashioned from a pool of such mortgages could appeal to a wide range of investors. With securitization, the whole was worth more than the sum of its parts.

The breakdown of financial markets during the financial crisis, associated with high default rates on loans in pools supporting securities, has reversed the equation. The total value of any mortgage security issue on which the AAA-rated pieces have been downgraded is now much smaller than the sum of the values of the individual loans, assuming those loans could somehow be disentangled from the security.

For example, assume 20 percent of a portfolio of 1,000 mortgage loans defaults and each default costs 50 percent of the balance. Because the 200 loans that default do not affect the value of the 800 that don't, the decline in the total value of the portfolio is only 10 percent. But if the loans are in a security issue, every piece of that security may be contaminated by the defaults. The overall decline in value could be 30 percent or even 60 percent; we have no way of knowing because markets have largely shut down.

Rating the Securities

In an interesting paper called The Law of Unintended Consequences, John Mauldin attributes this excessive value decline to the decision by the credit rating agencies to rate asset-backed securities in the same way they have always rated bonds. I agree with him that the rating system needs fixing, but I doubt that any rating system can wholly avoid value contamination within a security when default rates are very high.

In any case, the challenge right now is to find a way to unlock the hidden value in mortgage pools supporting contaminated securities. Perhaps the new federally supported asset purchase program will do it, but desecuritization would be surer and cheaper.

All that is needed to make desecuritization work is a way for investors to acquire control of 100 percent of a security issue. The investor who owns it all can dispose of the security and own the individual loans. To make this possible, we need a law that grants any investor who owns X percent of a security issue the right to buy the remaining 1 minus X at a price equal to Y percent of the average price the investor paid for the X percent already owned.

Profiting From the Program

Investors will attempt to profit from such a program in one of two ways. The basic strategy will be to acquire 100 percent of a security and realize the difference between the value of the loans and the price paid for the security. An alternative strategy is to acquire an amount of an issue equal to 1 minus X + $1, which is just enough to prevent any other investor from executing the basic strategy, forcing them to come to you.

The values for X and Y that will best facilitate the process depend on the characteristics of the security issue. Hence, a first step toward desecuritization is to develop a census of issues, showing the balance of each sub-issue, its initial and current rating, and the current owners. This information will not only help in formulating the enabling legislation but will also provide critical information needed by investors looking to buy up 100 percent of one or more issues.

The enabling law would override the maze of private contracts involved in a securitization, and it is not a step to be taken lightly.

In this regard, it is similar to the cram-down legislation that is being considered by Congress. An important difference is that cram-down is a zero-sum game, meaning that the gains to borrowers are exactly offset by losses to investors. Desecuritization is a positive-sum game because the gains for successful investors will be substantially larger than any losses suffered by other investors.

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