Glimmer Gets Brighter

After a weekend off, I’m back in the MoM command center. I’m beginning to read some of the books that came out over the past two years about the meltdown, in preparation for refreshing and publishing my own version.

Friday we saw the first residential mortgage deal since the crisis began.  A glimmer of hope, in other words.

The problem, as I saw it, was the extraordinary quality of the loans in the Redwood pool.

It was widely reported that the loans averaged about $923,000 with 57% LTV and average credit score of 798.  Another fact, very encouraging, was that the underwriters at Citi saw enough demand that they lowered the initial interest rate on the MBS bonds to 3.75% from 4% that was floated as a trial balloon.

My reaction was that it was a relief to see non-Agency issuance once again, but the average numbers were so far into the super-prime quality range that it was relief for almost no one.

It turns out the actual FICO score was 768.  Thank goodness.

I’m not sure about the bell curve of FICO scores, but I am sure that the 800+ territory is pretty far out there.  If we were to fund only the top 1% of with private financing, and then further restrict the available pool of borrowers with only large loans and only down payments north of 40%, the mortgage finance world would still be government-only, for all practical purposes.

Kudos to for catching the discrepancy that caught even Wall Street research departments.

So let’s run through how this deal worked, and how it was priced.

First, the 5/1 hybrid ARM (fixed interest for five years, and then floating over 1-year Treasury) loans were originated by Citi, and will be serviced by Citi.  Given their characteristics, these loans seem to be the production of Citi’s premium banking operation that caters to high net worth individuals.

With a collateral pool of $237 million in loans, they issued $230.7 million in publicly-offered bonds, with the bulk of them rated AAA ($222.4 million).  Beneath that are the junior B1, B2, B3 and B4 bonds.  Of those, the B1 and B2 bonds have investment grade ratings (Moody’s A2 and Baa2, equivalent to other rating agencies’ A and BBB ratings).

If we were to compare that issuance — $222 million in AAA bonds from $237 million in super prime loans, it’s clear that the Moody’s tightened their criteria enormously.  In times past, a loan pool of this quality might qualify for 99% AAA, and definitely not under 94%.  Before the meltdown, that was the kind of subordination we saw in pools of “liar loans” with lower FICO’s and higher LTV’s.

The subordination beneath investment grade is also much higher.

But at least the deal got done, and the only way we’re going to get out of this mess is to have private financing take back the 30% or so market share it had before the mania.

We can’t be sure what they’ll get for the IO (Interest Only, roughly 80 BP’s) off the AAA bonds, but it’s probably safe to assume it’s worth a couple of points, so the AAA bonds plus the AAA IO produce gross proceeds around 102%.

The most significant fact of this deal is that it returns high-grade new origination to the place where it produces a decent leveraged return for equity investors.  I’ve seen estimates of 10% and 13% on this deal.  The important issue is that the leverage is permanent, lasting for the life of the loans.

We all found out how bad relying on the repo market to roll over short-term financing can be.



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