While many variables acted in concert to bring about the 2007-2008 financial crisis, it is commonly accepted that the implosion of the real estate market and the securities tied to it was an enormous factor. As many of these securities live in the fixed income space, we thought it would be helpful to revisit the sub-sectors in the structured fixed income opportunity set to gauge their current health and to evaluate whether they present the same set of risks that they did not so long ago. So what are the lessons learned?
A definition and some history
Structured or collateralised securities is a general 'catch-all' category that is used to define any security whose cash-flows are tied to more than one security (typically a pool of similar securities) and whose valuations are tied to an asset or group of assets that serve as collateral. While structured securities can come in many forms, and hail from many different sector types, I will discuss those that are most closely related to the real estate market as they are the ones that left the deepest scars in the minds and portfolios of institutional and retail investors alike.
The use of collateralised debt, more specifically collateralised mortgage obligations and collateralised debt obligations, has been criticised as 'the' precipitating factor in the financial crisis. Rising house prices made mortgages appear attractive, but market and economic conditions led to a rise in defaults, foreclosures and payment risks that financial models did not accurately predict. Because many investors focused on income streams rather than the actual health of the underlying loans themselves, there was a heavy reliance on rating agencies’ ratings to bless these investments. The end result was that heavy demand led to over-borrowing to buy more and more at a time when fundamentals continued to deteriorate.
For the sake of perspective, Exhibit 1 below illustrates that structured securities (as depicted in the dark blue bars) collectively performed better than most think when compared to other major spread sectors of the fixed income universe. Corporate credit and emerging market debt suffered the greatest losses.
Exhibit 1: Excess returns (relative to sovereign debt) for various sectors of global fixed income markets in 2008 *
Source: Barclays, FFTW
* Here we define excess return as the difference between total returns of a fixed income security and an implied portfolio of government debt matching the term-structure profile of that security. This enables the measurement, on an 'apple-with-apple basis', of the performance of non-sovereign debt instruments relative to 'risk-free' sovereign debt instruments.
Defining the structured securities sub-sectors
Before we delve deeper into the historical performance of the components of the structured sector, it is best to define the sub-sectors.
US Agency Pass-Through Mortgage-Backed Securities (MBS) – While in some cases banks directly lend the money of depositors to borrowers for real estate backed loans (mortgages), more often, in the United States at least, they don’t. Instead, they sell their originated mortgages to a government agency (GNMA) or quasi-governmental agency (Fannie Mae or Freddie Mac). Those agencies package thousands of similar loans together and then sell them to the public in the form of bonds (also known as pass-through certificates). The principal and interest payments from all the individual mortgages are then distributed to the holder of the agency MBS bonds. Most importantly, interest and principal payments are guaranteed by the agency issuing the bond and therefore, for all practical purposes, the default risk is negligible. Because a mortgage can be pre-paid (or re-financed) at any time, and with no penalty, there is an embedded optionality that works against the investor. This pre-payment “risk” is the primary driver of MBS valuation and the primary driver of the risk is the direction and volatility of interest rates, not the value of real estate.
Covered Bonds (Covereds) – Covered bonds are backed by cash flows from mortgages or public sector loans (typically in Europe). They are structured similarly to other pass-through bonds, but covered bond assets remain on the issuer’s consolidated balance sheet, typically a bank. Covered bonds, like other mortgage securities, have recourse to a pool of assets ('the covered pool'). But as they continue as obligations of the issuer, the investor additionally has recourse against the issuer; this is known as 'dual recourse'. This additional safety measure has actually helped covered bonds maintain their higher investment ratings, even when the issuers were domiciled in some of the most troubled peripheral European countries.
Asset-Backed Securities (ABS) – ABS are a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. Structurally, an ABS is essentially the same thing as a mortgage-backed security, except that the securities backing it are assets such as auto loans, leases, credit card debt, a company’s receivables, royalties and so on, and not mortgage-based securities. One exception to this rule of thumb is the home equity loan market, which is a revolving line of credit that happens to be secured by a second lien on a real estate property. Risk in these securities is simply the aggregate quality of the principal and interest payments. Therefore, an ABS analyst must fully understand the source of payments and the nature of the collateral.
Commercial Mortgage-Backed Securities (CMBS) - This sub-sector of the market is similar in structure to MBS. It is comprised of pools of mortgages that are backed by commercial real estate. In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest-rated bonds, until all accrued interest on those bonds is paid. Interest is then paid to the holders of the next highest-rated tranches, and so on. The same thing occurs with principal as payments are received. This sequential payment structure is generally referred to as the 'waterfall'. As these securities do not carry the guarantee of an agency, the key drivers of valuation are: quality of the credit pool, quality of the underlying collateral and the securities position in the waterfall structure.
Next we observe the performance of the major components of the structured space: Exhibit 2 illustrates the performance of these sectors for the full year 2008.
Exhibit 2: Excess return of various sub-sectors of global fixed income structured security sub-sectors in 2008
Source: Barclays, FFTW
Clearly, those sectors with the greatest credit and/or structural support (MBS and Covered) had a much better experience during the crisis. The MBS market is also one of the largest markets in the world, so liquidity was also a contributing factor to its support. The worst hit were sectors whose primary risk was both the quality of the underlying borrowers as well as the quality of the underlying collateral. As the real estate market crumbled, home equity loans and CMBS were the most vulnerable. To be fair, Exhibit 3 illustrates those same sectors and how they rallied one year later in 2009, proving that calm heads prevailed. Those who did not sell in panic were rewarded with a significant rebound the very next year.
Exhibit 3: Excess returns of the sub-sectors of fixed income collateralised debt instruments relative to sovereign debt in 2009
Source: Barclays, FFTW
Note that while most sectors retraced their loss, CMBS and home equity ABS did not fully recover in one year’s time. This is because it took a number of years for real estate prices to stop their slide and for the great recession to ease. Defaults and foreclosures didn’t actually peak until 2010, but that did not stop a strong rebound in 2009 as most central banks employed extraordinary measures to inject liquidity into financial markets. Both of these sectors have continued to rally in the years since 2009.
Changes since 2008
As the adage states, “fool me once, shame on you; fool me twice, shame on me”. As we continue to invest in this space, we ask ourselves the crucial question: could this happen again? In short, we believe that while the real estate market could indeed break again, there are a number of changes in the securitised market that would prevent the level of loss seen in 2008. Below is an explanation of some of these changes.
Ownership - Theoretically, the default risk for Fannie Mae (Federal National Mortgage Association - FNMA) and Freddie Mac (Federal Home Loan Mortgage Corp - FHLMC) underwritten MBS is slightly higher than those underwritten by Ginnie Mae (Government National Mortgage Association - GNMA) because they are technically not part of the US federal government. However, when the real-estate market came apart in 2008, the federal government placed FNMA and FHLMC under receivership which effectively made their obligations fully guaranteed by the US government. They also supported them with hundreds of billions of dollars of aid. As GNMA, Fannie Mae, and Freddie Mac are responsible for the functioning of the housing market (financing over 90% of mortgages since the crash) they are too important for the government to let them default.
Leverage – As mentioned earlier, a good deal of leverage was used to purchase securities in the pre-crisis period. Proprietary trading by banks as brokers further exposed the market to highly leveraged positions. Unlike 2007, margin purchasing is now virtually non-existent as new accounting requirements have made such borrowing uneconomic, and a wave of deleveraging continues around the world. Additionally, the Dodd-Frank Act eliminated the ability of banks and brokers to operate proprietary desks.
Lending Standards - In the run up to the crisis (2000-2006), a boom in the US housing market caused a surge in non-prime mortgage originations. Given the lower underwriting requirements for non-prime mortgages, this explosive growth naturally caused a decline in lending standards for the overall mortgage market. Additionally, “no document” loans (those loans where proof of income and assets were not required on the application) became common, further decreasing the aggregate quality of the market. As demand for mortgage structures grew, originators became guided more by quantity than quality of loans, largely because all loans were moved off balance sheet within a month or two, packaged into a structure, and sold off. After the crisis, when this transfer mechanism went away, and after lenders were forced to retain loans, the natural result was a return to traditional, conservative credit standards. An ease in lending standards could of course happen again, but the combination of risk retention rules and the elimination of proprietary trading should serve as a significant barrier to this. At the least, we now know what to look for. Exhibit 4 below illustrates the impact of better lending standards on the residential mortgage market.
Exhibit 4: Impact of tighter residential housing lending standards
Source: Kaplan-Meier default probability study, FFTW
The commercial side of the mortgage market has changed significantly as well. Underwriting standards in 2005-2007 vintage deals were tragically low. For example, the percentage of loans in the pools which were underwritten on projected (pro forma) cash flows rather than historical/actual cash flows kept increasing in the years prior to the crash as did the percentage of non-amortising (‘interest-only’(IO)) loans in the pool. For example, the USD 7.6 billion GSMS 2007-GG10 deal, a benchmark CMBS transaction issued in 2007, had loans with a weighted average underwritten net operating income (NOI) at issuance that was 28% higher than the most recently reported incomes, and the percentage of full-term interest-only loans in the collateral pool was over 80%. These days, NOI, loan size to value of loan (LTV) and IO acceptability standards are significantly higher. Additionally, ratings agency standards have increased as well. The rating agencies responded by requiring higher levels of credit subordination for the rated tranches. Again using the 2007 GG10 deal as an example, the subordination for its BBB- rated tranche was 3.75% compared to an average of 7.6% conduit deals. Further, property prices for many property types have fully recovered from the financial crisis.
Regulatory Environment – In 2014 the Securities and Exchange Commission (SEC) and five other federal agencies approved a joint rule mandating that sponsors of certain types of securitisations retain a minimum level of credit risk exposure in those transactions and prohibiting such sponsors from transferring or hedging against that retained credit risk. Following the meltdown of the securitisation markets in 2007 (particularly subprime residential mortgage-backed securities), and the resulting global financial crisis, the Dodd-Frank Act mandated that the US federal banking, securities and housing agencies adopt and implement rules to require sponsors of new securitisations to retain not less than five percent of the credit risk of any assets that the securitiser, through the issuance of an asset-backed security, transfers, sells or conveys to a third party. Requiring securitisation sponsors to keep “skin in the game” aligns the interests of the sponsors with the interests of investors and thereby incentivises the sponsors to ensure the quality of the assets underlying the securitisation through appropriate due diligence and underwriting procedures when selecting assets for securitisation. The risk-retention provision ensures that the issuer is penalised if the securitised loans go bad; this is an enormous incentive.
The Volcker Rule, which is a sub-section of the Dodd-Frank Act, disallows short-term proprietary trading of, among other security types, structured securities, derivatives, and options on these instruments for banks’ own accounts under the premise that these activities do not benefit banks’ customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits.
Ratings Agency Methodology Reform -In 2014 the SEC adopted new requirements for credit rating agencies to enhance governance, protect against conflicts of interest and increase transparency to improve the quality of credit ratings and increase credit rating agency accountability. The new rules and amendments, which implement 14 rulemaking requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act, apply to credit rating agencies registered with the SEC as nationally recognised statistical rating organisations (NRSROs).