Q&A with Emily Hollis

Emily Hollis
April 7, 2009 | COMMENTS

Question: I read your article on Other than Temporary Impairment (OTTI). Are you saying that if the accounting rules are changed, that there should be gains in non-conforming securities?

You cannot paint all non-conforming loans with one broad brush. Some securities may have double-digit returns while others will lose all principal. It all depends upon the structure of the bond and the underlying collateral. As an example, prime, fixed-rate loans are experiencing dramatically lower foreclosure rates than prime, adjustable-rate loans. Alt-A loans may have high FICO scores but not necessarily be prime loans. There are prime option-ARM borrowers that are defaulting at high levels. And then, you have Alt-A, prime option-ARM borrowers that are defaulting at almost subprime levels. So, don't rely on FICO scores.

Credit supports of 10 percent are ample for fixed-rate prime mortgage loans but are most likely not high enough for prime Alt-A adjustable-rate loans in order to prevent losses. Consider this question: If your credit support is 10 percent and cumulative losses of the trust are 15 percent, do you lose five percent of your principal (15 percent minus10 percent) or 100 percent? The answer depends upon what type of bond you own.

Let's look at an example. There are generally four categories of bond classes: super senior and senior, senior supports, mezzanine and support. The support classes are the first to absorb losses when defaults begin to occur. When losses exceed the principal value of the support bonds, the mezzanine securities will then become the “first loss piece” and begin absorbing losses of the pool. Should the mezzanine class get wiped out; the senior supports then become the “first loss piece” and so forth until the senior bonds are exposed. Sometimes it gets a bit complicated; generally senior supports only support their designated senior tranche while the mezzanines generally support all senior and senior supports. But there is no hard and fast rule.

To answer the previously posed question, suppose that you own mezzanine 1 as shown in the chart below with 10 percent of credit support in front of you. Assume that your mezzanine piece comprises 1 percent of the entire deal. Now suppose that there are 10 percent cumulative losses which occur by year three. Your security is now in line to take losses from the trust—therefore you would lose 100 percent of principal. Given that your security only comprises 1 percent of the deal, this could occur in a fairly short period of time.

On the other hand, suppose that you own the super senior 1A1 tranche. The senior support 1A2 tranche will protect you once the mezzanine pieces are gone. Now suppose the senior support is gone and the trust reaches 14 percent in cumulative losses. The remaining one percent of principal loss (15 percent minus 14 percent) will now hit the senior bond and therefore the senior bond investors pro rata. However, chances are that the first principal loss will not occur for years down the road.

Rather than ask what the FICO score is, or the rating, the more pertinent questions to ask are:

• What bonds are owned?
• Where are the loans?
• What are the default rates?
• What are the projected loss severities?
• Is the existing pipeline of mortgages being flushed properly prior to analyzing future losses?
• What is the voluntary prepayment speed of the trust?

Credit unions understand mortgage loans. The only difference with investments is the structure. Being the first piece to lose all principal is obviously not a good thing. But to make a loan and have cash supporting it is. It is similar to a member giving you money in a share certificate to protect against defaults. If it is a big enough share certificate and the rate is double digits, it is probably worth the risk.

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.