Q&A with Emily Hollis

Emily Hollis
June 11, 2009 | COMMENTS

Question: I read a recent article analyzing one of WesCorp's securities: CUSIP 751153AC. The bond did not appear that bad and indicated only minimal losses, which wouldn't be incurred for five years; what are your thoughts?

The article revealed only the most optimistic scenario. I disagree with the statement “models are simply tools which depend on economist's inputs.” It does not take an economist to observe that loans in California and Florida are foreclosing at overwhelming levels and realizing huge loss severities.

The security modeled was not a “senior” bond, but rather a “senior support bond” – there is a big difference between the two. Although senior supports generally are paid pro rata with senior bonds in principal paydowns, they support senior bonds by absorbing credit losses. The analysis is simple; when credit support is depleted, the bond starts losing principal.

We are projecting that this security will lose 53 percent of its value in less than one year. This is based less on economist's projections and more on what is occurring in the market today. Facts about the bond are as follows:

• The security is backed by Alt-A option ARM loans issued in 2007
• 90+ day cumulative delinquencies are at 39 percent
• 58 percent of the loans are located in California
• Loan to values averaged 80 percent in 2007
• Credit support is 8.7 percent
• Current amount of the underlying loans is $749 million
• Current principal amount of the senior support bond is $102 million
• Cumulative losses are currently 3.0 percent

It does not take an expert to realize the obvious: that greater than 90-day cumulative delinquencies of 39 percent is a major problem. It is only a matter of time before these losses accumulate to a level that wipes out the credit supports.

How long will it take? According to our analysis, it looks like it will be around October of this year. You do the math. Assume that 75 percent of greater than 90-day delinquencies go into default and the homes are sold at a 50 percent loss severity (not a conservative number with current California home sales) over a period of one year. (39% X 75% X $749 million X 0.50 = $110 million). This bond is only supported with $65 million ($749 million of underlying loans times 8.7 percent credit support) of securities underneath it before it loses its first dollar. It is highly likely that the bond is going to have losses as a result of what is currently in the pipeline irrespective of future delinquencies.

If you take a look at the graphs below, we are projecting, given today's markets, that the securities supporting this bond will be depleted by October 2009. Once this happens, the bond begins to absorb the credit losses in order to protect the most senior bonds.

There is some good news. This senior support bond receives principal pro rata to the senior bond; therefore, every month that homeowners prepay principal, it is passed through pro rata to the senior support and the senior bonds. We are projecting that by the time the security receives its first loss, its balance will be approximately $92.35 million. Unfortunately, the bad news is by April of next year, we project that 53 percent of the security's principal will be depleted.

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.