Why are assets toxic?

An explanation for those who can’t understand how so many assets backed by mortgages can be worth nothing at all

From 2005 through the first half of 2007 approximately $2.8 trillion in mortgage backed securities were issued by the private sector. These securities were backed by $1.1 trillion in sub-prime loans, $0.9 trillion in Alt-A loans and $0.6 trillion in prime jumbo loans (and $0.2 trillion in “other” loans). Data in intro here.

I estimate that these $2 trillion in non-prime loans and $0.6 trillion in prime jumbo loans back $4.1 trillion in AAA mortgage related securities. How is it possible to have more AAA assets than underlying loans? Through the magic of credit default swaps.

I should be clear, however: I am including in my $4.1 trillion figure $1.75 trillion of unfunded tranches of mortgage backed securities and CDOs. The data on mortgage backed securities and CDOs that is reported almost never includes unfunded tranches, because these tranches are more comparable to insurance contracts than to bonds. I include them in my estimate of triple A “assets”, because these insurance contracts can result in losses that appear on financial institution balance sheets, just as if they were funded tranches of CDOs.

Credit default swaps were used in two ways to increase the quantity of mortgage related securities available to investors. CDOs sold credit default swap protection on mortgage backed securities in order to increase their exposure to the mortgage market and CDOs bought credit default swap protection from highly rated financial institutions in lieu of selling their senior-most tranches to cash investors. (Some mortgage backed securities did the same on mortgage loans, but since the process was most commonly used by CDOs, I will refer only to CDOs from here on.)

To understand what was going on, you need to realize that mortgage securities were the hot product of the mid-naughties. Mortgages, and especially high-yield mortgages and mortgage backed securities, were in such demand that the average structured financier simply could not find enough for the CDOs he wanted to ramp up. In 2005 innovation in the credit default swap market opened up the possibility that a structured financier could create a CDO that was constructed of 10% mortgage backed securities backed by real loans (known as cash assets) and 90% credit default swaps (known as synthetic assets). Credit default swaps make a payment when the mortgage backed security referenced by the swap defaults. The investor was taking on a risk comparable to a 100% cash CDO, but the financier only needed to purchase one-tenth the quantity of mortgage backed securities he had had to find for a comparable CDO in 2004. The other nine tenths of the investors’ exposure came from using credit default swaps to reference mortgage backed securities that had already been packaged into other CDOs. Credit default swaps on mortgage backed securities made life a lot easier for structured financiers.

One consequence of the use of synthetic assets is, however, that more than one investor has exposure to each subprime mortgage backed security and thus to each underlying subprime loan. Another consequence is that structured financiers did not need cash to buy 100% of the assets in the CDO. Most credit default swaps are at least partially unfunded. This means that the seller of CDS protection promises to come up with cash in case of a default, but does not post cash to guarantee his capacity to do so when he signs the contract. When a CDO included synthetic assets, the structured financier only needed to raise enough cash – or sell enough tranches of the CDO – to cover the costs of the cash assets. You may ask, “But what’s the point of creating this huge CDO, if you’re only going to bother to fund 10% of the tranches?” The other 90% of the CDO, specifically the last-to-take-losses tranche of the CDO, could be “sold” to a large financial institution, like AIG or a monoline insurance company, or even held at the originating bank (e.g. UBS). That is, the financial institution would sell credit default protection to the CDO to cover any losses that were not covered by cash investors.

Whenever you hear someone talk about a “super senior” tranche of a security, this is precisely what they mean – some financial institution has written a credit default swap promising to pay up if defaults exceed the amount covered by the cash investors in the security. Super senior tranches of mortgage backed securities and CDOs are almost never funded.

If it happened that a structured financier had a CDO with more cash investors than cash assets, the extra cash was stored in “safe assets”, such as Treasury or agency securities or guaranteed investment contracts (GICs) issued by large insurance companies.

Now, perhaps, you begin to understand how it is possible for $2.6 trillion in mortgage loans to back $4.1 trillion in AAA securities. Quite a few of those securities were never funded and are really just promises to make a payment when there is a default on a referenced mortgage.

It’s also important to understand that the cash investors in CDOs – those who believed they were buying a “mortgage backed bond” – are going to be the first to lose their money. Why? Because there are many different classes of AAA securities – and it is the financial institutions that sold super senior credit default swap insurance that have a senior claim to any loans that do not default or that have significant recovery. The cash investors in every case bought subordinate AAA CDO securities that are guaranteed to be wiped out if defaults rise beyond a certain level. (Diagram 1 is drawn to scale, so that you can see visually the fraction of losses that will wipe out the subordinate AAA tranche.)

Notice something else about the consequences of this CDO structure given the housing crisis. As it is the super senior counterparties who have first claim to the underlying value of the mortgages, all that underlying value is likely to do is to reduce the amount that the super senior counterparties have to pay out in “insurance”. Since these counterparties initially assumed that there was almost no likelihood that they would make any payment at all, they were never prepared to pay out the whole notional value of the swap.

Thus, when spectators assume that the losses can’t really be too bad, because after all these are assets backed by real estate and there will be some recovery, they are failing to understand the nature of the ABS CDO market: (1) because the CDOs were built on high yield MBS tranches, their value can be wiped out entirely if sub-prime losses exceed 25%, Alt-A losses exceed 10% and Prime Jumbo losses exceed 3%; and (2) the super senior counterparties did not provision for making payment on their obligations. Whereas the cash investors have already put up cash that may be lost, the super senior counterparties will need to come up with the cash as defaults are recognized. Thus the super senior counterparties face not only losses on the balance sheet reducing their equity, but also a liquidity squeeze as they are forced to make payments on more than $1 trillion of swap obligations.

AIG was the first to be caught by this liquidity squeeze, but the monoline insurers are still struggling to manage the problem; the Swiss National Bank stepped in to save UBS from its embarrassments; and Citigroup had to take some super senior swaps on balance sheet in 2007 when its asset backed commercial paper conduits began to implode. Furthermore, a complete breakdown of the financial institutions exposed to super senior cash calls has yet to be made public.

Secondly, some mortgage backed securities have the same CDS based super senior structure as CDOs. While I have only located one explicit example of such an MBS (BSARM 2006-2 discussed in “Bear Stearns Quick Guide to Non-Agency Mortgage Backed Securities”) and have found no data on this issue, it was widely recognized that super senior MBS was being issued. Ominously, BSARM 2006-2 had a super senior tranche that amounted to more than 90% of the total value of the MBS. In diagram 1, I have guesstimated that $0.5 trillion of super senior swaps on MBS were issued. This would mean that in addition to the funded MBS on which we have data, there was another 20% of unfunded MBS issued.

Diagram 1 shows my estimate of the AAA assets backed by the $2.6 trillion in mortgages loans that got packaged into mortgage backed securities from 2005 through mid 2007. Diagram 2 shows the consequences of 25% losses on subprime loans, 15% losses on Alt A loans and 3% losses on prime jumbo loans.

The basic story is explained clearly in Fabozzi. My estimate of super senior ABS CDOs backed by MBS is derived as follows: From SIFMA we know that $685 billion in funded structured finance CDO tranches were issued from 2005 through 2007 Q2. I assume that 80% of the structured finance products backing these CDOs were MBS (see Fabozzi p. 175) giving us $540 billion of “mortgage backed” funded CDO tranches. I then assume that 70% of the ABS CDO structure was the unfunded super senior tranche (see Fabozzi p. 142) resulting in a total – i.e. funded plus unfunded – "mortgage backed" ABS CDO issuance of $1.8 trillion.