Re-Securitization Fears Show Everyone&#39;s Still Fighting The Last War

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The popular deals are known as "re-remic," which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.

Regulators are pushing back, saying the transactions don't have enough substance and stand to benefit bankers and ratings firms...U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, "The credit-rating agencies could be setting us up for problems all over again."

The process of securitization allows diversification: you can take a pool of assets, called collateral, and then assign various priority to the cash flows of these assets (which are basically bonds). Diversification is generally a good thing. The most senior is rated AAA, and when done appropriately, has an extremely low default rate. Then there are AA, A or BBB pieces, and sometimes a mezzanine piece rated BB or B (ie, junk). The least senior piece is simply equity, and the issuer generally retains an interest in the most junior set of residual cash flows. is mainly one of diversification.

Many firms specialize in holding AAA debt, and it often is efficient to move this from the loan issuers, to other institutions. Now we know everyone screwed up with rating mortgage AAA bonds, they assumed housing prices would not fall. It was not a subtle mistake only perceptible via reverse engineering a complex security or copula.

The continued resistance to anything similar to what blew up before highlights the adage about generals are always fighting the last war. Many people lost money on mortgages. Those mistakes will not happen again in that asset class for a generation. Yet, regulators and regulators are finely attuned to anything with mortgage securitization.

I remember when I worked at Moody's and someone was telling me that since the 1990 Commercial Real Estate debacle, defaults in this asset class were well below average across the board for the subsequent decade. In the aftermath of that crisis, newly issued Commercial Real Estate Asset Backed securities did very well, because everyone was especially cognizant of the risk factors involved: investors, ratings agencies, regulators, issuers, even borrowers. A similar thing happened in railroads after the Penn Central railroad defaulted in the early 1970s.

It would be wise to focus not on mortgages, which have enough skepticism, but rather the current 'low risk' investments. Things related to energy, or health care, seem highly risky because they have done relatively well, and regulations could drastically change profitability within those sectors. A good rule of thumb in debt is whatever sector did worst in the last recession, will perform above average in the next.

(This post first appeared on the author's blog)

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