Mortgage Bonds Reviving Pre-Crisis Structures, Moody’s Says

Issuers in the reviving market for U.S. mortgage securities are creating debt with features not seen since before the financial crisis that can increase risks for certain investors, according to Moody’s Investors Service.

The expanding ways in which investors in the various slices of deals will share cash flows from the underlying loans raise additional “analytical challenges,” Moody’s said today in a report. The structures are creating debt -- with names including super-senior support bonds, exchangeable securities, principal-only notes and pool interest-only bonds -- in which investors in some pieces can have greater losses even with the same levels of loan defaults and repayments.

After a previous generation of mortgage bonds without government backing helped fuel a global credit seizure, Moody’s said the quality of the underlying loans in new deals remains “strong” and their senior-ranked bonds “will only incur losses in low-probability scenarios.” At the same time, some of the revived features have been exacerbating the losses in older bonds, Moody’s analyst Kruti Muni said.

“You can clearly see a difference in the performance” based on the structures, she said in a telephone interview. Muni, who’s based in New York, wrote the report with Linda Stesney and Peter McNally.

Expanding Complexity

The complexity of new non-agency mortgage bonds is expanding after Redwood Trust Inc.’s initial deals following the market’s revival in 2010 kept structures simpler to woo investors. Issuers and underwriters now may be using more complicated terms “to match different risk appetites and yield requirements” and increase demand, Moody’s said.

Sponsors employing the features cited by Moody’s include JPMorgan Chase & Co., Credit Suisse Group AG, Shellpoint Partners LLC, and Redwood, according to data compiled by Bloomberg. Underwriters that managed structuring of the deals include JPMorgan, Credit Suisse and Bank of America Corp.

Deals tied to new loans total about $12 billion this year, up from $3.5 billion in all of last year, Bloomberg data show. Sales have been building after freezing five years ago amid tumbling home values and soaring defaults, following issuance of $1.2 trillion in each of 2005 and 2006.

The transactions have all been linked to prime jumbo home loans larger than allowed in government-supported programs, rather than the riskier subprime and Alt-A debt that accounted for most securitizations before the crisis. For Fannie Mae and Freddie Mac loans with the lowest costs for most types of borrowers, the loan limits range from $417,000 to $625,500.

Excessive Risk

Federal Reserve Governor Jeremy C. Stein said in a February speech that the U.S. central bank’s stimulus measures may be fueling excessive risk-taking, citing as examples a resurgence of corporate loans with limited covenants and bonds with payment-in-kind structures that allow companies to make interest payments in the form of extra debt.

Mortgage-backed securities can slice up the cash flows from the underlying loan pools in numerous ways.

Super senior support bonds are created by allocating losses on the underlying loans to some top-rated debt before other Aaa bonds. Depending on how early principal repayments get split, the timing can put either class at more risk amid large levels of losses, according to Moody’s. Junior-ranked Aaa notes can also be relatively “thin,” meaning investors in those can be wiped out quicker than buyers of other pieces, the firm said.

Exchangeable Securities

Exchangeable securities give investors the option of swapping one type of note for one or more of another. Some versions can lead to super senior support bonds being created, Moody’s said.

Principal-only bonds can be tied to “a subset of loans in the securitized pool that carry relatively low mortgage rates,” allowing other securities to offer higher yields, the firm said. The low rates on the loans mean they are likely to pay off more slowly, “leaving the PO bonds with greater exposure to later losses.”

Pool interest-only bonds “have notional balances tied to the aggregate principal balances of the loans in the mortgage pools,” differing from IOs that reference only the size of a senior class, Moody’s said. They can be more at risk of shorter lives, offering fewer payments, because of defaults and certain pool IOs can heighten the risks of losses to other bonds caused by loan modifications, the firm said.

Doing ‘Homework’

Redwood, which used those notes in a July deal, has a “done lot to help restart” the market and eschewed other risky terms, Michael McMahon, a spokesman, said in an e-mail. “Investors have sufficient time to analyze structures, and the investor base does their own homework in the post-crisis world.”

Spokesmen for other sponsors and underwriters either declined to comment or didn’t return e-mail messages.

Mortgage-bond issuers including JPMorgan and Credit Suisse have also introduced terms since the crisis that create new investor risks, seeking to limit when and how investors can force repurchases of mortgages that fail to match their stated quality. The banks are responding to the billions of dollars of costs for buybacks of loans with flaws they’ve said were often unrelated to the reasons that borrowers defaulted.

In March, Moody’s criticized the top grades that competitors assigned to $571 million of JPMorgan securities because of such terms, after saying a month earlier that “significant” restrictions probably would limit its rankings to as high as its Aa tier. Fitch Ratings, Standard & Poor’s, Kroll Bond Rating Agency and DBRS Ltd. have said on some deals they required more loss protection because of weaker repurchase protocols.

The congressionally appointed Financial Crisis Inquiry Commission and a Senate investigative panel blamed inflated ratings on mortgage bonds for helping to fuel the worst economic slump since the Great Depression.