• C++ Programming for Financial Engineering
    Highly recommended by thousands of MFE students. Covers essential C++ topics with applications to financial engineering. Learn more Join!
    Python for Finance with Intro to Data Science
    Gain practical understanding of Python to read, understand, and write professional Python code for your first day on the job. Learn more Join!
    An Intuition-Based Options Primer for FE
    Ideal for entry level positions interviews and graduate studies, specializing in options trading arbitrage and options valuation models. Learn more Join!

Toxic CDOs Given Up for Dead Coming to Life With Pension Funds

Toxic CDOs Given Up for Dead Coming to Life With Pension Funds

By Jody Shenn

July 8 (Bloomberg) -- CDOs are back.

Collateralized debt obligations that helped drive banks to $400 billion of writedowns and credit losses are finding buyers under a different name: Re-Remics.

Goldman Sachs Group Inc., JPMorgan Chase & Co. and at least six other firms are repackaging unwanted mortgage bonds as sales of CDOs composed of asset-backed securities fall to less than $1 billion this year from $227 billion in 2007 because of the global credit crunch. Re-Remics contain parts that are structured to guard against higher losses on underlying loans than most CDOs, allowing holders to sell or retain other sections at lower prices that can translate to potential yields of more than 20 percent.

``It's just the reincarnation of the CDO,'' said Paul Colonna, who manages more than $100 billion as chief investment officer for fixed income at GE Asset Management in Stamford, Connecticut. ``The mechanics are the same, but you're getting in at a much different level of valuation.''

GE Asset Management has considered buying the debt, Colonna said. The General Electric Co. unit may also have Re-Remics made out of bonds it owns if disposing of the riskier pieces boosts the securities' overall value.

Re-Remic stands for ``resecuritizations of real estate mortgage investment conduits,'' the formal name of mortgage bonds. Sales of the securities may help revive the market for new home-loan debt, according to Bernard Maas, an analyst in New York at credit-rating firm DBRS Ltd.

`Look to Restart'

``The hope is that by moving illiquid bonds to interested parties, the structured-finance community can look to restart,'' he said.

More than $9.3 billion of Re-Remics were created in the first five months of 2008, almost triple a year ago, according to Inside MBS & ABS. The debt represented 47 percent of mortgage bonds issued in the period, excluding those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.

A record $25 billion of Re-Remics were formed in 2007, the newsletter said. Sales in 2008 may exceed that, according to Sharon Greenberg, a Barclays Capital analyst in New York.
Unlike most CDOS, Re-Remics don't own debt or credit-default swaps based on the lowest-ranking subprime mortgage-bond classes. They are composed of AAA rated bonds backed by so-called Alt-A mortgages, issued to borrowers with higher credit scores who don't prove their incomes, seek higher debt ratios or buy investment properties.

Few Bonds

While CDOs are backed by more than a hundred bonds, Re- Remics typically combine fewer than a dozen, allowing holders to more easily analyze the debt.
Holders of mortgage bonds use Re-Remics to separate better- quality from riskier debt. That increases the chance the higher- ranked debt will retain its AAA rating, enhancing its value enough to boost the total worth of the mortgage pool, said Doug Dachille, chief executive officer of New York-based First Principles Capital Management LLC, which oversees $7 billion in fixed-income investments.

Lower-ranked pieces of the Re-Remics would be the first to record losses from defaults on the underlying mortgages, once lower-ranking bonds from the initial deals are wiped out, Dachille said.

A bond trading at 40 cents on the dollar could be split into a piece worth 80 cents and another piece that could then be sold cheaply enough to offer returns as high as 20 percent, Dachille said. Banks advised by First Principles bought lower-yielding senior pieces and some are also considering buying the bonds for their pension funds, he said. The firm is also starting a fund for pension clients that would invest in the debt, Dachille said.

`Credit Support'

``A lot of the stuff they wouldn't buy without the additional credit support,'' he said. ``They're happy with the 7.5 percent return. They just wanted greater certainty that they're going to get that 7.5 percent return.''

Transamerica Life Insurance Co., a unit of the Hague-based Aegon NV, is among holders of Re-Remics created this year by Lehman Brothers Holdings Inc., according to data compiled by Bloomberg. Reliance Standard Life Insurance Co., a unit of Wilmington, Delaware-based Delphi Financial Group Inc., owns a Re-Remic created by Countrywide Financial Corp., the data show. Cindy Nodorft, an Aegon spokeswoman, declined to comment. Bernard Kilkelly, a spokesman at Delphi, didn't return a message.

``It's one of the few cases where re-securitization actually increases, rather than destroys, value,'' said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. He wouldn't disclose whether the Newport Beach, California-based firm, the world's largest fixed-income manager, has bought the debt or used Re-Remics to repackage debt held by its funds.

$370 Billion

Commercial banks and savings-and-loans held more than $370 billion of non-agency mortgage bonds on March 31, according to Federal Deposit Insurance Corp. data. Much of that can only be sold at fire-sale prices after record subprime-mortgage defaults and home-price declines sparked losses on the underlying loans.

``This is an attempt to shake things up,'' said Scott Kirby, who manages about $20 billion of structured-finance securities at Ameriprise Financial Inc.'s RiverSource Investments LLC in Minneapolis. ``There's a lot of paper floating around that's having difficulty finding a home.''
CDOs, once the fastest-growing part of the debt markets, tumbled to zero cents on the dollar and credit ratings on some AAA pieces were cut to junk levels.

Goldman Sachs, based in New York, had about $15 billion of residential-mortgage securities on its books as of May 30, Chief Financial Officer David Viniar said on a conference call last month. New York-based JPMorgan's investment bank had $12.8 billion of prime and Alt-A securities as of March 31, according to an investor presentation in April. Lehman had $15 billion of home-loan assets as of May 30, CFO Ian Lowitt said on a conference call last month.
Restructuring Needed

``There are ample bonds that would fit the description of needing restructuring,'' Greenberg, the Barclays analyst, said.

Banks can increase the total credit quality of their assets by selling off lower-rated pieces and keeping the better part, Matthew Jozoff, an analyst at JPMorgan said. Avoiding downgrades also would prevent the banks from having to hold more capital to protect against losses on the debt.

Goldman spokesman Michael Duvally, JPMorgan spokeswoman Tasha Pelio and Lehman spokesman Mark Lane declined to comment.

Riskier Re-Remic mortgage securities are ``natural fit'' for hedge funds, according to a June 27 report by JPMorgan's Jozoff and John Sim. The debt offers higher potential yields at a time when it's difficult to borrow to boost returns, they wrote.

Re-Remics have repackaged so-called non-agency mortgage securities, which lack explicit or implied government guarantees, for at least 15 years. Re-securitizations of agency mortgage bonds date to the mid-1980s under First Boston's Laurence Fink, now chief executive officer of BlackRock Inc., and Lewis Ranieri of Salomon Brothers, now chairman of Ranieri & Co., Franklin Bank Corp. and Root Markets Inc.

Today's Re-Remics are ``an opportunity for dealers to find liquidity and to move bonds out of their inventory,'' said DBRS's Maas.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.
Last Updated: July 8, 2008 00:01 EDT