Wall Street Wizardry Reworks Mortgages
Repackaged Investments Are Good for Bankers and Ratings Firms, but the Regulators Scoff
By Leslie Scism and Randall Smith
The Wall Street Journal
October 2, 2009
A new wave of financial alchemy is emerging on Wall Street as banks and insurers seek to make soured securities look better. Regulators are pushing back, saying the transactions don't have enough substance and stand to benefit bankers and ratings firms.
The deals come as Wall Street firms, buoyed by surging markets, are seeking to profit from the unwinding of the complicated securities that helped fuel the credit crisis. Regulators, meanwhile, are struggling to prevent a recurrence of the crisis.
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.
The net result is financial firms' books look better and they need to hold less capital against those assets, even though they are the same assets they held before the transaction.
Some state insurance regulators worry that current ratings are flawed -- perhaps even too harsh -- for determining the capital that should back up residential-mortgage securities. But they are chafing at the re-remic strategy. That's partly because of the fees and partly because re-remics rely on ratings firms -- faulted for failing early on to identify problems with mortgage-backed bonds -- to rate the new securities.
At hearings Wednesday on Capitol Hill focused on the 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."
New York and some other key regulators are considering an alternative to re-remics that doesn't entail insurers paying millions in fees to investment banks and the ratings firms; they also have debated possibly unfavorable accounting treatment for the re-remic deals.
Regulators would like "a lot fewer dollars" paid to Wall Street, as well as "less reliance on the ratings agencies," said Kermitt Brooks, first deputy insurance superintendent in New York. The state is an important voice on financial matters at the National Association of Insurance Commissioners, or NAIC.
The alternative solution, proposed by trade group American Council of Life Insurers, calls for hiring an analytical firm with expertise in residential mortgage-backed securities to help regulators determine the value of deteriorated holdings on insurers' books, bypassing the ratings providers. This firm would help size up potential losses and how much capital the insurers need to hold.
The re-remic accounting treatment, meanwhile, is expected to be taken up at a meeting of NAIC regulators in December.
It is unclear how big a concern this is for banking regulators. Alabama Deputy Banking Superintendent Trabo Reed said he has seen only a few examples of re-remics. His concern is that banks engaging in this practice account for it correctly.
From a Trickle to Flood
Wall Street analysts said activity in re-remics has ramped up this year, from a trickle in January to several billion dollars from March to June, with a big increase in volume in July, partly thanks to reviving credit markets.
Estimates of volume this year range from $30 billion to more than $90 billion. The transactions are typically done as private placements and aren't disclosed publicly.
A hypothetical example cited in research by Barclays Capital said that a $100 million asset that required $2 million in capital at a triple-A rating may require $35 million if downgraded to double-B-minus. At triple-C, the capital requirement might rise to 100%, or $100 million.
In a re-remic, three-fourths of the same asset may regain a triple-A rating, requiring just $1.5 million in capital, Barclays said. The remaining one-quarter may require 100% capital, but the total capital requirement would fall to $26.5 million.
Wall Street bankers and analysts said a minority of re-remics, perhaps as little as 10% to 30%, are aimed at helping firms like insurers manage capital requirements. The general goal, as one banker put it, is to help "create buyers for orphan securities that otherwise would have languished."
"There is $350 billion to $400 billion in market value of securities with no natural buyer due to their rating," Barclays said in a June report. "The re-remic market provides a way out of this gridlock by creating new AAA securities, which are likely to be viewed as attractively priced."
Wall Street firms that have acted as middlemen in re-remics include J.P. Morgan Chase & Co., Credit Suisse Group, Jefferies & Co., Royal Bank of Scotland Group PLC, as well as Barclays PLC, according to a Barclays tally.
Citigroup Inc., meanwhile, is pursuing its own re-remic strategy, to repackage some toxic real-estate securities on its balance sheet, according to people familiar with the bank.
Insurance executives estimate that insurers pay 0.35% or so of a deal's size in investment banking, ratings firm, legal and other costs.
American Equity Investment Life Holding Co. has told analysts that it is considering a re-remic. Recent downgrades of its mortgage bonds overstate their risk by a wide margin, its executives said.
Still, a re-remic is "not cheap," John Matovina, the company's finance chief, said in an interview.
On Sept. 15, an executive at American Financial Group Inc. noted to investors that re-remic transactions there involving about $1.2 billion of mortgage bonds provide "flexibility." And Protective Life Corp. said in August that its re-remics, totaling about $1.4 billion, improve the company's capital standing "in the ballpark" of $75 million.
At an NAIC hearing last week, ratings firms described changes over the past year to improve their analytical, compliance and corporate-governance processes. But they also generally agreed that their ratings weren't ideal as a sole basis for determining insurers' capital levels.
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