Toomre Capital Markets LLC

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PIK Your Own Poison

Toomre Capital Markets LLC (“TCM”) has been quite concerned about the future of mortgage finance in America. Back in July 2008, TCM created the post Fannie Mae, Freddie Mac and Future of Mortgage Finance. The key point of this post was the need for “the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to ‘turn’ the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.”

Some four months later, the GSE’s have effectively been seized by the Federal government. Lehman Brothers has gone bankrupt. Merrill Lynch has agreed to be become part of Bank of America. And both Goldman Sachs and Morgan Stanley have become bank holding companies actively looking to attract deposits. As predicted in that July post, institutional investors have “gone on strike” against mortgage-backed securities (“MBS”). As a result, in the last week both residential and commercial mortgage backed securities have widened to extreme spreads against swap spreads. Those spreads narrowed considerably this week with the announcement that the Federal Reserve will be buying up to $100 billion in GSE debentures as well as $500 billion in agency pass-through securities.

Still, there is little discussion about the future of mortgage finance in America. In order for the American residential mortgage market to stabilize, there needs to be available financing for well-underwritten home mortgage loans. These purchases by the Federal Reserve are a temporary solution. There no longer is a savings and loan industry to provide the long-term holdings of MBS. The community and commercial banks are capital constrained and looking forward to greater losses on many types of loans as the credit crisis worsens becoming perhaps the worst recession since the Great Depression.

Part of the reason for the GSEs conservatorship was that it was deemed that their portfolios were too large for their capital bases, especially given projected future losses due to the decline in residential real estate prices. As mentioned above, the various traditional institutional investors who previously bought securitized MBS and their “sliced and diced derivates” such as CMOs, CDOs, and private pass-throughs are on a “buyer’s strike”. In many cases, these institutional investors also are trying to reduce their exposures to the mortgage sector.

Toomre Capital Markets LLC has long suspected that the securitization process will be key to answering this quandary about where longer-term mortgages should be financed in America. There is a critical problem that has been displayed in how that business was conducted prior to the current credit crisis. As a loan moved from the mortgage originator to the mortgage wholesaler to a warehouse facility to Wall Street and eventually on to institutional investors (blessed of course with a high-grade by one or more of the rating agencies), no one had a vested interest in the quality of the underlying mortgage loan. For several months now, it has been clearly understood that for the securitization process to restart, each part of the process will need to have some “skin in the game.”

On Wednesday, November 26th 2008, New York Times columnist Joe Nocera devoted his column entitled PIK Your Own Poison to a truly excellent article written by Emanuel Derman. This is one of the best “thought” articles that TCM has read about possibly to restart the securitization process. Interested readers, particularly those interested in the subject of mortgage finance and securitization, are urged to read this article in its entirety. The article starts

Emanuel Derman is a former physicist-turned-Goldman Sachs quant who helped create several widely-used options models in the late 1980s and early 1990s. He now runs the program in financial engineering at Columbia where he thinks and write and teaches about risk management issues, and is also a principal at Prisma Capital Partners. Recently, he sent me an article he had written about how we might begin to “recreate trust in the financial supply chain,” as he puts it. I asked him if he would share his article with Executive Suite’s readers. Happily he said yes.

“All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face with sober senses, his real conditions of life, and his relations with his kind,” wrote Engels and Marx in The Communist Manifesto. They were describing what chemists call sublimation, the process by which a solid changes directly into a gas without passing through an intermediate liquid phase, an apt term for the past few months of evanescent financial values and firms.

This insubstantiality is not surprising — it’s modernity itself. Developed economies now revolve around service rather than solidity, and the growth of seemingly arcane financial securities personifies this trend. The assets of financial firms are predominantly people, and their product is service and ideas. Securities are not cars or iPods; they are things of the mind, about as unsolid as you can get, obligations or contingent promises created by people, once upon a time inscribed on pieces of paper and now, increasingly, encoded on magnetized bits of computer memory. Once invented, they can be replicated over and over again, cheaply.

One airy invention is the PIK (payment-in-kind) bond, a loan that pays its promised interest in additional bonds of the same kind, as opposed to solid cash. It sounds insubstantial, a barely disguised pyramid scheme in which you make your promised payments each time with further promises of payment, each at least as chancy as a subprime CDO. But think about the dollar: deposit it in the bank for a year and you get more dollars at the end. What is paper money but a PIK, an early derivatives contract? To trust it you have to trust the country that provide its value, and the same is true of payment in kind. Used wisely, maybe payment in kind can serve as hallmark of trust in the financial supply chain too.

Toomre Capital Markets LLC would like to thank Emanuel Darman for his contribution to the discussion about “how to recreate trust in the financial supply chain” and strongly urges readers to review this column in its entirety. Reader comments and thoughts are welcome.