ABS East 2010. Time of disconnect.

The annual securitization industry conference has just concluded in Miami. I attended it mostly due to gracious gesture of my former colleague who got me a free pass at the very last moment. Since I’ve been out of industry for a year I had to get current on recent developments. My second reason for going was anthropological, of course. I wanted to get a general feel of the market participants.
I will get very specific with terms during my observations, but I will make the best effort to explain terms to the uninitiated. This is not, after all, a financial blog.

But first things first. The biggest topic of discussion and concern at the conference was government and legislative actions. After attending a few panels and listening to speakers from different camps I came to sad conclusion that Wall Street, Government and regulatory and legislative bodies are a beast with more than two hands and naturally neither hand knows what the other is doing. First, let me describe the participants. Each panel consisted of specialists in that particular area of expertise. If it was a regulatory panel – there were people from some government agencies, FDIC, OCC, etc. If it was a research panel – it had a bunch of analysts on it, and if it was a traders’ panel – you guessed it! Normally, at this sort of conferences, I would just skip the lectures all together and hang out by the pool or at the bar with salespeople, but this time I wanted to make full use of the conference pass acquired through the kindness of others. I had to go listen to the panelists in order to refresh my memory on things and get the feel on the state of current affairs. So the uncertainty about legislative maneuvers was on everybody’s minds. Because this is not a specialty industry publication and it’s not even a market blog I will not delve into the specifics about deals and bonds performance. (Those who are interested to know about trade ideas can ask me specifically, but being in a generous mood I put a few at the end of the post). I will try to make it into a 3d party observation from 10,000 foot view.

“It’s not the product, it’s the macro.”

Binary would be a word I use to describe people’s perceptions of the market. You see, bonds – corporate, mortgage and government have rallied to unprecedented levels. Investors are hungry for yield and they really can’t get it anywhere, unless they go down capital structure. But this is where things become tricky. There are still bonds out there that can make you 20% but there’s no way you can run any sort of analysis on these bonds, because it’s not the prepays, defaults and severities you should be concerned about, but how the new legislature will treat foreclosures, short sales, bondholders interests vs. taxpayers interests, etc. This is the kind of risk that you can’t measure – a non-economic risk. In essence you analysis turns into a coin toss. A funny thing happened at one of the traders’ panels with Josh Weintraub (JW) on it. JW is a mortgage industry veteran, but that’s not important right now. I’m just trying to tell you a funny but illustrative story.
We’re sitting there, in a rather small colloquial room with maybe 50 people. Josh and a couple of other traders on the panel proceed to describe in down to earth terms (unlike the government and regulatory folks) what the situation is, where we can find value, what to avoid, etc. Then, suddenly a hand rises in the audience and some guy wants to ask a question. Please forgive me, but I will get into some jargon right now. After JW said that they hedge interest rate risk with buying IOs (interest onlys, it’s a bond that has no principal and pays only interest for some period of time, you get it for like cents on the dollar) the guy asks how do they determine the amount of hedge – do they use OAS (Option-Adjusted Spread)? For those outside the industry let me just say that using OAS to price a bond in this environment is like using Ipad to hammer the nail into the piece of wood. OAS is a fancy shit invented by a bunch of PhDs with too many degrees and too much spare time on their hands. It used to work in their fancy models until it didn’t. Like any other fancy statistical tool it works fine 99% of the time until some sigma event happens. Guys using OAS are akin to the highly skilled swordsman, who gets shot by non pretentious Indiana Jones. But I digress. So JW, slightly surprised to hear this kind of question after everything he said, proceeded to say that in this day and age they really just rely on cash-flow methodology vs. OAS and continued on. “But how do you measure the probability, do you use historical data?” – the guy was really implacable. JW, mildly annoyed, with WTF expression on his face, nonetheless smiled and exclaimed “Well, that’s the beauty, isn’t it, that really is the trick!” and patiently proceeded to repeat, in different terms, that in this kind of environment there are other kinds of uncertainties that cannot be measured. I thought that would be the end of it. But then the guy asks him again – as if he didn’t hear what has just been said – “What model inputs do you use, is there something we don’t think about?” Stunned silence fell over the room, interrupted by giggles stemming from fratboys in the audience, unable to hold it back anymore. Josh, ultimately astonished, was at a loss for words for a moment and, fighting back laughter, figuring that the more nuances he gives this guy, the more questions he will have, went for a foolproof answer: “Just be concerned about the macro, not the product itself!” Everyone in the room exhaled with relief. But this was not the end. Another hand rises in the room. “I just walked around the vendor’s site and a lot of guys out there are offering all these elaborate models to price bonds– what model or software do you use?” Guys, do you ever get the feeling where you’re embarrassed for other guy? This is how I felt at the moment. And I felt sorry for Josh, who probably thought to himself – “Who are these guys?” “Well, Intex and some in-house models, but we do not necessarily rely on the outcomes” – he said and was echoed by the 2 other flabbergasted guys on the panel.
I used this story as an illustration of the disconnect in investors’ perceptions about current situation. I would call it situational awareness or lack of it. Apart from that, can you believe that there are still guys out there who have ratings guidelines – I’m not kidding! But after listening to those questions I’m not surprised that there are. What’s more is that, and this is rather depressing, in the recent Dodd-Frank proposal there’s a provision that prohibits regulators to rely on ratings – and that does not make them happy! Yeah, because, OMG!, they would actually have to do the work themselves! But not to worry! There will be loopholes in the new law that would only force the regulators to use ratings “when appropriate” and rely on actual analytics in all “other cases”. Needless to say, the definition of “appropriate”, I suspect, will be rather loose. But that’s not the only disconnect that was apparent to me as I listened to more speakers. I think the reason people tend to love and trust models is because they are lazy. They spend some time building it, then feed some data into it, then test the results for like a year (statistical negligence) and then rest on the laurels and occasionally tweak inputs. And of course, lazy guys are more abundant in the regulatory field than on Wall Street. Wall Street can make a good business out of selling their models to regulators – this way they’ll kill many birds with one stone: make money from the sale and maintenance of the models, keep regulators happy and, this is very crucial, know what’s on regulators’ mind.

One of the most boring panels I listened to was about regulatory requirements for banks. You see, the government wants banks to lend and yet threatens to raise capital requirements for holding those loans on the balance sheets, which will, in turn, force banks to securitize. But nothing is being securitized right now, so the banks will hold on to the cash they have and not lend. So banks are flush with cash and don’t know where to put it. Where else such a massive rally in bonds came from? When the choice is between lending, which comes with too many rules and guidelines and hassles these days, and buying bonds what would you rather do? Here’s the disconnect #2: While the regulators are trying to figure out how to regulate one activity, banks have already moved on to the next.

Disconnect #3: There’s also a disconnect between Fed and legislature on securitization. Chris Flanagan thinks that Fed understands nuances about securitization and the need for it and the legislators don’t. But there’s only that much the Fed can do and the legislators will be the ones writing the new law. It will all come down to how they will eventually define what a securitization is.

I think that ultimately there will be business as usual on Wall Street. Whether it will take 6 months or a year or more – it doesn’t matter. No matter how tough the new regulatory law they will write and how restrictive they will be to appease the public – there will always be a small loophole that renders the whole new law essentially useless. The legislators have no capacity to anticipate what might happen, they are a reactive body and I’m not even discriminating between Republicans and Democrats. The get-tough-on-Wall-Street Democrats will write some strict law, the wily Republicans will mitigate it with some small print provisions. The public by that point will be confused with so many details and provisions and exceptions, that they will not be able to explain whether they are for or against it. By that point – no one will care. The Wall Street will grumble about being made a scapegoat and will proceed to make use of the loopholes. What it comes down to is this: There’s a demand for yield, so it shall be provided. How? Don’t ask.

My anthropological conclusions: I figured that after the industry has shed so many workers, those who stayed are the cream of the crop (unlike me) and really know what they are doing. Judging by the questions I heard – I’m beginning to doubt that. But on the other hand, why would you want your clients to know too much? So it’s a win-win for everybody. But still, too many salesmen and broker-dealers chasing too few accounts. Regulators and government officials – don’t even get me started. Some of them understand what’s going on but voices of reason tend to be too nuanced to be heard. I haven’t really met any PMs, I think those juicy accounts have been ushered into private meeting rooms and into boat rides. The rest of attendees were vendors peddling useless crap. But I had a very productive time and got a good color on many things. And the parties were great!

Some near term ideas:
There’s still more room to tighten, technicals are still strong. Much focus in servicing risk, like I said – it’s binary, some guys like it, some don’t. Those who understand how a particular servicer works can have an edge.
Mezzanine investors, since there’s nothing left of those in the RMBS, like CLO subs originally rated BB, B and equity. They think BBs will pay off in all likelihood, plus you get a lot of duration, 5-7 years, with a double digit yield. CLOs didn’t have much in a way of losses, unlike MBS, so even equity pieces can be attractive – front-loaded payoff, you can get like 20 pts a year.
John Devaney likes following trades: Oh, come on, guys I already told you enough.


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