Once upon a time in Mortgage Land

By Allan Sloan
Saturday, November 28, 2009

Back two years ago when the mortgage meltdown was heating up, I wrote an article with Doris Burke called "Junk Mortgages Under the Microscope" dissecting a particularly wretched issue of mortgage-backed securities peddled by Goldman Sachs. We wanted to show how these complex securities really worked and how Moody's and Standard & Poor's, the rating agencies, aided and abetted the process by giving two-thirds of an issue backed by ultra-risky second mortgages the same safety rating they gave to U.S. Treasury securities.

What we thought was a cautionary tale has turned into a horror story. All the tranches of this issue, GSAMP-2006 S3, that were originally rated below AAA have defaulted. Two of the three original AAA-rated tranches (French for "slices") are facing losses of about 90 percent, and even the "super senior," safer-than-mere-AAA slice is facing losses of 25 percent. How could this happen? And what lessons can we take away from it?

First, let's revisit the way this security was put together, and how and why it fell apart. Our tale begins in April 2006, when Goldman Sachs sold $494 million of securities to institutional investors seeking yields somewhat above those that were available on Treasuries or high-rated corporate bonds.

It was an especially hinky offering, because it was backed by second mortgages rather than by traditional first mortgages. A first mortgage rarely becomes completely worthless, because a house is usually worth something. But often all it takes is a decline of 20 percent in a home's value to wipe out a second mortgage, which is typically piled on top of an 80 percent first mortgage. In our case, borrowers' stated equity in their homes averaged less than 1 percent -- 0.71 percent, to be precise. Even that was doubtlessly overstated, because a majority of the mortgages were low-documentation and no-documentation loans.

Despite these problems, the formulas used by Moody's and S&P allowed Goldman to market the top three slices of the security -- cleverly called A-1, A-2 and A-3 -- as AAA rated. That meant they were supposedly as safe as U.S. Treasuries. But of course they weren't. More than a third of the loans were on homes in California, then a superhot market, now a frigid one. Defaults and ratings downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted and stopped making interest payments. Now every month's report by the issue's trustee, Deutsche Bank, shows that the old AAAs -- now rated D by S&P and Ca by Moody's -- continue to rot out.

Few mortgages left

As of Oct. 26, the date of the most recently available trustee's report, only $79.6 million of mortgages were left, supporting $159.9 million of bonds. In other words, each dollar of bonds had a claim on less than 50 cents of mortgages. But even worse, those mortgages aren't worth anything like their $79.6 million of face value, according to ABSNet Loan HomeVal. ABSNet, unveiled in October, combines a database from Lewtan Technologies of Waltham, Mass., that has a list of every mortgage underlying every mortgage-backed issue, with data from Collateral Analytics of Honolulu, which tracks individual home values. Their numbers give you a snapshot of the value of the collateral backing a mortgage security. As of Sept. 26 -- a slightly different date from what we're using above -- ABSNet valued the remaining mortgages in our issue at a tad above 20 percent of their face value. Now, watch this math: If the mortgages are worth 20 percent of their face value and each dollar of mortgages supports more than $2 of bonds, it means that the remaining bonds are worth maybe 10 percent of face value.

If all the originally AAA-rated bonds were the same, they'd all be facing losses of 90 percent or so in value. However, they weren't all the same. The A-1 "super senior" tranche was entitled to get all the principal payments from all the borrowers until it was paid off in full. Then A-2 and A-3 would share the repayments, then repayments would move down to the lower-rated issues.

But under the security's rules, once the M-1 tranche -- the highest-rated piece of the issue other than the A tranches -- defaulted in July 2008, all the A's began sharing in the repayments. The result is that only about 28 percent of the original A-1 "super seniors" are outstanding, compared with more than 98 percent of A-2 and A-3. If you apply a 90 percent haircut, the losses work out to about 25 percent for the "super seniors," and about 90 percent for A-2 and A-3.

This was an especially bad issue, which we picked (on the advice of some bond mavens who aren't competitors of Goldman Sachs) precisely because it was so awful. According to Bloomberg data, recent trades in the A's were at less than 7 percent of face value. So the market is saying the losses are even greater than our estimates. Goldman and Moody's declined to discuss this security. S&P told us that it had toughened its standards in 2005 and had discontinued rating second-mortgage securities in 2008. "Had we anticipated fully the severity of the declines in these markets at the time we issued our original ratings, many of those ratings would have been different," a spokesman said.

Three big tips

Now to the investment lessons: The first is, Don't put your faith in rating agencies, even though some branches of the federal government, including the Federal Reserve, use ratings to determine whether certain securities qualify as collateral under federal loan programs to financial institutions.

Our problem is that if things change for the worse after the original rating comes out, the agencies' response is, "Oops, sorry about that," and they revise the ratings down after you've already taken a hit. When lawsuits arrive, the agencies say all they did was issue an opinion that's protected under the First Amendment, therefore they're not liable.

The second lesson is: No matter how fancy the name is on the offering statement -- Goldman Sachs, the calumny being heaped on it lately notwithstanding, is still Wall Street's alpha outfit -- you're on your own if the issue heads south.

The final lesson is: Beware of the dangers of bottom fishing. It would have been tempting to buy this security when the original AAA paper traded down to the low two-digits -- but any buyer that did that is sitting on big losses.

Just as things often rise further than you think they will and stay there longer, they can also fall further than you think and keep on falling. Remember that when someone tells you that something is so cheap that it has nowhere to go but up.

Allan Sloan is Fortune magazine's senior editor at large. Doris Burke is a senior reporter at Fortune.

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