Manufactured Housing Asset Back Securities: Learning From The Past, Part 5A: Institutional Bond Version by David Merkel, CFA of The Aleph Blog
This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money. Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.
Manufactured Housing Asset Back Securities – Mezzanine and Subordinated Certificates
In 2001, I lost my boss. In the midst of a merger, he figured his opportunities in the merged firm were poor, and so he jumped to another firm. In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions. All of them worked out well, except for one: The — Mezzanine and Subordinated Certificates of Manufactured Housing Asset Back Securities [MHABS]. What were those beasts?
Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US. You get a type of inexpensive independent living that is lower density than an apartment building, and the rent you have to pay is lower than renting an apartment. What costs some money is paying for the loan to buy the prefabricated housing.
Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default. Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual. I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.
In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered. But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals. That was the key insight.
One day, I was able to confirm that insight by talking with my rep at Lehman Brothers. I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?” After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.
That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months. The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses. The investment idea was as follows:
Buy AA-rated mezzanine and BBB-rated subordinated Manufactured Housing Asset Back Securities originated by Green Tree in 1997 and before that. The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds. These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.
That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001. I did it for several reasons:
- The yields were compelling.
- The company that I was investing for was growing way too rapidly, and we needed places to put money.
- The cash flow profile of these securities matched very well the annuities that the company was selling.
- The amount of capital needed to carry the position was small.
By the end of 2001, two things happened. The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose. Second, I was made the corporate bond manager, and another member of our team took over the trade. He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.
He kept the positions on, but did not add to them. I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.
Can You Make It Through the Valley of the Shadow of Death?
I left the firm about 14 months later, and around that time, the prices for Manufactured Housing Asset Back Securities fell apart. Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all Manufactured Housing Asset Back Securities bonds.
The effects of the losses were similar to that of the Housing Bubble in 2007-9. As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used. This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.
With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.
They feared the worst, and sold the bonds at a considerable loss, and blamed me.
Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period. So what happened to the Manufactured Housing Asset Back Securities bonds that I bought?
Every single one of those bonds paid off in full. Held to maturity, not one of them lost a dime.
What was my error?
Part of being a good investor is knowing your client. In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses. I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities. For that reason, I should have never bought them in the first place. Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you. This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities