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Seasoned Versus Mortgage bonds

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Seasoned Versus Mortgage bonds1) One place where being an actuary and being a financial analyst melded well was with Affordable Housing and Historic Tax Credits.  In all of these investments, it made a great difference as to what the Statutory, Tax, and GAAP accounting bases.  When I described my methods of working through the free cash flows, AHIC [The Affordable Housing Investors Council] wanted me to speak to the whole regarding my methods.

I never gave the talk because we were full on tax credits, and I was too busy managing the portfolio of Fidelity & Guaranty Life.   The moral is: watch free cash flow.

2) Probably the ugliest incident in managing money for Fidelity & Guaranty was when the management of F&G decided to try to buy the structured settlement liabilities of Confederation Life.  Big block, five potential buyers.   St. Paul had a rule: we don’t outsource asset management.  Sadly, the chief actuary, against our admonitions allowed for reinsurance treaties that outsourced asset management.

During the conference call to legitimate the offer that we would make, several things happened:

a) F&G management accused St. Paul management of being bureaucrats, not businessmen.

b) St. Paul management told F&G management that they were ignoring the rules.

c) I informed both sides that we were all gentlemen here, and that the tone of discussion was not worthy of real businessmen.

d) The CEO of F&G eventually broke off the call, calling the St. Paul folks bureaucrats, rather than businessmen, and saying that they killed a good deal.

Personally, I think he said this to save face with his employees.  Also, the deal was marginal at best.  We would have had to take a lot of risk to make the deal work.  But F&G would not listen to us.

3) I liked buying seasoned bonds, because they were more predictable.  Problem: you could not buy them in size.  Buying bonds in the aftermarket is typically picking at scraps.  Face it — most bond buyer want to hold their bonds for a while.  Aside from the few that sell for a quick profit, most bond investors hold on for a long time.  But I would pick up scraps.  Enough scraps, and you have some decent positions.

If you do find a seasoned bond selling at a reasonable price, buy it in, subject to the advice of your credit analyst.

4) Regarding mortgage bonds, remember that default and prepayment are dual.  Debtors divide up into three groups: a) Very solvent, they will easily pay off their debts, and if there is an opportunity to refinance their debt, they will take it.  b) Solvent. They don’t have a lot of margin, but they can pay their debts if nothing serious goes wrong. c) We did not deserve the loan.  We will fail with high probability in the next year.

Ideally, if you want the best yield out of a bunch of consumer lending assets, you want a lot of the middle group.  Not the highest credit quality, but likely to pay off, and not so likely to prepay.  There is a hierarchy:

  • Best: pay,
  • Next best: prepay,
  • worst: don’t pay.

5) So as I learned about CMBS, I wondered about the interest only strip that many of the deals held — from my own testing, it had the credit properties of a BBB tranche at best, and a Single-B tranche at worst.  Sadly, because they had no principal to pay they were nominally rated AAA, and so the firm I worked for (not my area) crammed them into Stable value plans.  Because I had done the credit stress testing, I knew this, and resisted their use in my own portfolios.

But this is another example where accounting rules have led us afoul.  Nominal principal should be implied to “interest only” obligations.  “Principal only” obligations should have implied interest.

That’s all for now.  I will finish up in the last segment, probably on Monday.

By David Merkel, CFA of Aleph Blog

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