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Handle With Care

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T. is selling me CMO bonds. I've bought seven of them in the last three months. Their prices range from 15 to 50 cents on the dollar, meaning that a lot of pain is priced in. And price is everything. There’s an old saying in the bond market that there are no bad bonds, only bad prices.

My CMOs are “whole loan”—that means they come with no guarantee from any federal agency (the bonds with federal backing trade at a premium; no bargains there). Similarly, the deepest discounts are available for structured bonds that are made up of bits and piece of individual loans. The holders of unstructured bonds have an advantage in this climate because they are better able to negotiate with individual homeowners and possibly lower their principal—that enables them to keep the house (their benefit) and it keeps the level of payments to the bondholder higher than if the house went into foreclosure (the bondholder’s benefit). With structured bonds, negotiation is difficult, if not impossible, because the loans are all split up among different bonds. And that drives the price of these bonds down further, into the freefall zone that’s attractive to me.

The first variable I look at in assessing the attractiveness of a bond is the current Loan to Value Ratio (LTV). A good homeowner would start with an LTV of 80 percent—they put 20 percent down, so the bank loan covers 80 percent of the house’s value. All good until the value of the house drops. If it drops in half, a common occurrence of late, that poor guy’s LTV is suddenly over 160. They call that being underwater, and that’s when people start walking away from their homes. So you look for LTVs well below that, say 100 to be safe.

The second variable is credit support. Bonds are typically broken up into different risk segments—for absorbing more risk, you get a higher rate of return. At this point, I am interested only in the least risky portions of the bond, the top shelf of toxic assets, which are known, in descending order, as AAA super senior and AAA mezzanine. Not only do I avoid anything below that grade, but I calibrate what I’m willing to pay for the bond with what percentage of bondholders are absorbing credit risk ahead of me. So if the price is 20 cents on the dollar, I want credit support of at least 20 percent. If the bond is more expensive, say 40 cents, I’ll want 40 percent credit support.

Then there’s the FICOS scores, or credit ratings of the homeowners. If they’re declining—which indicates they’re falling behind on their car payments or credit cards or whatever—I don’t touch the bonds. Finally, there’s loan size, which the simplest of all. I prefer bigger loans because of the many fixed costs associated with foreclosure (everything from lawyers to house painters to Realtors). If the loan is bigger, there’ll be more left over to pay the bondholders in the event that the bank has to seize the house and sell it.

Buying toxic assets is brutal business. You’re trying to calculate the economic effects of other people’s misery. But that’s how the world works. It’s what keeps the economy from tumbling into the abyss. Somebody’s got to be there to buy what other people can no longer afford.

Buying bonds that you know will be devastated by defaults is a race against time: How much cash flow will you receive before the bond washes out with the tide? Price is the ultimate protection. If you pay 15 cents for a bond, you can stand to lose a lot. If there's 20 percent credit support under you, you've bought time. Will you harvest those flows before that second wave carries you and your bonds away? As the wave gets closer to you, it's harder to gauge its height. All you know for certain is that it will smash you.

There are $120 to $150 billion of option-ARM loans out there that will recast in 2010 and 2011. Those are people who haven’t been paying down any principal, in the hope that they can refinance before their payments balloon. Most of them won’t be able to, not with their house having shed half its value. The option-ARM wave is cresting right now, forming angry whitecaps. You can see its shape in the latest foreclosure and delinquency numbers in the loan-remittance reports. How high will it swell? What if that second wave is smaller than the current fears? What if things only get a little worse?


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