IRIDIAN Iridian
Asset Management LLC
Our typical quarterly letter has three parts. We describe our current macro view of the world, discuss briefly a current investment theme, and conclude with an examination of micro-market dynamics. Our goal with this structure is to share with our investors what we are seeing from the front lines of the global capital market battleground. But rather than write one more description of the pros and cons of QE 2, rather than write one more post mortem of the SEC report on the Flash Crash or the pernicious impact of correlation on stock picking, we have decided to devote this entire letter to an in-depth review of an investable theme that we are currently researching and acting upon: the mortgage backed securitization (MBS) crisis of 2010. This theme also has secondary and tertiary macroeconomic implications, and therefore influences our portfolio-wide views on risk and exposures.
We call this an MBS crisis, as opposed to “foreclosure-gate” or “robo-signing”, because there are three distinct dimensions to the crisis, only one of which is directly related to the foreclosure process, but all of which are inextricably part of the mortgage securitization process. The dimensions are:
1) Securitization and Underwriting
2) Trust Formation
3) Servicing
We believe that there are substantial investment risks and opportunities stemming from each. Before we discuss these opportunities, however, a brief review of the mortgage securitization process is in order.
In the beginning, there is a loan made to a homebuyer, secured by the title to that home. That is, for every mortgage loan there are two essential legal documents: the IOU or promissory note that establishes what is owed to whom over what period of time and what interest rate, and the deed of trust that is the security pledged to support that IOU. Of the two documents, the note is the dominant one, although without the deed of trust the note is simply a non-recourse note.
For the 900 or so years in which mortgages have existed in the world, the two documents have typically been treated as two sides of the same coin, inseparable and indivisible. With the development of asset-backed securitization, however, that all changed. The two documents were split so that the notes could be pooled, tranched and then sold in the form of securities to different investors with different risk appetites, while the deeds of trust stayed at the local county courthouse. An electronic database kept track of what securities contained what notes, and what notes were linked to what deeds of trust. In this way the securities composed of similar notes could be freely sold and resold, while the unique deeds of trust remained safely off to the side.
This pooling and tranching of residential mortgage notes became the dominant capital market activity in the world, with approximately $9 trillion in such securities created between 2004 and 2008. To create these securities, sponsors (typically investment banks) would purchase the notes in bulk from an originator (typically a commercial bank or dedicated mortgage lender), which would make a representation as to the underwriting standards on which the loans had been made to the homebuyers. The sponsors might “sample” the batch of purchased loans, by hiring a third party such as Clayton Holdings to double check if the homebuyers actually lived up to the standards claimed by the originator, but this due diligence was for the benefit of the sponsor, not the investor in the security. That is, the sponsor might use the results of the sampling to negotiate a better price for the purchase of the bulk loans, but not to update the prospectus of the securitization with more accurate loan quality information. Typical sponsor practice was to parrot the originators’ underwriting claims in the representations made concerning loan quality in the prospectus, because investors in the security were granted a far-reaching warranty – if it turned out that the representations concerning loan quality were not true for any given loan, the investors could put the loan back to the sponsor, where it would be repurchased at par.
As part of the process of creating a “true sale” and a pass-through tax entity, the securities formed by the pooling of the residential mortgage notes are passed through an entity known as a depositor and are ultimately held within a trust, managed by an independent trustee on behalf of the owners/investors of the securities. For a set annual fee (maybe 25 bps of the securitization par value), the trustee takes possession of the notes, confirms that they have been properly assigned and that the deeds of trust are appropriately linked, hires a servicer, and distributes the proceeds of the loans to the investors as per the trust indenture.
The servicer, who also works for a set annual fee (another 25 bps of the securitization par value, perhaps)is responsible for collecting loan payments and taxes from the homeowners as per the terms of their individual note, as well as confirming that title and property insurance are in force. The servicer is typically responsible for remitting those payments to the trust or the appropriate tax authority regardless of whether the homeowner pays what he or she owes, although the servicer is repaid in full for these “advances” plus any associated fees, prior to any other claims that the trust may have, from any recovery proceeds in a foreclosure process. The servicer is responsible for managing any loan modification or foreclosure process, as governed by the loan servicing agreement and the instructions of the trustee.
Problems with Securitization and Underwriting
We believe that the banks that created these mortgage backed securities face as much as $150 billion in “put back” losses on the basis of the standard reps and warranties clause within the securitization documents, against a total current reserve of approximately $10 billion.
There are three potentially aggrieved parties who have purchased these securities in vast quantities and are now in the process of putting the individual loans back to the originating or sponsoring banks: the housing agencies (Fannie Mae and Freddie Mac), the monolines (insurers of MBS, particularly those comprised of home equity lines of credit and 2nd liens), and investors in “private-label securitizations” (essentially any non-agency securitization). We will examine each in turn...
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