PIMCO shocked by prices paid to gamble on toxic RMBS

Bloomberg reports that JP Morgan is trying to bring a non-agency backed residential mortgage-backed security to market and PIMCO is shocked by the terms that gamblers are willing to accept to place their wager on these securities.

As everyone knows, residential mortgage-backed securities are opaque.  Therefore, buying these securities is simply blindly betting on the contents of a brown paper bag.

Leading up to the financial crisis, buying these securities was a losing bet for the gamblers and selling these securities was a winning bet for Wall Street.

Since nothing has changed, most notably these securities still do not offer observable event based reporting under which all activities like a payment or default on the underlying assets are reported before the beginning of the next business day so market participants can know what they are buying or know what they own, there is no reason to believe the gamblers won't lose again.

Which is precisely why PIMCO cannot believe the prices paid by the gamblers.

JPMorgan Chase & Co. is seeking to sell securities tied to new U.S. home loans without government backing in its first offering since the financial crisis that the debt helped trigger. 

The deal may close this month, according to a person familiar with the discussions. 

Servicers of the underlying loans may include the New York-based lender, First Republic Bank and Johnson Bank, said the person, who asked not to be identified because terms aren’t set. 

The market for so-called non-agency mortgage securities is reviving as the Federal Reserve’s $85 billion a month of bond purchases help push investors to seek potentially higher returns. 

As deals accelerate, Pacific Investment Management Co. is questioning the prices paid. 

At the same time, a weakening of contract clauses that offer protection to investors if the loans don’t match their promised quality is stoking debate, said Kroll Bond Rating Agency analyst Glenn Costello. 

“There’s a pretty heavy dialogue going on right now between all participants in the market about what makes sense,” Costello, who is based in New York, said last week in a telephone interview....

What makes sense is that the deals provide observable event based reporting.

JPMorgan is telling investors its deal’s terms may allow some of the so-called representations and warranties about the mortgages from originators or itself to expire after 36 months to 60 months, the person said. Such contract clauses, which can be used to force loan repurchases, have led to billions of dollars of costs for banks on debt made during the housing boom. 

After Credit Suisse included so-called sunsets of 36 months on certain buyback promises in a November deal, Standard & Poor’s, the only grader to rate the bonds, said in a statement that the move didn’t affect its view of the debt’s risks. The ratings firm cited the “exceptionally high credit quality” of the loans and that all of them had been reviewed by third-party firms before being packaged into the securities.

Interesting to note the use of third-party firms to review the mortgages and the reluctance of the issuers to provide the data on the mortgages to all market participants so that investors can do their own independent assessment.

As everyone knows, one of the weak spots in securitization is the reliance on third parties making representations about the quality of the underlying collateral and the deal.  A prime example of this was the rating firms.

Yet, here is Wall Street trying to repackage and sell the same snake oil.

Rivals including Fitch Ratings, which publicly called S&P’s grades too high, are taking a more skeptical view. Changes such as sunset provisions and clauses that void loan-quality warranties if borrowers default after events such as job losses or illness generally should require greater so-called credit enhancement, said Rui Pereira, a managing director at Fitch. 

Credit enhancement can include some bonds taking losses before others, cash reserves or payments from the underlying assets that exceed coupons on the securities created. 

“Less investor-friendly provisions are something we need to take into account,” Pereira said last week in a telephone interview.

Issuers are seeking to move past a framework for representations and warranties provided by Redwood that represented a “gold standard,”Kathryn Kelbaugh, a senior analyst at Moody’s Investors Service, said last month during a panel discussion at a securitization conference in Las Vegas. 

In Redwood’s latest deal, it may sell a top-rated class as large as $561.2 million with a 2.5 percent coupon at about 102 cents on the dollar, a person familiar with that offering said today, asking not to be named because terms aren’t set. 

That compares with current prices of about 99 cents on the dollar for Fannie Mae-guaranteed 2.5 percent securities, according to Bloomberg data. 

Bonds issued in recent months by Redwood have been “insanely expensive” by comparison with Fannie Mae debt, Pimco’s Scott Simonsaid in an interview yesterday. 

“I can’t believe someone would pay anywhere near where they have sold them,” said Simon, the mortgage-bond head at Newport Beach, California-based Pimco, manager of the world’s largest mutual fund.

 It is hard to argue with Mr. Simon's observation about the Redwood deal or the prices gamblers are paying for other opaque residential mortgage-backed securities.