The prepayment wave that has wreaked havoc in the mortgage securities market for the last year has also given rise to an innovative collateralized mortgage obligation specifically designed to relieve investors of prepayment risk: the cash flow security.
By repackaging the most risky or prepayment sensitive securities, such as interest-only strips, with the less risky components of CMOs, a number of Wall Street firms are creating new derivative securities that in many cases closely resemble pass -- through mortgage securities for investors.
In the past six weeks alone, at least seven public triple-A-rated deals have been structured and sold.
The firms are reluctant to divulge their methods or their views on the future of the market, and the ratings agencies disagree on how to approach the offerings and whether investors understand the risks. But if the recent surge in interest from Wall Street firms and clients is any indication, the cash flow security may outlast the current mortgage refinancing spree.
Most deals are structured to resemble pass-throughs or, in some cases, inverse floaters. Wall Street firms have used their own shelf registrations to issue the securities or shelf filings for Ryland Mortgage Corp. and Fund America Investors Corp. State Street Bank and Trust frequently acts as trustee.
Underwriters generally use the senior/subordinate structure to avoid any tax consequences since the deals cannot qualify for Remic status. Some pools may include pre-Remic securities, debt securities or residuals, which disqualify the pools for Remic status, said Andrew Jones, vice president and head of Duff & Phelps' residential mortgage group.
Because one purpose of the deals is to reduce the risk associated with the underlying securities, the senior classes of these senior/subordinate cash flow securities are structured to obtain high ratings from the agencies. But so far, only two agencies have assigned ratings: Fitch Investors Service and Duff and Phelps.
With the same letter grade system it applies to conventional mortgage-backeds and debt offerings, Duff & Phelps has developed a method of assessing the prepayment risk and the total cash flow of the underlying securities to determine whether investors will get their money back.
Fitch also addresses the total cash flow on the deal with its letter grade ratings and has typically assigned triple-A ratings to the senior tranches of cash flow securities, according to Glenn Costello, vice president in the CMO group.
Fitch also applies its new CMO volatility ratings, which range from V-1 through V-5, with the low volatility. Fitch has typically assigned ratings of V-1 and V-2 to the senior tranches of cash flow securities. But the subordinate pieces are more risky. They are typically rated V-4 or V-5 and are not rated on the letter scale, Costello said.
Investment bankers involved in the mortgage securities market are quick to note that repackaging CMOs is not new. Principal-only strips are often combined to create new offerings. Freddie Mac has recombined its own Remics and created more attractive offerings from older securities through its "giant" program.
But combining an array of diverse securities purchased in the secondary market, or from different clients, to meet their investment needs is taking the concept even further.
While these derivative securities are designed to mitigate prepayment risk, they also provide an arbitrage opportunity for the firms that structure them. By locating distressed securities, like 10s in the current market, firms get the benefit of their upside potential should market conditions change.
"If you believe that IOs are undervalued, you can get more value out of them by repackaging them. It's a form of arbitrage ... that plays on the volatility of interest rates," says Moody's Brian Clarkson. "If interest rate rise prepayments should slow down, los will increase in value and the window of opportunity will be gone."
Investment bankers are more optimistic, albeit on an anonymous basis. "It's the future of the business in a certain sense," said a banker at a large firm.
"When collateral dries up, you can repackage existing securities."
How far the market goes ultimately depends on investor's appetite for the securities. Judging by the recent increase in activity, investors are becoming more comfortable with them.