Banks are among the many financial institutions that purchased residential and commercial mortgage-backed securities over the past few years. Many of them were purchased as triple-A securities but have recently been downgraded.
Initially in the financial crisis the downgraded securities were backed by subprime mortgages, but now downgrades are occurring on securities backed by prime loans.
These securities had very few losses, if any, over the previous 15 years (essentially, since their invention), so losses have taken many investors, including banks, by surprise.
For regulatory capital purposes, a downgrade of a triple-A security can be disastrous. Unlike with other triple-A securities, many of the recent downgrades have been several notches, including from triple-A to triple-C. Instead of being treated with a risk capital weighting of 20%, they now need dollar-for-dollar reserves.
Despite the downgrades, there may be substantial value still in these securities. The rating agencies cover "first dollar of loss", so a large security may be downgraded even if the amount of loss it will ultimately incur is minor. For those backed by prime loans, recoveries may be expected to be significantly higher than for similarly rated "junk" corporate unsecured debt, where pennies on the dollar may be received in a bankruptcy proceeding after considerable delay.
To give an example, suppose a bank bought a triple-A security backed by prime mortgages with a principal balance of $80 million.
There is still $85 million of collateral in the deal. The rating agencies expect losses on the remaining collateral to be $10 million, so they downgrade the security to triple-C. However, the triple-A security is first priority, so all principal coming in on the collateral is paying it down.
Clearly, a portion of the bond has an implicit or hidden rating higher than the rating on the entire security.
Resecuritization is a way to isolate the higher-rated portion of a downgraded security. If, in our example, the $80 million MBS were deposited into a resecuritization trust, and a $50 million senior security and a $30 million subordinate one were created, it may be possible to obtain a higher rating on the senior piece. If a triple-A rating could be obtained on the senior piece, then the liquidity position and the regulatory capital treatment of a bank holding such a security would be greatly improved.
Resecuritization is not in any way deceptive. In fact, it more accurately shows what the bank holds in its portfolio. When the initial transaction was conducted, clearly the bond could have been broken into several subordinated pieces, each rated triple-A. Given that the transaction has performed significantly worse than expected, that should not prevent the creation of a triple-A cash flow with a high likelihood of recovery.
Resecuritization structures are varied — sometimes they are re-Remics, and sometimes grantor trust or owner trusts are used, depending on the structure and whether the security was a real estate mortgage investment conduit interest or a bond from a debt-for-tax transaction. Multiple tranches or exchangeable securities can be created to slice up the security so that there would be no further need to resecuritize. Accounting issues and legal issues are involved, but they are not insurmountable.
Many banks and other financial institutions have taken advantage of resecuritization to restructure securities held in portfolio or held for other reasons. In particular, given the level of regulatory capital relief which may be obtained, it is a particularly attractive option for distressed banks with concerns in this area.
