Standard & Poor’s probably didn’t expect to spark a rally in commercial-mortgage-backed securities when it proposed a new ratings methodology in late May and disclosed that billions of dollars of bonds could lose their triple-A status, including as much as 90 percent of the most senior tranches backed by 2007 mortgages. But after initially shocking the market, S&P’s move ultimately reinforced demand for the highest-quality paper that still met the tighter triple-A standard. To carve this exposure out of existing CMBSs, Wall Street’s financial engineers have turned to resecuritization, boosting issuance of instruments known as “re-REMICs,” which are composed of the top tranches of multiple underlying mortgage-backed securities.
The senior slices of re-REMICs — whose name is derived from the acronym for “real estate mortgage investment conduits,” the technical term for the underlying mortgage-backed bonds — tend to appeal to insurance companies, which were big buyers of the underlying securities that may be facing ratings downgrades. The junior bonds, which offer yields as high as 12 percent to 14 percent, attract hedge funds and other opportunistic buyers of credit risk.
Bank of America–Merrill Lynch was the first to market after S&P’s announcement, in mid-June, with a re-REMIC composed of CMBSs that pooled several “superduper senior bonds,” as the highest-rated securities are known. These securities already featured credit enhancement of 30 percent, meaning investors’ principal and interest were protected unless credit losses on the underlying bonds exceeded that percentage of the principal. Still, BofA–Merrill’s new re-REMIC structure created an even safer security by dividing the cash flows from the underlying CMBSs to support a new triple-A-rated bond with 50 percent credit enhancement and a junior tranche that still has 30 percent credit enhancement as well as an additional buffer that protects against certain credit losses that might hit the new senior bonds.
“Investors will pay up over generic CMBS collateral to have paper that is theoretically rock solid so they can sleep better at night,” says Christopher Callahan, co-head of CMBS trading at BofA–Merrill Lynch.
At first the resurgent re-REMIC market was a pure arbitrage play: BofA–Merrill was able to buy the old CMBS bonds from existing holders desperate to sell them — at a discount to par — repackage them as re-REMICs, sell the two pieces for a premium and pocket the difference. But many of the firm’s top rivals, including Morgan Stanley, JPMorgan Chase & Co. and Credit Suisse, quickly joined the race. “As soon as people figured out where the demand was, they saw that the underlying bonds were way too cheap,” notes Callahan.
In the two months that followed BofA-Merrill’s issue, the firm estimates that the market absorbed $2.2 billion of commercial-mortgage-backed re-REMICs, mirroring the brisk business of resecuritizing residential-mortgage-backed securities that began heating up 18 months ago. Activity hasn’t been this robust since 2002.
Eric Rothfeld, a managing director at Fitch Ratings, says the commercial-mortgage-backed re-REMIC deals done so far have all repackaged the “superduper” tranches of credits that Fitch rates triple-A with a stable outlook. The objective for many market participants is balance-sheet repair. Insurance companies facing a hit when their CMBSs are downgraded to below investment grade, for example, can hire an investment bank to put those bonds into a re-REMIC and sell the subordinated tranche, retaining just the triple-A-rated slice carrying a lower regulatory capital requirement.
The senior tranches of re-REMIC deals also provide a way for money managers benchmarked against the Barclays Capital U.S. aggregate bond index to gain exposure to the underlying CMBS — a segment of the bond market that has a 4 percent weight in the index — while minimizing risk. “Buyers give up some yield spread,” says BofA-Merrill’s Callahan, “but they still get some of the price appreciation if the spread tightens on this rock-solid bond.”
