It Isn’t Voodoo....It’s Just Math

There has been quite a lot of attention lately on re-securitizations, specifically re-REMICs. The re-REMIC is a form of repackaging mortgages that Wall Street and mortgage bond investors are very familiar with.

Much of the press that’s getting out about re-REMICs sounds fearful to me. I was interviewed recently by AP reporter Matt Apuzzo (you can see what he wrote in a USA Today story). Although Matt did not sound fearful, in our discussion, he referred to the re-REMIC as “magic,” as if there might be something going on behind the scenes, akin to the old trick of pulling a rabbit out of a hat.

I explained, and Matt understood, that a re-REMIC is something that’s actually quite straight-forward. You take securitizations that are already issued, bundle them together and issue a new securitization. As with the underlying securitizations, you sell that new securitization in classes, or tranches. The triple-A class gets paid before any other class whenever money comes in on the securitization, and the bottom-most class, which is usually known as the unrated or first loss class, takes all the losses, such as from foreclosures, before any other class takes a loss.

Although these are sophisticated financial instruments, it isn’t that hard to see that the bond that gets paid first is a safer investment than the bond that takes losses first. A simple translation of that rationale says that the bond that gets paid first is worth more than the first loss bond. To me, that’s simply math, and there is no voodoo or black magic behind it. What the market needs, and wants, is transparency. A re-REMIC is a structure that is transparent.

Although I am certainly not opposed to CDOs, I see room for trouble when investors who don’t have the staff or resources to manage them take them on. For one thing, many of them mix collateral types, so that there are equities bundled with residential credits and commercial loans. That calls for three entirely different skill sets in order to manage them. Also, CDOs often have many more financial instruments buried in them. That calls for a larger staff of experts, just to get their arms around the basics of what has gone on in those securities each month. CDOs are less transparent, in other words, than re-REMICS. That doesn’t make them bad, but it does call for a higher degree of expertise to manage them.

Re-REMICs are breathing life into the mortgage industry, and that’s having a positive effect on the economy. As is often true, once you understand the fundamentals behind something that seems difficult to fathom at first, the magic disappears, and in its place is something familiar, like math.