Could Your A Rated Subprime Mortgage Tranche be ‘Impaired’?
…Not yet, but this could happen quicker than any of us might imagine.
Other Than Temporary Impairment (OTTI) rules vary by company, auditor, region and, seemingly, time of year. However, they all have in common a comparison of market to book values. When it comes to structured securities, like ABS, CMOs, etc, getting good valuations can become problemmatical in certain markets. And, these are definitely problemmatical times for tranches of sub prime mortgages.
Of course, your friendly investment manager has probably told you that your company owns very few sub prime mortgage tranches and, these tranches are all investment grade, well protected by lower rated tranches. However, the market may beg to differ.
Simply go to Markit’s web page that lists prices for indices of various ABS secured by sub prime mortgages. These indices, called the ABX, are stratified by issuance date and credit rating. As of today, A rated ABS in the index that were originated since the second half of last year, now have a market value of 68 to 75, well below the standard for typical OTTI review.
Could this be merely a short term, overly pessimistic view of these securities? Yes, these securities may improve in value and this can be a temporary move, but, alas, things could also get worse.
But, this move below 80 has primarily occurred over the last week, so is OTTI really an issue? Not yet, but this certainly has the potential to be an OTTI question from your auditors. The recent high profile nature of this investment and the fact that few, if any, insurers have finalized their Q2 results, mean your auditors may be sniffing around this issue.
Please remember, the ABX is an index of tranches, and your company’s ‘investment grade’ holding of a sub prime ABS may have either a higher or lower value. The real problem will be assigning an accurate price for a given tranche. In the case of the ABX, it is an index that is traded and does indeed provide a better estimate of fair market value than many of the matrix pricing schemes used by various broker/dealers. It is with this in mind, that your auditors may come a sniffing.
As noted in my previous blog post, With a more conservative approach imbedded in the rating agency models, we can expect further downward pressure on subpime ‘matrix’ pricing, even if the bond has not been noted as downgraded in the agency press releases.
Apparently, the trading of the ABX tells us that, as usual, the market is ahead of the rating agencies in repricing sub prime mortgage tranches. And, with Bear Stearns closing two subprime hedge funds due to the "unprecedented declines in the valuations of a number of highly-rated (AA and AAA) securities", it is probably time to question the pricing of subprime tranches rated higher than A.
Please feel free to join the discussion at the Insurer Investment Forum Online
