Aug. 28, 2007: Tranche – French for “cut” or “slice”

“Daddy, what’s a tranche? Does it make you lose your job?” (That is just what I need my little girl asking me!) How do large accumulators take our loans and “mysteriously” increase the quality of them to potential investors? For example, let’s GMAC has $100 million in mortgage loans. They take this pool and divide it up into 5 groups called tranches, each one being 20%, or $20 million. The first group, in our example, gets the first 60% of the principal which gets repaid. That means that 80% of the loans would have to default and lose 50% (80% of the loans times 50% loss is 40% total portfolio losses) of their value before your money would be at risk. Therefore the risk of an actual loss is quite small.

GMAC hires an investment bank to go to a rating agency (Moody’s, Standard and Poor’s, or Fitch) and pays them a fee to rate that tranche in terms of risk. Since the level of risk is small, that first tranche gets an “AAA” rating. Then the agency goes to the next group. Maybe it is 10% of the pool. It would get all the principal repayments after the first group. In this case, 60% of the loans would have to default and lose 50% of their value before your group lost money. The ratings agency might give this group an AA rating.

This process continues until GMAC gets to the lowest-rated tranches, including an “equity” tranche which is about 2-4%. That tranche is the last group to get its money repaid. In our example, if 8% of the loans went bad and lost 50% (8% times 50% is 4%) of their value, the equity tranche would lose all their money.

Let’s assume the average interest rate on the loans was 7%. Because of the lower risk, the investment bank putting the security together might decide to pay the AAA-rated tranche only 4%. Each successive tranche would get a higher rate, as the owners are taking more risk. The equity tranche is priced to pay in the mid-teens (or more) if all the loans are paid off. Insurance companies, pension funds, and other institutions can buy this security that pays an interest rate higher than they could get from a similar government bond (this difference is called the “spread”). Simple, huh?

Overall, yesterday was a relatively quiet day in terms of mortgage company news, which is nice!

Nat City announced that they have introduced Freddie Mac’s Home Possible program. This is similar to FNMA’s My Community program where borrowers are qualified based on certain income and census tract information.

SunTrust announced that the company is seeking to cut $530 million in annual costs by 2009. The Company expects to eliminate about 7% of its workforce (2,400 of 33,000 jobs) by the end of next year.

As I mentioned, Indymac will return to originating prime, single-family residential, full-documentation jumbo loans. These loans will be retained in its investment portfolio.

Yesterday we had Existing Home Sales -0.2% in July, which suggests that there are no signs of recovery in the housing market. The inventory-to-sales ratio surged to 9.6 months, while the median existing price is down by 0.6% from one year ago. The Conference Board will post this month’s Consumer Confidence Index (10:00AM EST) measuring the consumer’s willingness to spend, which is important because consumer spending makes up two thirds of the U.S. economy. It is expected to show a reading of 104.5, a big drop from July’s 112.6. We also will see the release of the minutes from the last FOMC meeting. There is a pretty good possibility of the markets reacting to them following their 2:00 PM EST release, but others view these minutes as “old” news and think that the Fed has re-evaluated their thought process since there is 50 basis points’ worth of Fed easing by year-end priced into the fed funds futures market. And our friend the 10-yr stands at 4.57%.