The Rules, Part XIV & Thoughts on Maiden Lane LLC, Part 1

Prepayment and default are dual to each other.  The less likely is default, the more likely is prepayment, and vice-versa.

In a pool of loans, the critical distinction is the likelihood of loans to prepay or default.  Just because prepayment has been high, does not mean the remainder won’t default under stress.

I don’t have clear answers to Maiden Lane LLC, the bailout of Bear Stearns yet.  The complexity of Maiden Lane LLC, as compared to Maiden Lane 2 or 3, is enormous.  I have a more work to do.  But, at least, I have scrubbed the data, and figured our what the Fed released to us.

In the Bear Stearns bailout, the Fed received a wide variety of securities, including:

Comm RE WLs
CRE Notes
Agency pools
Agency MBS
Res Re WLs
CDS Corporate
CDS CRE Securities
CDS Municipal
Interest Swaps

Maiden Lane 2 & 3 were simple compared to this, and this had over 10x the securities of both combined. Plus, this had CDS transactions which would profit from failure of a wide variety of assets.

Additional difficulties included a lot of coding difficulties on the CDS.  The Fed did not try to make things clear.  I spent many hours trying to clarify the tranches in question.  A few of them are guesses, but 99% are reliable.

The Fed’s principal figures were original principal figures not those for current principal.  That was another area of ambiguity.

After all that, here is my breakdown of the assets by original principal:

original principal

And, here is my breakdown of the assets by current principal:


The current value of what is owed to the Fed is over $28 billion.  There is almost $49 billion in current principal, so why worry?

Worry because of all of the interest only securities.  The principal for them is notional; principal payments will never be made.  With CMBS, I know that IO securities are typically worth no more than 5% of the notional principal balance.  Because most CMBS protect against prepayment, the prices of interest only securities reflect  the likelihood of default.  Though they are rated AAA, their creditworthiness is more like BB.

With Residential mortgages, the question is harder.  How big is the interest margin, and when might it cut off due to default or prepayment?  Interest only securities are typically worth a lot less then the  notional principal.  Same for principal only securities.  Their value is the likelihood of payment discounted by the length of time until payment.

Beyond that, there are the residential and commercial loans made, with almost $10 billion of principal, for which we have no idea of the creditworthiness.  Are there any statistics on the currency of the collateral?  The Fed had not deigned to tell us.  I place the creditworthiness at BB, but who knows for sure?

I can tell you now that the securities involved were mostly originated 2005-2007, during the worst of the underwriting cycle.  Is it any surprise?  Few can escape the credit cycle.  Within a given credit cycle, the credit quality of securities originated declines all of the way till slightly past the peak of the credit cycle.

I am going to do more analysis of the RMBS, so that I can get a better feel for the value there.  It is not clear to me whether Maiden Lane LLC is adequately funded or not.  The high degree of junk, whole loans, and interest only securities gives me doubt.