Test for bonds tied to loans

Times Staff Writer

The housing market boom of the last few years also has been a boom for Wall Street firms that have played a crucial role as conduits -- linking home buyers and investors by packaging mortgages and selling bonds backed by the loan payments.

Now, with mortgage defaults surging, it’s clear that some of those investors are going to lose money.

And that is shining a bright light on the Wall Street middlemen, including Los Angeles-based TCW Group Inc., which has been one of the biggest names in mortgage investment products.


TCW, parent of Trust Co. of the West, could emerge as a hero or a villain to the hedge funds, insurance companies and wealthy investors worldwide that have been avid buyers of the firm’s complex mortgage securities.

The company says it is the global leader in managing collateralized debt obligations, or CDOs. These are investments that are backed by pools of loans or other assets. The simple idea: The investors get interest and principal payments from the pools passed through to them.

But in reality, CDOs aren’t simple at all. They are a creation of cutting-edge financial engineering. That engineering can turn part of a portfolio of high-risk securities into new securities that, in theory, carry low risk but still provide above-average returns.

The acid test for that seeming alchemy now looms. Much of what backs up CDO pools are securities tied to mortgages. And specifically, bonds backed by sub-prime mortgages -- loans to people with poor credit histories or high debt burdens -- are the core of many CDOs.

TCW manages $48 billion in CDO portfolios for investors. Of that total, $15 billion, or about one-third of the CDO asset pool, is in securities backed by sub-prime mortgages. An additional $3.9 billion of loans behind the firm’s CDOs are “Alt-A,” or mortgages to people who didn’t qualify as top-quality borrowers but were viewed as better risks than sub-prime borrowers.

The question facing TCW and other investors in higher-risk mortgages: Who’s going to take the biggest hit from loans that go bad?


“There are a lot of CDO managers that have a lot of toxic waste in CDOs,” said Pete Nolan, who analyzes the portfolios for money manager Smith Breeden Associates in Chapel Hill, N.C.

Jitters over the growing troubles of sub-prime borrowers have been rocking financial markets for weeks. Lenders’ shares slumped further last week after the Mortgage Bankers Assn. said more than 13% of sub-prime loans had fallen behind on payments, up from 12.6% in the third quarter and 10.6% two years ago.

Jeffrey Gundlach, TCW’s chief investment officer, says the firm isn’t stunned by what’s happening with sub-prime loans.

Gundlach has been pessimistic about the U.S. economy for much of the last year, and has predicted that a weakening housing market would be the final blow to cash-strapped consumers. A recession would more than likely result, he has said.

That view isn’t inconsistent with putting sub-prime mortgage bonds into investment pools like CDOs, Gundlach says.

“Our strategy all along has been, let’s put together a portfolio that will hold up better when the defaults come,” he said.

Said Louis Lucido, Gundlach’s team leader for mortgage CDOs: “It’s not that we’re arrogant, or that we’ve got a lot of hubris, but we think we’ve got the position and the talent in place to be able to analyze and manage through this period.”

TCW’s expectation, Lucido said, is that it will benefit by picking up the pieces of smaller CDO managers that collapse.

Gundlach, 47, has a reputation across the investment business as a sharp mind on mortgage securities. He has led the firm’s concerted push into that sector since the 1980s.

TCW, he says, has far surpassed its competitors since the late 1990s in hiring staff and developing computer programs to monitor mortgage securities and other asset-backed bonds.

“It occurred to me we would be able to succeed if we just used the Reagan plan for the Cold War: outspend them,” Gundlach said. “We outspent everybody.”

The point of that spending, he said, was to develop an infrastructure that could identify the best opportunities in sectors including mortgage securities, and avoid potential disasters.

“One of the biggest distinguishing features for our group is the amount of due diligence we do, and our own rating process for [loan] originators,” Gundlach said.

In a memo to clients this month, TCW sought to assure them that the firm all along had “minimized and often avoided” mortgages that it believed to carry excessive risk -- for example, loans to housing speculators as opposed to someone who planned to live in a home.

Mortgage CDOs are just one piece of TCW’s business. The firm’s total of $150 billion in bonds and stocks under management includes accounts of pension funds, wealthy individuals and mutual fund investors.

But its focus on mortgages put TCW in the right position in recent years to feed investors’ voracious appetite for investments backed by home loans.

Relatively low interest rates since 2001 on Treasury bonds and other high-quality securities left many investors starved for decent yields. As home sales and prices surged, Wall Street was thrilled to ride in as the boom’s financier.

Securitizing mortgages -- packaging the loans for sale to investors via bonds -- has provided borrowers with the funding they need and investors with securities that have paid them more than many other bonds.

Securitization isn’t new, but the market had never seen anything on the scale of the rush to securitize mortgages in recent years.

Collateralized debt obligations became the natural buyers for mortgage bonds. Wall Street previously had used CDOs for investments such as corporate “junk” bonds and manufactured-housing loans. Some of those pools ended badly for investors. But mortgage bonds, traditionally a stable asset, seemed a perfect fit for CDOs.

CDOs offered investors the option of picking the specific levels of risk and return they wanted from a loan portfolio. That’s where financial engineering by firms like TCW came in.

A CDO creator could take a pool of mostly sub-prime mortgage-backed bonds and cut it into tranches (French for “slices”). At the top of that stack of slices would be the highest-quality tranches, which offered modest yields but (theoretically) no risk of principal loss.

“The whole deal is set up to protect them,” Gundlach said of the top tranches.

The investors in the lower tranches would earn higher yields while also agreeing to absorb any losses suffered by the loan pool, if necessary.

At the very bottom would be the so-called equity tranche holders, who would get paid only if everything worked out well.

Investors wildly embraced the CDO concept: Global sales reached a record $476 billion last year, nearly six times what was sold in 2001.

As a CDO manager, TCW’s role is not only to construct the tranches but also to manage the underlying assets. For that, its investors are paying TCW fees of up to 0.5% of assets yearly.

The crucial questions ahead for TCW and other CDO managers: How many of the mortgage loans in their pools will fall victim to default, and then foreclosure? How big will the losses on those loans be? How high up the tranche food chain will the losses reach?

Whatever happens, it won’t be overnight. For one thing, CDO pools are designed to be long-term investments, maturing in years, not months. Likewise, it also can take a long time for a home to be placed in foreclosure, and for the lender to find out whether the home value covers the loan or falls short.

For a mortgage player of TCW’s size, the risk of a slew of problems in its mortgage portfolios goes beyond the obvious issue of angry clients.

The firm’s own money is invested in its portfolios, so its own finances could take a hit.

And for the economy as a whole, serious losses in mortgage securities managed by a firm of TCW’s stature could scare bond investors away for an extended period -- which could make home loans tougher to get, more expensive or both.

“We’re pretty sure we’re going to come out on the good side of this,” Gundlach said.

More than just his career may be riding on that.