Michael

+1. I suspect much like Mortgage Backed Securities (MBS), the bonds are divided into tranches from the senior tranche, possibly several junior tranches, and the equity tranche. The senior tranche is typically rated AAA or AA+, the junior tranches are typically rated from AA to BBB-, and the equity tranche is typically rated as junk bonds (BB or lower).

Typically the senior tranche is about 60% of the bonds, the junior tranches are about 30%, and the equity tranche is the remaining 10%. For MBS securities, if the borrower has to pay an average a 7% interest rate for the loan, when the bonds are securitized there may be a 0.25% annual handling charge leaving 6.75% that can be paid to investors but a cushion of maybe another 0.25% is set aside for possible defaults leaving 6.5% that can be paid to investors. Someone buying the senior tranche may get a 4.5% interest rate, the junior tranches 5.5%-6.5%, and the equity tranche 8% for an average of 6.5%.

The risk is in how the interest and principle is paid to investors. The equity tranche is hit first for any default so if the borrower can't make interest payments on certain properties, the equity tranche first loses it's interest payments, and then the junior tranches, and finally the senior tranche. If properties are foreclosed, again the equity tranche takes the first hit on principle followed by the junior tranches, and finally the senior tranche. If the properties go into bankruptcy and the lender gets 80 cents on the dollar, the equity tranche is completely wiped out, the lower junior tranche may possibly also be wiped out, the senior junior tranche may get 70 cent on the dollar back, and the senior tranche may get 100% back.

EB5 investments may not follow exactly the same repayment concept as MBS but the principle is similar. However as an EB5 investor, you are basically acquiring the equity tranche. Investments may possibly also be zero coupon bonds (typically for 7 years or less maturity) where interest will not be paid until maturity. Generally the higher the interest rate in each of the tranches, the higher the risk and the lower that each tranche is rated.

During the credit crisis, the first problem was that the rating agencies weren't rating the bonds correctly giving AAA ratings to the senior tranche when most of the mortgages were junk within the Collateralized Debt Obligation (CDO). Even a bigger problem was that investment bankers created many Virtual CDOs of the junior and equity tranches that ended up having a 60% senior tranche rated as AAA to leverage the loans. Now with lawsuits against rating agencies and investment banks no longer able to create CDOs, rating agencies are now actually over cautious about their ratings.

Steve_

I was under the impression some investors threatened to sue and they got back $350,000 each?

civilservant

An excellent post, but jeez I'm confused

Michael

My summary was only the basics aimed at the masses. If you looked deeply into what investment bankers did prior to the credit crisis with derivatives, you'd really be shocked.

Out of one CDO (the cash CDO), they may have created many different Virtual CDOs with names such as "CDO squared" and "CDO cubed" all to create massive leverage and high profits for the investment bank. Some Virtual CDOs were just duplicates of the "cash CDO". Once they created those derivative CDOs, they then had to find buyers for both the short and long position of the CDO but sometimes that investment banks got caught holding the long position since they couldn't find buyers (especially the equity tranche). Goldman Sachs was one of the few investment banks that realized that they had created a bubble that was about to explode and made sure they sold the all the long positions and held only short positions or if they got caught with long positions, then they purchased Credit Default Swaps (insurance) from companies such as AIG to insure against defaults on those bonds. To compound the problems even further, hedge funds and investors would also purchased Credit Default Swaps on the long positions held by some banks, pension funds, municipalities, or by other investors. At the time of the credit crisis, there were approximately $66 trillion (insured value) of Credit Default Swaps issued worldwide primarily sold by investment banks and insurance companies.

If it was only the bad mortgages, we wouldn't have had a credit crisis and severe recession but it was the leveraging (derivatives) that put everything into a tail spin. The primary derivatives were the Virtual CDOs and Credit Default Swaps. It wasn't just American banks that were creating the derivatives but also most of the large European banks.

Pulaski

No, my summary was only the basics aimed at the masses!

That was a significant part of it, but there was a perfect storm of simultaneous circumstances which led to the calamitous collapse of the financial system, notably the sharp drop in the price of real estate in several (most) large markets in the US, and the forced liquidation of a number of CDO's holding "real" debt instruments for which there was no liquid secondary market. It led to a rapid downward spiral of the "market" price of non-traded (illiquid) debt securities, causing value downgrades of further portfolios resulting in further forced liquidations.

Michael

However if you look at the total real mortgage losses since 2007, that is only about $500 billion which is about the same amount that was originally estimated as a loss during the 1980s S&L crisis. The eventual figure was about half that amount as the FDIC held the securities until the market felt there was value in those securities and then sold the securities. If it wasn't for the derivatives, RBS wouldn't have needed over $500 billion in government guarantees to keep them afloat, Ireland wouldn't have needed to double it's national debt to keep it's banks afloat, and the Swiss wouldn't have had to loan UBS 25% of it's gdp to keep it afloat.

Therefore since the S&L crisis was managed without a crisis or sharp recession, I suspect the current crisis should have also been managed similarly if there wasn't the derivatives.

Pulaski

Agreed. That is what I meant by "perfect storm": all pieces of the puzzle were required to create the ensuing mess. Without the derivatives the problem would have been less, but without the forced liquidation of a significant number of CDOs the problem would have been much less too, and the problem there was the application (but not the principle) of "mark to market" which makes no sense what so ever when applied to securities for which there is no liquid market (and often no market at all), and when most of the securities were generally held to maturity. So any short term price fluctuations of otherwise creditworthy securities, arguably should not have been included in the current financial statements of the investors (mark to market should not have been applied), and therefore most of the CDOs would not have become technically insolvent and forced to liquidate, putting further downward pressure on the prices of the underlying securities.

Michael

I agree that "Mark to Market" is not a good way of valuing securities but "Mark to Value" is even worse. When using "Mark to Value", as long as the bank doesn't sell one single bond from a tranche of a CDO, they get to mark that whole tranche according to the price gotten for the last bond sold in that tranche. So if the last bond was sold in 2008 at 105% face value, the whole tranche will be valued at 105% face value as long as they don't sell any bonds from that trance even if the current market price for that tranche is 40%. With "Mark to Value", a bank can be insolvent even though it may be showing a profit. Therefore allowing banks to "Mark to Market" means that the taxpayer will likely have a much larger bill in the future as bank deposits - current true value of securities is less than $0 even though the bank is showing a profit but doesn't have any cash to pay employee salaries.

Therefore I'd prefer a "Mark to FDIC" where FDIC evaluates the portfolio potential and creates a realistic future price.

The banks didn't allow people to "Mark to Value" their home (what they paid for it) when the housing market crashed but for some reason, banks seem to think they should be treated special. Eventually most houses that were underwater will be above water but a bank appraiser will "Mark to Market".

Pulaski

Oh, there was much worse than that, there was also "mark to model" aka "mark to myth"! It was used to ascribe a value to complex derivatives for which there was no market, no market for the underlying securities, and no way to track how the "value" (I use the term loosely ) of the derivative varied when the "value" of the underlying securities varied.
But the bank did allow something very similar: mark to revaluation, allowing their mortgage borrowers to obtain a revaluation, then draw the increase in value on an equity line. The rules varied by state, with most states allowing it, though Texas did/ does not. Now the maximum borrowings allowed against the borrowers home are capped at a percentage (less than 100%) of the purchase price.

Michael

The banks loved "Mark to Market" when the housing and equity markets were rising since each quarter, they could show a bigger and bigger profits and therefore give themselves bigger bonuses and more stock options. But once everything crashed, they no longer liked it.

I believe "Mark to Myth" was the name given to the proposal that the banks wanted to implement where the "board of directors" would decide what was the value of securities.

The main problem with "Mark to Value" is that a bank can't survive if it can't sell it's securities at the price they need when they need to sell them. It's sort of the same as when a person is out of a job and can't make his/her mortgage payments but tells the bank that sometimes in the future, I'll again have a job and will be able to make the payments. So just trust me.

sir_eccles

Having now read up on the Matter of Izummi, I can clarify what I meant by my statement. Any guarantee or promise of a return of the investment negates that it is at risk. i.e. an EB5 investment cannot have any guaranteed rate of return or any sort of agreement to future use or ownership.

Michael

As Larry Kudlow said "this is a once in a century event" and as bankers said "we don't need to be regulated since this won't happen again" (until the next time).

eb5s

This is investment on loan project, right? A capital repay schedule is given to the EB-5 investor.

eb5s

Anybody knows what percentage real estate projects account for total EB-5 investment projects?

Michael

You'd have to look at each investment as to how it is structured. It could possibly be a 5 year maturity zero coupon bond where if successful and new financing can be arranged (possible bank loans or new bond sales), you'd probably get 100% repayment plus interest at 5 years. However if they can't get new financing on the open market, they may have to file for reorganization (chapter 11) to reduce their debt load to be able to acquire new investors or bank loans or file for bankruptcy (chapter 13) and sell off all assets.

If you are holding bonds in the equity tranche and the company is reorganized or files for bankruptcy, you can probably kiss the principle good by. If you hold a more senior tranche, you may possibly get some of your money back.

Therefore everything is in the details with the right tranche, the right project, the right time, and the right location.

Some projects could also be just you but even if you can find such a project, would you give $500,000 to $1,000,000 to someone and trust that person knows how make the project successful, not just use your money to pay his salary, and knows how to meet the requirements for EB5?