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Bank of America Corp., seeking to reduce risk and meet new capital standards, upgraded billions of dollars of distressed mortgage bonds by repackaging them into new securities using a variation of a Wall Street technique that failed during the credit crisis.

The transactions, known as re-remics, are designed to add a layer of protection to residential mortgage-backed securities that sustained losses, enabling them to regain investment-grade ratings. The strategy helped the bank pare its RMBS holdings by $5.2 billion in the second quarter, or about 15 percent, according to a company filing.

With bank stocks mired near historic lows in relation to book value, firms such as Bank of America and JPMorgan Chase & Co. are searching for alternative ways to meet rules set by global regulators since the 2008 financial crisis. By turning junk-rated securities into investment-grade bonds, Bank of America will need to hold less capital under rules agreed to by the Basel Committee on Banking Supervision.

“The larger banks are going to do anything and everything they can to create capital other than issuing stock,” said Matthew Pieniazek, president of Darling Consulting Group Inc., a Newburyport, Massachusetts, firm that provides asset-liability management advice to banks. “The most punitive way of raising capital is by issuing highly dilutive common equity in the current marketplace.”

‘Scrubbing’ Balance Sheets

Re-remics, short for re-securitizations of real estate mortgage-investment conduits, are one way for lenders to improve capital ratios without issuing stock, according to Pieniazek, who also runs educational programs for bank regulators. Firms such as Bank of New York Mellon Corp. have been doing re-remics since the credit crunch began in 2007, primarily to restructure private-label RMBS to make the bonds easier to divest.

Bank of America repackaged $13 billion of mortgage-linked securities in the first half, according to Jerry Dubrowski, a spokesman for the company, and filings with the Securities and Exchange Commission. The Charlotte, North Carolina-based bank is the only one of the five biggest U.S. lenders to disclose that it used re-remics this year for regulatory capital purposes.

More banks may turn to the technique as they come under pressure to boost capital, said Marty Mosby, an analyst at Guggenheim Securities LLC in Memphis, Tennessee. While the transaction may trigger a writedown, improved profits this year can cushion the blow.

“Re-remics are a way of doing some scrubbing of the balance sheet at a time when banks have other gains that give them a lot of flexibility,” said Mosby, who was chief financial officer at First Horizon National Corp. in Memphis, Tennessee’s largest bank, from 2003 to 2007.

Housing Boom

The housing boom of the past decade was fueled by the securitization market, in which Wall Street firms bundled mortgages into trusts that then issued different classes of securities. A record $1.2 trillion of mortgage bonds lacking government support were issued in both 2005 and 2006, according to newsletter Inside MBS & ABS. Many of them were rated AAA based in part on their priority in receiving payments made on underlying mortgages.

Banks invested heavily in these bonds, also known as private-label or non-agency RMBS because they didn’t have guarantees from government-backed agencies such as Fannie Mae or Freddie Mac, only to suffer big losses after borrowers began defaulting on subprime mortgages in 2007. Lenders held about $197.2 billion of private-label RMBS as of June 30, down from $383.5 billion at the end of 2007, according to data compiled by the Federal Deposit Insurance Corp.

‘Toxic Waste’

“When you talk about toxic waste in the banking system, privately issued mortgage-backed securities are at the top of the list,” said Richard Bove, a bank analyst at Rochdale Securities LLC in Lutz, Florida. “The banks have written down these portfolios very aggressively.”

As of July 31, Standard & Poor’s had downgraded $2.4 trillion of the $3.3 trillion in structured-finance securities tied to the U.S. housing market that were issued from 2005 through 2007, according to an Aug. 30 report by the credit- rating firm.

Most securitizations during the housing boom consisted of senior securities that got investment-grade ratings and junior securities that were first in line to absorb losses when borrowers defaulted.

Financial Engineering

In a re-remic, the senior mortgage bonds that have lost their investment-grade ratings are placed in a new trust, which issues a new set of senior and junior securities, with the higher-ranking bonds receiving first rights to cash flows from the original home loans. The junior securities in the re-remics provide an additional layer of protection to the cushion created by subordinated bonds from the original securitization. They’re second in line to bear any losses, which means more senior investors wouldn’t suffer any damage unless the junior securities were wiped out.

The financial engineering allows the senior re-remics securities to regain AAA ratings, lowering the amount of capital a bank needs to hold against them. The junior securities, which retain non-investment-grade ratings, can be sold to investors looking for higher yields.

“What broke the asset-finance market — securitization — is what’s fixing it,” said Matthew Lambiase, managing director at Annaly Capital Management Inc., a New York-based real estate investment trust that owns mortgage-backed securities.

Re-Securitization Trust

Bank of America, the largest U.S. bank by assets, had a net $2.8 billion of unrealized losses on $37.9 billion of non-agency RMBS listed in its financial statements as available for sale at the end of last year, according to company filings. The bank pooled $13 billion of these bonds in a re-securitization trust that issued two new classes of debt during the first half of 2010, said Dubrowski, the company spokesman.

Sales of re-remics, in combination with mortgage repayments, reduced the carrying value of the bank’s RMBS holdings by $5.2 billion, according to a quarterly report the company filed with the SEC on Aug. 6. Dubrowski declined to say which firm rated the bank’s re-remics, what the ratings were or who purchased the securities.

At issue is whether defects in the securitization market that contributed to the financial crisis, including faulty credit ratings and weak underwriting standards, have been eliminated. Janet Tavakoli, a structured-finance consultant who has criticized the financial industry for lax underwriting and excessive leverage, said senior bonds created through re-remics remain vulnerable to losses on soured home loans.

‘Going to Fail’

“The underlying problem is that securitization professionals were securitizing loans they knew were going to fail,” said Tavakoli, founder of Chicago-based Tavakoli Structured Finance Inc. and author of books on securitization. “None of those problems has gone away.”

In May, S&P cut to junk the ratings on re-remics granted AAA grades when they were created in 2009 by companies such as Credit Suisse Group AG, Jefferies Group Inc. and Royal Bank of Scotland Group Plc. The downgrades to about $150 million of debt “reflect our assessment of the significant deterioration in performance of the loans backing the underlying certificates,” Cesar Romero and Terry G. Osterweil, analysts at the New York- based ratings firm, said in a note at the time.

Tougher Standards

Credit-rating companies such as S&P are using tougher standards before meting out top grades for mortgage bonds, according to Thomas Capasse, a founding member of Merrill Lynch & Co.’s asset-backed securities group. The firms are demanding lower loan-to-value ratios on mortgages that underlie the bonds and higher credit scores for borrowers, as well as full documentation of their income and financial condition, said Capasse, now a principal at Waterfall Asset Management LLC, a New York-based firm that invests in high-yield structured debt.

“The securitization that failed,” said Capasse, was intended to get risk off of bank balance sheets and “create access to higher-risk loans with more leverage.” In contrast, re-remics are designed to restructure distressed mortgage bonds so they qualify for investment-grade ratings under the tougher criteria, Capasse said.

In addition to the $13 billion of its own securities, Bank of America has been carrying out “customer-driven” re- securitizations and re-remics of mortgage bonds backed by the government, according to Dubrowski, the bank spokesman. The company’s overall repackaging, reflecting all three categories, increased to almost $69 billion during the first half of 2010 from $16 billion for the same period last year.

JPMorgan Re-Remics

JPMorgan transferred about $14.3 billion of government- backed mortgage bonds, along with $1 billion of private-label debt, to re-securitization trusts during the first half of this year, according to its quarterly report for the three months ended June 30. The New York-based bank said in the filing that its re-securitizations involve both residential and commercial mortgages and are often structured on behalf of clients.

Bank re-remics of agency mortgage bonds aren’t tied to regulatory relief because the underlying debt carries AAA ratings, thanks to their government backing, reducing the amount of capital firms need to set aside for these assets. Rather, these re-remics are designed to redistribute cash flows on the agency debt to provide investors with securities that have varying sensitivities to interest rate changes, said Scott Buchta, head of investment strategy at New York-based Braver Stern Securities LLC.

Beaten-Down Bonds

With the yield on 10-year Treasuries diving below 2.4 percent, and the Federal Reserve buying $1.25 trillion of agency bonds to support housing and mortgage markets, the supply of higher-yielding AAA securities began to shrink, said Lambiase at Annaly Capital. That provided an opportunity for banks and brokerages to repackage beaten-down private-label mortgage bonds into AAA debt through re-remics.

“There are not a lot of high-yielding AAA assets in the marketplace,” Lambiase said. “People are using re-remic technology to create AAA bonds” that are relatively high yielding, he added.

About $36.2 billion of re-remics for private-label RMBS was issued in the U.S. during the first eight months of the year compared with $45.5 billion for all of 2009, according to data from Austin, Texas-based Amherst Securities Group LP, a dealer in mortgage-backed securities.

Average Life

The re-remics had an average life of 3.2 years and yielded about 4.5 percent, according to Amherst, compared with a 3.55 percent yield on corporate bonds rated BBB, the second-lowest investment-grade rating from S&P, with a life of 5.7 years.

The assets of Bank of America’s re-securitization trusts grew to $32.6 billion as of June 30 from $7.4 billion at the end of last year, according to the Aug. 6 SEC report. Holdings in the senior class of securities issued by these trusts rose to about $17.9 billion from $543 million, the filing said. The bank had about $1.7 billion of the subordinated securities as of June 30 compared with none at the start of the year.

By carving up cash flows from the mortgages that back the bonds in the re-securitization trust, Bank of America was able to cut its junk-rated holdings in the first half, according to Dubrowski. The bank hasn’t disclosed the dollar value of RMBS converted from junk to investment-grade levels.

The cut reflects the sale of newly created subordinated securities as well as upgrades on senior bonds formed through the re-securitizations.

$711 Million Loss

The re-remics resulted in a loss of $711 million in the second quarter that was offset by other trading gains, according to the Aug. 6 filing. Simply selling the junk-rated debt could have triggered even larger losses that would have depleted the bank’s capital, according to Allen Greer, a former Bank of America commercial real estate analyst who now runs Greer Advisors LLC, a market-research company in Los Angeles.

“Bank of America is structuring this re-remic to take the lowest upfront hit possible,” Greer said. “The $711 million they reported is probably a fraction of what the loss should have been, based on what distressed-debt websites are showing.”

Bank of America declined 4.9 percent to $12.64 at 11:32 a.m. today in New York Stock Exchange composite trading. The shares have declined 16 percent this year.

Kevin Bailey, the deputy comptroller for capital and regulatory policy in the Office of the Comptroller of the Currency, declined to comment on bank use of re-remics. Andrew Gray, a spokesman for the FDIC, and Barbara Hagenbaugh, a Fed spokeswoman, also declined to comment.

‘Streamlining’

Bank of America entered into the second-quarter re-remics in late May “following a review of corporate risk objectives in light of proposed Basel regulatory capital changes and liquidity targets,” according to the August SEC filing.

“What we decided to do was reduce non-investment grade RMBS,” Dubrowski said, adding that the bank inherited some securities by its acquisitions of Merrill Lynch & Co. in 2009 and Countrywide Financial Corp. in 2008. “It was part of an overall strategy of streamlining the balance sheet ahead of the Basel standards and meeting certain liquidity targets we had.”

The standards, approved by the Basel committee last month, will more than double the ratio of capital banks must hold in relation to the amount of risk on their balance sheets. In separate reports last month, KBW Inc. and Morgan Stanley said Bank of America was likely to have the weakest Tier 1 common equity capital ratio among four major banks under the new rules.

While banks have as long as eight years to comply, they must “maintain prudent earnings retention policies” until they reach a 7 percent Tier 1 common equity ratio, according to Frederick Cannon, an equity strategist at New York-based KBW. In practice, that means they can’t buy back stock or pay dividends until they reach the threshold, he said.

Capital Ratios

“The banks are going to want to get to those levels as soon as possible,” Cannon said. Lenders “will continue to be active in trying to manage down their risk-weighted assets.”

Jamie Dimon, chief executive officer of JPMorgan, the second-largest U.S. lender by assets, said in an investor presentation last month that the Basel rules would reduce the bank’s capital ratio by about three percentage points. The company also said that the standards would require it to hold a greater proportion of assets in financial instruments that could be sold easily.

The committee, which includes central bank governors and regulators from 27 nations, also adopted a market-risk regulation in July 2009. That rule, scheduled to go into effect by the end of next year, raises the capital requirement for securitized and re-securitized debt.

Cut to Junk

Under the market-risk rule, banks would have to hold as much as $100 of capital for a $100 junk-rated mortgage bond. By re-securitizing those bonds, banks can turn a portion of them into AAA rated securities that would lower the capital charge to as little as $1.60 for those bonds.

In pursuing its re-remic strategy, the primary risk for Bank of America is that mortgage delinquencies will increase, causing losses to seep into the AAA re-remics that the company continues to hold, said Pieniazek at Darling Consulting. That’s what happened during the credit crisis, when defaults burned through layer after layer of protection and made some AAA rated securities almost worthless.

“We look at the re-remic trade as being more of a restacking of the credit deck,” said Donald Ramon, chief financial officer of Atlanta-based Invesco Mortgage Capital Inc., a real estate investment trust that trades mortgage-backed securities. “You end up with a security at the bottom that has all of the risk, and there’s not much liquidity.”

To contact the reporters on this story: Miles Weiss in Washington at mweiss@bloomberg.net; David Mildenberg in Charlotte at dmildenberg@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net