SBC Discusses Ways to Reinvigorate the PLS Market
AT OCTOBER 1ST’S SENATE BANKING COMMITTEE HEARING, industry representatives and academics discussed ways to reinvigorate the private label mortgage backed securities (PLS) market.
In their opening remarks, Chairman Tim Johnson (D-S.D.) and Ranking Member Mike Crapo (R-Idaho) both expressed the pressing need for housing finance reform, noting the outsized role of the government and the severe contraction of private capital in the housing market since the crisis. Johnson said the combination of Dodd-Frank reforms and higher guarantee fees are providing stronger incentives for private capital to return, but stated that future reform efforts must create incentives that allow the private market to play a “central role” in a future housing system. Crapo said it is important for the Committee to identify the regulatory, legal or structural hurdles facing the PLS market, including the effects of eminent domain schemes, so that reform efforts can bring the private sector and private capital into an “appropriate balance.”
In his opening statement, Martin Hughes, Chief Executive Officer of Redwood Trust, focused his testimony on the current state of the PLS market and ways to incentivize the return of private capital to the housing market. He said several factors are negatively affecting the PLS market, including the increase in the conforming loan limit, the “significant” pricing advantage of the Government Sponsored Enterprises (GSEs), banks’ decision to hold jumbo loans in portfolio, and investors’ lack of confidence in their ability to invest in the housing market safely. Despite the list of issues affecting the PLS market, Hughes said the problems he outlined are solvable by identifying best practices for reps and warranties, establishing binding arbitration as the minimum standard for dispute resolution, requiring better credit risk management from securitization trusts, addressing servicer conflicts-of-interest, controlling systemic and loan-level risk of second lien mortgages, and reducing government participation in the market by reducing GSE conforming loan limits.
In his testimony, John Gidman, testifying on behalf of the Association of Institutional Investors (AII), said conditions in the PLS market have improved since the crisis, but absolute volume is “a small fraction” of what it was before the crisis. He highlighted the average requirements of a PLS loan post-crisis, noting that current PLS standards cannot be used to finance mortgages for the majority of Americans. He said there is “pent-up demand” on behalf of institutional investors to participate in the market, but they will not participate until there is a “structural reform” of the market. Gidman praised S.1217, the Housing Finance Reform and Taxpayer Protection Act of 2013 for moving the reform process forward, but said the legislation must address investor’s concerns more directly, including trustee fiduciary duty provisions, the elimination of the ability-to-repay rulemaking and the risks associated with current eminent domain schemes.
In his opening statement, Adam Levitin, Professor of Law at Georgetown University Law Center, said the crisis proved that the PLS market cannot be the backbone of the housing finance system and blamed it for providing the “rocket fuel” that drastically increased housing prices in the run-up to the crisis and spurred their subsequent collapse in 2007-2008. He noted that the PLS market has yet to truly recover, echoing several of the concerns highlighted by Gidman, but said regardless of structural housing reform, private capital will only be able to support $500 billion annually in mortgage credit risk, compared to the $1.5-$4 trillion of financing needed. In closing, Levitin advocated for a “hybrid” public-private housing finance structure with first-loss private capital “sitting in front of an explicit government guarantee” and the ability for the federal government to provide counter-cyclical support to the market.
Question and Answer:
Several Members, on both sides of the aisle, asked the witnesses to detail the consequences of municipalities using their powers of eminent domain to seize underwater mortgages from private investors. The witnesses noted that the impact on the PLS market has been relatively minor to this point, but if eminent domain is utilized, it will have a significant negative effect on private investor participation in the housing market. Gidman advocated for an expansion of the Home Affordable Refinance Program (HARP) to combat the attractiveness of eminent domain schemes to struggling municipalities and warned that if eminent domain powers are used to seize mortgages, private investors will not stand in a first-loss position in a reformed housing market. He further urged Members to act preemptively to shut down the eminent domain scheme “for housing reform to have a chance.”
Johnson asked Levitin to describe “one key lesson the market learned” about mortgage-backed security (MBS) investing during the crisis. Levitin said the markets learned “just how flighty private capital can be,” highlighting how quickly private capital receded from the market and flowed into “safer assets.”
“… But the one key lesson learned is that the market needs some sort of explicit government role for stability purposes,” Levitin concluded.
Johnson and Crapo asked Hughes if standardization of PLS terms and documentation would bring private capital back into the market. Hughes said it would, noting that some progress has been made on the standardization front, but work is still needed on standardizing reps and warranties and establishing market best practices.
Johnson and Crapo asked Gidman how to effectively address conflicts affecting private label MBS trustees and servicers of “MBS pools with troubled loans.” Gidman said increasing transparency, aligning interests and enforcing a fiduciary duty on Trustees are notable gaps in the PLS market that must be fixed.
Sen. Elizabeth Warren (D-Mass.) asked the witnesses how regulators could exert “counter-cyclical pressure” on the PLS market in coordination with counter-cyclical guarantee fee increases or decreases. Levitin said there is a “tool missing in the regulatory toolbox,” referring to regulators inability to control the amount of leverage in the housing finance market.
“Regulators need to have the ability to limit combined loan-to-value (LTV) on new mortgages being originated,” he said, noting that regulators have this authority in other countries. He added that regulators can affect the market through interest rates, but he called that a “blunderbuss” approach that affects other markets.
Hughes and Gidman both agreed with the approach advocated by Levitin, although Gidman added that another tool could include mandating capital ratios for originators.
Warren asked Levitin if he agreed with the notion that the Qualified Mortgage (QM) definition and Regulation AB (Reg. AB) will effectively limit risks in the private market. Levitin said he has “concerns” with both QM and Reg. AB. He said his biggest concern is that a large portion of the market will be non-QM, and industry players, and regulators do not yet understand the risks of a non-QM mortgage.
Sen. Bob Corker (R-Tenn.) asked the witnesses if the provisions in his legislation, such as a uniform PSA, a clear definition of reps and warrants, electronic registration, and uniform data are enough to encourage private capital back into the market. Gidman and Hughes said they believe the provisions Corker mentioned are “extremely helpful,” but not sufficient without the other structural reforms mentioned earlier.
Sen. Jack Reed (D-R.I.) asked if the first-loss capital provisions in the Corker-Warner legislation are set at an appropriate level. Levitin said the better question is how the word ‘capital’ is defined in S.1217 and said the authors should more explicitly state what constitutes capital for bond guarantors. Following up, Reed asked if the first-loss capital provisions in S.1217 will need to be “adjusted” for public policy purposes by the government. Levitin said he believes it will be and is concerned about how politicized that process may become.
Following up on Reed’s line of questioning, Mark Warner (D-Va.) and Mike Johanns (R-Neb.) asked if there should be an “ability to tranche” loans subject to the first-loss capital provisions. Gidman, Levitin and Hughes said it is “incredibly important” to allow for tranching, noting investors varying appetites for risk.
Heidi Heitkamp (D-N.D.) asked about the timing of reform. Levitin it is more important to get reform right, then done quickly because the problems in the market are not acute. Gidman and Hughes said there should be a high sense of urgency, noting the consensus reached in S.1217 and the general agreement on the structural reforms necessary to attract private capital back into the market.
For testimony and a webcast of the hearing, please click here.
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AT OCTOBER 1ST’S SENATE BANKING COMMITTEE HEARING, industry representatives and academics discussed ways to reinvigorate the private label mortgage backed securities (PLS) market.
In their opening remarks, Chairman Tim Johnson (D-S.D.) and Ranking Member Mike Crapo (R-Idaho) both expressed the pressing need for housing finance reform, noting the outsized role of the government and the severe contraction of private capital in the housing market since the crisis. Johnson said the combination of Dodd-Frank reforms and higher guarantee fees are providing stronger incentives for private capital to return, but stated that future reform efforts must create incentives that allow the private market to play a “central role” in a future housing system. Crapo said it is important for the Committee to identify the regulatory, legal or structural hurdles facing the PLS market, including the effects of eminent domain schemes, so that reform efforts can bring the private sector and private capital into an “appropriate balance.”
In his opening statement, Martin Hughes, Chief Executive Officer of Redwood Trust, focused his testimony on the current state of the PLS market and ways to incentivize the return of private capital to the housing market. He said several factors are negatively affecting the PLS market, including the increase in the conforming loan limit, the “significant” pricing advantage of the Government Sponsored Enterprises (GSEs), banks’ decision to hold jumbo loans in portfolio, and investors’ lack of confidence in their ability to invest in the housing market safely. Despite the list of issues affecting the PLS market, Hughes said the problems he outlined are solvable by identifying best practices for reps and warranties, establishing binding arbitration as the minimum standard for dispute resolution, requiring better credit risk management from securitization trusts, addressing servicer conflicts-of-interest, controlling systemic and loan-level risk of second lien mortgages, and reducing government participation in the market by reducing GSE conforming loan limits.
In his testimony, John Gidman, testifying on behalf of the Association of Institutional Investors (AII), said conditions in the PLS market have improved since the crisis, but absolute volume is “a small fraction” of what it was before the crisis. He highlighted the average requirements of a PLS loan post-crisis, noting that current PLS standards cannot be used to finance mortgages for the majority of Americans. He said there is “pent-up demand” on behalf of institutional investors to participate in the market, but they will not participate until there is a “structural reform” of the market. Gidman praised S.1217, the Housing Finance Reform and Taxpayer Protection Act of 2013 for moving the reform process forward, but said the legislation must address investor’s concerns more directly, including trustee fiduciary duty provisions, the elimination of the ability-to-repay rulemaking and the risks associated with current eminent domain schemes.
In his opening statement, Adam Levitin, Professor of Law at Georgetown University Law Center, said the crisis proved that the PLS market cannot be the backbone of the housing finance system and blamed it for providing the “rocket fuel” that drastically increased housing prices in the run-up to the crisis and spurred their subsequent collapse in 2007-2008. He noted that the PLS market has yet to truly recover, echoing several of the concerns highlighted by Gidman, but said regardless of structural housing reform, private capital will only be able to support $500 billion annually in mortgage credit risk, compared to the $1.5-$4 trillion of financing needed. In closing, Levitin advocated for a “hybrid” public-private housing finance structure with first-loss private capital “sitting in front of an explicit government guarantee” and the ability for the federal government to provide counter-cyclical support to the market.
Question and Answer:
Several Members, on both sides of the aisle, asked the witnesses to detail the consequences of municipalities using their powers of eminent domain to seize underwater mortgages from private investors. The witnesses noted that the impact on the PLS market has been relatively minor to this point, but if eminent domain is utilized, it will have a significant negative effect on private investor participation in the housing market. Gidman advocated for an expansion of the Home Affordable Refinance Program (HARP) to combat the attractiveness of eminent domain schemes to struggling municipalities and warned that if eminent domain powers are used to seize mortgages, private investors will not stand in a first-loss position in a reformed housing market. He further urged Members to act preemptively to shut down the eminent domain scheme “for housing reform to have a chance.”
Johnson asked Levitin to describe “one key lesson the market learned” about mortgage-backed security (MBS) investing during the crisis. Levitin said the markets learned “just how flighty private capital can be,” highlighting how quickly private capital receded from the market and flowed into “safer assets.”
“… But the one key lesson learned is that the market needs some sort of explicit government role for stability purposes,” Levitin concluded.
Johnson and Crapo asked Hughes if standardization of PLS terms and documentation would bring private capital back into the market. Hughes said it would, noting that some progress has been made on the standardization front, but work is still needed on standardizing reps and warranties and establishing market best practices.
Johnson and Crapo asked Gidman how to effectively address conflicts affecting private label MBS trustees and servicers of “MBS pools with troubled loans.” Gidman said increasing transparency, aligning interests and enforcing a fiduciary duty on Trustees are notable gaps in the PLS market that must be fixed.
Sen. Elizabeth Warren (D-Mass.) asked the witnesses how regulators could exert “counter-cyclical pressure” on the PLS market in coordination with counter-cyclical guarantee fee increases or decreases. Levitin said there is a “tool missing in the regulatory toolbox,” referring to regulators inability to control the amount of leverage in the housing finance market.
“Regulators need to have the ability to limit combined loan-to-value (LTV) on new mortgages being originated,” he said, noting that regulators have this authority in other countries. He added that regulators can affect the market through interest rates, but he called that a “blunderbuss” approach that affects other markets.
Hughes and Gidman both agreed with the approach advocated by Levitin, although Gidman added that another tool could include mandating capital ratios for originators.
Warren asked Levitin if he agreed with the notion that the Qualified Mortgage (QM) definition and Regulation AB (Reg. AB) will effectively limit risks in the private market. Levitin said he has “concerns” with both QM and Reg. AB. He said his biggest concern is that a large portion of the market will be non-QM, and industry players, and regulators do not yet understand the risks of a non-QM mortgage.
Sen. Bob Corker (R-Tenn.) asked the witnesses if the provisions in his legislation, such as a uniform PSA, a clear definition of reps and warrants, electronic registration, and uniform data are enough to encourage private capital back into the market. Gidman and Hughes said they believe the provisions Corker mentioned are “extremely helpful,” but not sufficient without the other structural reforms mentioned earlier.
Sen. Jack Reed (D-R.I.) asked if the first-loss capital provisions in the Corker-Warner legislation are set at an appropriate level. Levitin said the better question is how the word ‘capital’ is defined in S.1217 and said the authors should more explicitly state what constitutes capital for bond guarantors. Following up, Reed asked if the first-loss capital provisions in S.1217 will need to be “adjusted” for public policy purposes by the government. Levitin said he believes it will be and is concerned about how politicized that process may become.
Following up on Reed’s line of questioning, Mark Warner (D-Va.) and Mike Johanns (R-Neb.) asked if there should be an “ability to tranche” loans subject to the first-loss capital provisions. Gidman, Levitin and Hughes said it is “incredibly important” to allow for tranching, noting investors varying appetites for risk.
Heidi Heitkamp (D-N.D.) asked about the timing of reform. Levitin it is more important to get reform right, then done quickly because the problems in the market are not acute. Gidman and Hughes said there should be a high sense of urgency, noting the consensus reached in S.1217 and the general agreement on the structural reforms necessary to attract private capital back into the market.
For testimony and a webcast of the hearing, please click here.