By Christopher B. Killian and Joseph Cox

 This article originally appeared
in The Securitisation & Structured Finance Handbook 2015/16.

The restoration of private-sector securitization – non-government guaranteed securities – is a necessary component of the broader reinvigoration of the housing system in the United States. Why has the market for Private-Label Mortgage-Backed Securities (PLS) remained largely stagnant while others have gained momentum since the financial crisis?

In this article for The Securitsation & Structured Finance Handbook, the SIFMA Securitization Group (SSG) explores the continued dormancy of the market and the factors that continue to constrain it. The authors point to the enactment of housing finance reform legislation as a critical component of the recovery of PLS markets. While there were promising and substantive discussions in 2014, much work remains to be done: now is the time to review the state of our housing finance system, reform the GSEs, and set a positive direction for the future that helps to maintain credit availability and support the economy’s needs.

“A clear direction for the future provided by the passage of housing finance reform legislation would support greater private investment in the mortgage market, and we believe this is a critical action that needs to be taken.”

The US private label mortgage-backed securities market in 2015

By Christopher B. Killian and Joseph Cox

Mortgage loans in the United States are usually funded in one of threeways: (i) by banks, through retention on their balance sheets;(ii) through securitisation with government or quasi-government guaranteed mortgage-backed securities (“MBS”) guaranteed or issued by Ginnie Mae, Fannie Mae, or Freddie Mac (the latter two, government sponsored enterprises or “GSEs”, and the guaranteed MBS “Agency MBS”); or (iii) through securitisation in non-government guaranteed securities commonly referred to as private-label mortgage-backedsecurities (“PLS”).

The PLS market has significantly shrunk over the last seven years. PLS issuance averaged US$368.7bn per year from2001-07 but only averaged US$9.6bn per year from2008-14. While the global economy has gained momentum since the financial crisis, and other securitisation markets (e.g. collateralised loan obligations and auto-loan asset-backed securities) have seen restored issuance volumes, the PLS market has been fairly stagnant.

This article discusses the continued dormancy of the PLSmarket and briefly outlines some reasons for its current diminished condition. In our view, the low level of activity in PLS is due in part to the lingering effects of poor origination practices during the housing boom and the resulting reluctance of sophisticated investors to buy senior debt. The PLS market is also significantly constrained by other factors including market dynamics, regulatory uncertainty, as well as disagreement over roles and responsibilities of transaction participants. Perhaps most importantly, PLS suffer a relative disadvantage to GSE and Federal Housing Administration (“FHA”) MBS due to government guarantees and preferential regulatory treatment, and low bank funding costs create a strong bid for loans to be held in investment portfolios. We believe that enacting housing finance reform legislation will be acritical component of the recovery of PLS markets.

Origination economics do not support robust PLS issuance

The core issue of whether or not a loan is held for investment, securitised in the Agency MBS market, or securitised in the PLS market is dictated by price execution. The fact is that PLS execution often comes at a higher all-in “cost” than GSE and bank portfolio execution. The all-in cost takes into account not only direct funding costs, but also legal and reputational risk and expectations of future issuance and liquidity.

PLS funding cannot compete with government-guaranteed alternatives, and currently is not competitive with the bank portfolio bid that is driven by a very low cost of funds. Accordingly, those channels dominate PLS for comparably sized mortgages. Since lenders will utilise the most efficient sources of funding for their activities, PLS will thrive when the economics of securitisation work for the originator, issuer and the investor all at once.

Accordingly, efforts to improve PLS markets should focus on reducing current roadblocks to issuance, leveling the playing field, and increasing the competitiveness of PLS even if the issuance will not rebound to high levels immediately.

PLS investor concerns remain

PLS investors continue to express a number of concerns regarding data and transparency of cash flows, documentation, the roles and responsibilities of transaction participants, enforcement of contractual terms, and ex-post policy changes.

• Documentation – Most investors believe that information on securitisation structure and documentation should be more accessible and clearer in transaction documents. Investors typically see benefit in things such as greater disclosure of due diligence processes and results and guidelines by which loans will be serviced and losses mitigated. Many investors also believe that reporting on transaction cash flows should be improved and made more transparent and verifiable.
• Enforcement of terms – Investors do not have confidence in their ability (or the ability or willingness of other transaction parties) to enforce the terms of representations and warranties on underlying assets. This has led to calls for a stronger role for trustees, including calls for a fiduciary duty to investors, and/or inclusion of a third-party collateral risk manager ordeal manager to examine suspected defective loans and oversee the activities of the servicer. Developing appropriate mechanisms to enhance the enforcement of contractual terms is an issue of intense debate among securitisation market participants.
• Assignee liability and legal uncertainty – Investors are concerned with the prospect of assignee liability stemming from violations of the ability-to-repay rules contained in Title XIV of Dodd-Frank and embodied in the Consumer Financial Protection Bureau’s (“CFPB”) implementing regulations which include the Qualified Mortgage (“QM”) safe harbours. It will be through litigation where the market learns the exact boundaries of the protections provided by any safe harbour and the contours of gray areas stemming from a lack of clarity in the lending regulations. This potential liability for lenders and investors is likely to reduce the availability of higher-priced QM loans and non-QM loans, all else equal, due to higher required yields that compensate for increased risk.
• Ex-post policy changes and other risks – Investors have significant concerns with and continuing distrust of the policy environment driven by a sense that rules have been (and continue to be) changed ex-post. The threat by certain municipalities to use eminent domain to seize performing mortgage loans has been a focus of MBS investors for the last three years and would introduce a significant new risk into PLS investments. Similarly, PLS investors, while supporting loan modifications for troubled borrowers, have also expressed frustration at the process of the creation of the Home Affordable Modification Program (“HAMP”)and the numerous changes made to the programme without inclusion in the decision making process of investors who were directly impacted. Various federal and state legal settlements also have created mistrust among MBS investors and a feeling that they were not only excluded from discussions about but also harmed by activities that impacted them directly.
• Liquidity – SIFMA estimates there is approximately US$33bn of AAA PLS outstanding today. In combination with a number of other factors not discussed here, this dramatic decline in outstanding PLS has reduced liquidity in PLS markets, which causes larger players to remain on the sidelines as they await larger and more regular issuance volumes and liquidity. Investors will not allocate the necessary resources to analyse and manage PLS if they have no assurance of regular issuance.

Conflicting signals from policymakers and regulators

Conflicting signals from policymakers and regulators regarding acceptable lending practices have been detrimental to mortgage credit availability as well as to PLS issuance. Policymakers continue to exhort originators to loosen credit standards, but many policy actions have had the effect of driving investors away from PLS or causing originators to lend more conservatively.

Carefully reducing the government’s footprint creates room for the PLS market to operate and grow and is often a stated goal of policymakers. Policymakers have implemented a number of initiatives that are aimed at reducing the GSEs’ role in the mortgage market, but at the same time have made it more challenging for the private market to provide credit. The Federal Housing Finance Agency (“FHFA”) raised GSE guarantee fees and Congress, for its part, imposed a 10bp increase in guarantee fees to fund other government priorities. The intention of this was to increase the cost of GSE securitisation so as to make PLS more competitive. However, recent experience has shown that increasing guarantee fees will not necessarily lead to increased PLS issuance.

Examples of actions that have impacted the availability of credit are the GSEs’ and FHA’s enhanced put-back efforts and litigation against seller/servicers. These actions have caused lenders to become more risk averse so as to ensure they do not originate loans that they must buy back in the future. More recently, the GSEs have attempted to provide clarity regarding this put-back risk, but positive impacts of this effort have been slow to materialise. The FHFA and the GSEs have also tried to expand the reach of the Home Affordable Refinance Programme (“HARP”) (a government refinancing programme), and otherwise incent origination activity through expanding high loan-to-value lending programmes. These efforts work in opposing directions and a clear signal has not been sent to the market.

Other actions (or inactions) have the effect of preserving Agency MBS dominance over PLS. GSE loan limits remain elevated, there is an exemption for ability-to-repay regulations for GSE-eligible loans, and a special ability-to-repay regime was created for FHA loans. Furthermore, PLS are not given any credit in the liquidity coverage ratio rules which apply to banks, and capital treatment of PLS looks to be headed in a less favourable direction. Government guaranteed MBS receive much more favourable treatment.

Numerous policymakers have exhorted banks to make more loans and publicly spoken about the importance of the loosening of credit terms. However a brief perusal of the news finds continual attacks on banks for making too many risky loans in prior years, and a strong desire for punishment and retribution. Litigation brought by various branches of the government continues. This dichotomy keeps private capital away as it waits for a less threatening environment.

Forward progress: The need for comprehensive housing finance reform

Mortgage underwriting standards have been strengthened by the ability to repay regulations issued by the CFPB pursuant to Title XIV of Dodd-Frank. Bad origination was a fundamental problem of 2005-08, and ensuring that underwriting is strong and prudent is likely to be the most critical of changes to the system. The CFPB has also issued servicing standards that apply to all mortgage loans, however they only address borrower-servicer interactions. Taken together, these are substantive and important reforms that should promote a more stable, robust, and safe and sound market for mortgage finance. The question is whether they will promote a broad enough market to fund the credit needs in this country.

As shown in Exhibit 1, the credit quality of recent new-issue PLS is extraordinarily high. However, it is clear that the range of credit currently being funded by securitisation is not broad enough – borrowers whose loans funded by PLS tend to obtain large loans, have very high credit scores, and significant down payments and/or cash reserves.

On the positive side, the regulatory environment for securitisation is becoming clearer given the finalization of the risk retention rules mandated by Dodd-Frank and the finalisation of the SEC’s suite of securitisation rules known as Reg AB2. Leaving aside the merits of the finalised rules themselves, which vary, there is a macro benefit from simple certainty regarding these rules.

On the other hand, uncertainty regarding the direction of GSE reform and broader housing policy questions has discouraged PLS issuance. Issuers and investors are not likely to build the infrastructure necessary for a vibrant PLS market until they have a better understanding of how the government’s role in mortgage funding will change and a belief that the market structure is stable. We have already discussed that PLS execution simply cannot compete with the government-guaranteed market; where housing finance reform moves the boundaries of the government market will in large part determine the future of the PLS market.

A clear direction for the future provided by the passage of housing finance reform legislation would support greater private investment in the mortgage market, and we believe this is a critical action that needs to be taken. Reform should support the continued availability of mortgage credit, preserve the 30-year mortgage and the critically important to-be-announced market, while also rationalizing the role of the government in housing finance. Such reform would provide much needed clarity and boundaries within which the PLS market may once again flourish.

Conclusion

In this article we have explored some of the issues that impede the return of a more active and liquid PLS market. Our writing is not intended to be exhaustive but rather to highlight some of the key issues facing the market. GSE reform legislation has not moved forward and it appears that it will be some time before it does and the future nature and size of government involvement in housing finance remains uncertain. Policymakers exhort banks to loosen credit standards with one hand, yet continue the drive to punish with the other. This creates unforeseeable risks for originators, securitisers and investors, and delays capital commitments to mortgage markets from each of them. Each of these issues has contributed to the dormancy of the PLS market. We have begun to see signs that a shift in views from policymakers is beginning to take hold, and there were promising and substantive discussions about housing finance reform in 2014 – but there is much work still to be done.

Chris Killian
Managing Director
SIFMA Securitization Group (SSG)
SIFMA

Joseph Cox
Assistant Vice President
SIFMA Securitization Group (SSG)
SIFMA