PERSON OF THE WEEK: Since the financial crisis broke out, William A. Frey, CEO and founding partner of Connecticut-based Greenwich Financial Services LLC, has cemented his position as a voice for the mortgage bondholder community, speaking out against industry practices that are perceived as detrimental to investor interests.
However, prior to the U.S. housing bust, Frey was also a chief architect of Russia's asset-backed securitization market. As the man behind the first Russian RMBS deal – a 2006 transaction that International Securitization Report named ‘Deal of the Year’ – Frey brings a unique perspective to the ongoing efforts to reform the U.S. private-label market.
In his newly released book – "Way Too Big To Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System" – Frey lays out his recommendations for U.S. policymakers to consider as they reshape the market.
Q: What was the impetus for your new book, and what do you hope to accomplish with its release?
William Frey: The main reason I wrote this book was to make sure policymakers have the information they need to understand the underlying problems. I read a lot, and 95% of what I read about the mortgage-backed securities (MBS) crisis does not address the real problems. Without understanding the problem, I fail to see how any policymaker can even ask the right questions, let alone craft some sort of solution.
Q: You were instrumental in the construction of Russia's asset-backed securities market in the mid-2000s. What lessons from that experience do you believe could help inform the current situation in the U.S. market?
Frey: The fact that I was starting with a blank piece of paper meant that I did not have any legacy issues I needed to work around. The most important issue was that I needed to tie the contractual responsibilities with economic incentives for all the parties involved.
To do that, I needed to make sure that all participants – including me – had "skin in the game." This made it possible to get large institutional investors to purchase the securities, because they felt comfortable that the underwriting and servicing functions were committed to the long-term success of the transaction.
Q: In your book, you outline changes that you believe are necessary to rebuilding the private MBS market. Among your recommendations is the requirement for securitization participants to have skin in the game, which the Dodd-Frank Act attempted to do with its Qualified Residential Mortgage (QRM) provision. Do you think the legislation succeeded in that regard?
Frey: No. The problem with QRM is that it provides an exception based on collateral. I think that issuers should have skin in the game for all collateral used in public securities. Under the proposed rules, if the collateral is poorly underwritten but is QRM, then the issuer has no skin in the game. When the success of the securitization directly depends on the quality of the collateral, this exception makes no sense.
Q: Many have argued that the government's handling of the housing crisis has severely impeded lenders' and investors' ability to foreclose. In your view, has the Obama administration's foreclosure-avoidance policies helped or hurt the market's recovery?
Frey: If you believe, as I do, that the market will recover only after we have worked through the foreclosure backlog, then you have to conclude that the Obama administration's foreclosure-avoidance policies have hurt the market recovery. The problem is that efforts to date have primarily been focused on modifications to loan payment schedules, but several studies have shown that payment modifications alone are ultimately unsuccessful; there must be principal reduction as well, especially with underwater mortgages.
If you say the answer, then, is principal reductions – and it may well be – the problem becomes, who pays for it? Respecting lien priority means that only the government can absorb the costs of principal writedowns, as bank capital positions are too weak. A government-funded principal modification program would entail a political battle going into a re-election year. Political considerations may trump economic reality, and the market recovery is further delayed.
Q: Since the start of the crisis, mortgage servicing practices have come under increasing investor scrutiny. What are your thoughts on the ongoing efforts to reform servicing standards, and which practices do you believe must absolutely be changed?
Frey: There is no doubt that RMBS investors have been harmed by sloppy servicing practices in the case of the robo-signing issue, and flawed servicing practices in the course of regular servicing.
In the robo-signing issue, thousands of incorrectly documented files were represented to the courts as correct and legally proper. However, while this is a fraud on the courts, I have not seen any evidence of systematic foreclosure on people who were paying their mortgage.
In other words, the harmed parties in the robo-signing scandal are not the homeowners subject to foreclosure action but the mortgage investors that were relying on the servicer to foreclose in a timely and legal manner in order to mitigate loan losses.
Separate from problems with the foreclosure process, regular servicing for investors has been flawed. A standard part of a pooling-and-servicing contract is that the servicer will service in the best interest of the first-lien holder. This has not been the case. There has been a problem with banks servicing not in the interest of the first-lien holder, but to support the banks' second-lien position liens that are not securitized but held as whole loans in the banks' portfolio.
In addition, situations arise under which servicer banks maximize the expenses billed to the trust through the use of captive vendors. Simply put, the interests of the servicers are not aligned with those of investors, and a strong case can be made that they are actually opposed to those of investors.