BLOG VIEW: When a football hits the upright, odd bounces have changed the fortunes of many NFL teams. The mortgage market makeover necessitated by the 2006-2008 credit debacle has seen equally unpredictable bounces that threaten a repeat of past mistakes.
'Tis the football season, so relating our mortgage industry makeover attempts (or the lack thereof) to our favorite pastime's rules is timely. Allow me to answer the question, ‘Whatever happened to the move away from the government-sponsored enterprises (GSEs) to a private mortgage investor market?’ using a football metaphor.
A delay of game penalty is charged for the inability of participants (congress, regulators, administration, banks, etc.) to make much headway on a private market mortgage loan sales solution – seemingly, a priority problem in 2008 when Fannie Mae and Freddie Mac went into receivership. Only recently have ‘watered-down’ qualified residential mortgage rule (QRM) requirements been finalized, with another 12 to 24 months before implementation and impact.
‘Watered-down?’ What would you call the elimination of loan-to-value and credit scores from the final requirements? The two items that have the highest correlation to the probability of default are not included.
There were too many players (i.e., special interest groups) in the huddle contributing to the final toothless QRM rule set. Of course, proponents of a no down payment, no-credit-score QRM rule warned that consumer credit would evaporate and private investor capital could not be attracted.
Is there really a viable private market solution? Of course there is. Fannie and Freddie have historically issued private transactions from internal "shelves" designed for that specific purpose. One has to wonder, given that taxpayers ended up with all the GSE risk, why didn't the GSEs issue private transactions as a jumpstart to the expansion of a private footprint?
Certainly, execution would have been poor to begin with – and credit risk would need to be "retained" by the GSE/taxpayers to accomplish transactions. The GSE/taxpayer has all the risk of mortgage losses anyway. In doing so, we wouldn't have needed multiple proposals to reinvigorate the private mortgage investor, as we would have developed an execution method and known the "credit discount" we have given borrowers over the years.
The recent advent of GSE risk transfer transactions combined with traditional private-label nonconforming loan and loan advance securitizations provide the mechanism to not only sell mortgage loans to private investors, but also to sell, insure and reinsure credit risk and to provide liquidity for delinquencies and loan buyouts.
Here is my version of a possible execution: The senior bonds that I estimate to be "sized" by the rating agencies at 95% of the transaction trade into the private secondary market. Likewise, the remaining 5% subordinate bonds are also sold to private investors. Investors will be "backed" by a second loss piece that is provided by the GSE/taxpayer; however, the GSE/taxpayer will not be the "last loss" insurer.
If losses exceed the second loss piece, senior bondholders will have to take bond losses. In this example, the second loss piece (paid by the GSE/taxpayer) takes losses from 1.5% to 3.0% of the original pool, and receives a participation interest of 75 basis points (or 0.75%) of the loan pool. The estimated cost, initially, in terms of consumer credit costs of the past, would be as follows:
- Lower selling price/higher yields for senior bonds 20 basis points;
- Lower selling price/higher yields for subordinate bonds 12 basis points;
- Cost of GSE/taxpayer second loss insurance 19 basis points; and
- Estimated higher mortgage rate to consumers 51 basis points.
How might the private market evolution play out? Initially, say for two to three years, the GSEs' test the private market by auctioning their new production monthly. Next, a subsidiary is formed (probably another two to three years) to add the sale of credit risk (via transactions like the risk transfer noted above) and to provide credit resolution outsourcing to private investors. Last, with a market and operating platform in place, the subsidiary (or, better, multiple "like kind" entities) is/are spun-out to equity investors. What is left of the GSEs? They are a second-level loss (but not last loss) provider and monitor for the consumer/taxpayer, private market transactions and evolution.
Why is the private market languishing at $20 billion per year instead of the $1.2 trillion per-year highs of the past? Investors have had no problem paying attractive prices for existing non-agency mortgage and risk-transfer securities. Why are they reluctant to buy new deals? Why are issuers not interested in selling into the private market?
For one, there are risk retention rules – current and historical attempts to ‘augment’ bank capital with ‘asset specific’ retention mandates. Isn't that what risk-based capital rules are for? If the credit issue is asset-based – in this case, mortgage loans – shouldn't that be addressed via loan underwriting? Overlapping macro-capital requirements and not addressing specific loan underwriting is confusing to loan originators and investors and deserving of a personal foul for piling on. Likewise, issues such as moral recourse and "skin in the game" should be addressed via adequate capital.
Common loan origination and servicing representations and warranties are another thing. If we were serious about moving to a private-market solution, the GSEs' representations and warranties and loan buy-back processes could be adopted as the standard and provided to private-label investors just as they are provided to agency residential mortgage-backed securities (RMBS) investors today.
Private investors will never have an ‘in-house’ credit resolution department, but what we can provide buyers is consistency in loan-loss rules in terms of buyer and appraisal fraud, early payment defaults and limits on dispute periods. If and when the private market expands, pure credit investor/insurers representation and warrant standards could be taken from the then last resort/reinsurer GSE and possibly evaluated/modified by an oversight group comprising mortgage credit-takers and consumer/taxpayer advocates.
Let's call the penalty for this infraction ‘defensive holding.’
Third, issuers/investors must embrace data and sampling due diligence processes. In the beginning, 5% to 10% due diligence based on smart sampling (focused on higher-risk portfolio loans) needs to replace 100% due diligence, which is not scalable. Additionally, delivery parameters need to be developed (i.e. investor concentrations, low FICO segments, limited documentation limits etc.). Investors will take some time to gain comfort in delivery/due diligence standards, but anyone who has performed due diligence on current or past agency loan files knows the RMBS bar is pretty low.
Fourth, there is the delay in defining a qualified mortgage, as addressed earlier.
Did we adequately address mortgage issuer/major participant capital concerns? Mortgage credit deterioration prompted a renewed focus on the capital and market structure necessary for financial firms to weather unexpected loan defaults. Regulated banks raised a considerable amount of additional equity, but there remain unaddressed capital weaknesses. Mortgage insurance (MI) companies remain thinly capitalized and, for firms that had minimal risk management, no changes have been made with regard to how to mitigate default risk. MIs will claim that underwriting is more conservative, which it is, but over the long run, their business success is insuring low-down-payment loans that, by nature, have higher risks.
Why haven't MIs purchased default hedges? Why didn't they execute ABX transactions versus their subprime books? Why not purchase credit default swaps?
There is no surprise that every six to eight years, the bottom of a credit cycle sees MI capital evaporate. MIs risk management structure gets the illegal procedure penalty.
Non-bank, bank and GSE institutions all have taken heavy losses on loan servicing and excess loan servicing assets related to high prepayments and/or loan losses. As the mortgage market has grown, so has the size and risk exposure related to fee-based assets.
The problem with a fee-based asset is that the servicer/issuer receives no income once a loan is prepaid or results in a loss. When a loan is prepaid, the issuer receives their principal back; when a loan loss occurs, the owner gets to keep the proceeds from the sale of the underlying property.
Continuing to compensate loan servicers via ‘fees’ is reminiscent of the NFL's decision to initiate kick-offs from the 30-yard line to aid kick returners and add special team excitement. Unfortunately, it neglected to recognize the increased speed, size and strength of modern-day players. The result was an increase in injuries due to fierce collisions between return and kick-off team members.
Long ago, when the GSEs changed their initial participation loan sale programs to fee based servicing compensation, they (maybe unknowingly) increased loss and prepayment risks. Loan servicing/excess servicing assets versus equal value loan participation interests are three to five times riskier in terms of price volatility. Couple that with the increased size of the mortgage market, loss exposure has grown exponentially since the servicing fee compensation model was determined.
Then why not go back to participation interests? The NFL made an adjustment and returned kick-off placement to the 35-yard line. Is there a fear of upsetting the GSEs' and Wall Street's agency RMBS market?
Here is an example of RMBS execution with 1% to 1.375% loan participation compensation to the loan servicer. Say we have 30-year fixed mortgage loans with note rates of 3.50% to 3.875%. Let us further assume that Wall Street is only interested in selling securities at the half coupon (i.e. 3.0%, 3.5%, 4.0%, etc.). Notice that the adjustment made to achieve half coupon execution is to modify both the servicer and investors participation interest.
Very little progress has been made in an effort to redesign the mortgage market to increase sales to private investors and de-emphasize GSE involvement. Make no mistake, this type of re-do is a long-term project, but we have wasted six years if you use 2008 as the starting line. Memories are short, the GSEs are making money, credit losses are low, and recent home finance underwriting/guidelines are widening as housing slows and loan origination declines.
Hopefully, we can clean up the infractions to date in developing a private market solution and minimize future mortgage loss impact to banks, non-bank mortgage players and taxpayers. Higher consumer mortgage costs related to a new private market solution are a function of undercharging for the cost of credit in the past. It's always harder to take the benefits away from the consumer – but it's important that we understand that if we don't pay more now, we will pay far more in the future.
Nick Krsnich is president and portfolio manager at JMN Investment Management, offering investment and business advisory services to both institutional and individual investors since 2006.
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