REQUIRED READING: The 17th century English playwright William Congreves observed, ‘Uncertainty and expectation are the joys of life.’ However, there are many people who might disagree with that remark – especially around the residential mortgage-backed securities (RMBS) market. While there is a great deal of uncertainty and expectation surrounding the current and near-term future of the RMBS environment, one might be hard-pressed to locate a bounty of joy.
That's not to say that things are completely awful. ‘It's come back some,’ says Jordan Brown, managing principal at MarketWise Advisors LLC, headquartered in Ponte Vedra Beach, Fla. ‘In the first half of 2009, approximately $112 billion was issued. But if you look at the first half of 2010, approximately $217 billion was issued – roughly double where it was a year ago.’
Yet Brown warns this should not be used to cue a rousing rendition of "Happy Days Are Here Again."
"It is unfair to categorize this as a patient who is healthy," he continues. "The patient has stabilized. The patient was in cardiac arrest and was then on oxygen, but the patient is now ambulatory."
For many industry experts, however, the real problem with the market involves the major players that are calling the RMBS shots.
"The RMBS market is largely dominated by the federal government, with a 90-plus-percent share of the residential mortgage purchase and insurance market," states Dr. Anthony B. Sanders, professor of finance at George Mason University in Fairfax, Va. "And with 30-year fixed-rate mortgages down to about 4.5 percent, the federal government has its hands firmly on the RMBS market."
What's wrong with that picture? According to Sanders, federal domination of the market came at a steep price – and the private-label sector is the one paying for it.
"The problem is that the government guarantee on Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) has forced much of the private RMBS market out of business," he continues. "Lest we forget, the government-sponsored enterprises (GSEs) captured the lower-risk mortgage market, leaving only the riskier jumbo, nonconforming and Alt-A market to the private sector. Now, the GSEs have raised the conforming loan limits to capture most of the jumbo market, as well."
So where does this leave the private-label market?
"Dead," says Frank T. Pallotta, executive vice president and managing partner at Loan Value Group, based in Rumson, N.J. "Dead in the water – dead for the foreseeable future. It is not surprising, because nothing in the market is innovative."
That's today's snapshot. The real uncertainty and expectation, however, is a little further down the road. Looming over the RMBS market are questions regarding the reanimation of the RMBS market in general and the private-label market in particular, the ultimate fate of the GSEs and other wild-card considerations.
Y'all come back!
Getting the market back to full speed will not be simple, according to Brendan Keane, senior vice president of advisory and evaluation services at Santa Ana, Calif.-based CoreLogic.
"It's at a pause due to a confluence of a lot of different things that the market never had to endure before: politics, marketing and business concerns," Keane says. "Investors face a number of issues. They continue to reserve judgment of RMBS. Some are coming back, and expect more to come back as deals trickle through. Investors are the ones in the driver seat."
Scott Stern, CEO of the St. Louis-based Lenders One Mortgage Cooperative, believes that the problem facing the RMBS market is one of perceived image.
"If people look at the product, they will see the vintage is outstanding," he explains. "This is a great time for buyers of RMBS, but we [as an industry] have a reputation problem. If we go to foreign governments and pension funds, we get a sense of "You fooled us once, and we do not want to be the first buyers to jump back into buying RMBS."
Vicki Beale, senior vice president of transaction management at Clayton Holdings LLC, based in Shelton, Conn., concurs. "This is all about building investor confidence in order to get the market back," she says. "The securities have to be economically sound for issuers and investors. The investors will not buy into it without confidence."
Yet there are still reasons for investors to be uncertain. Sue Allon, CEO of Denver-based Allonhill, points out that fraud is still a major problem in the mortgage banking industry.
"We're seeing a tremendous amount of fraud already," Allon says. "If loans [with fraud] get into securitization, it will slow down the market. Issuers are extremely concerned, and the banks feel that their reputations are on the line – they are determined to get it right."
Many lenders are going the proverbial extra mile to ensure quality control within their loans.
"The level of industry scrutiny is phenomenal," says Richard Zahm, portfolio manager with Darien, Conn.-based Second Angel Fund I. "This is being done almost on a loan-by-loan review. This is largely because the loans are not that big anymore, so the lenders can afford to do what they should have been doing all along."
Brown adds that this level of scrutiny will not abate when the recovery goes into full swing. "Going forward, the industry will need to be laser-focused on asset transparency in order to establish investor confidence in MBS products," he says.
False starts?
One of the most highly scrutinized MBS issuances of the year was also the first private-label RMBS since the economic crisis took root: Redwood Trust's $238 million prime jumbo residential mortgage loan securitization in April. During a presentation at the Mortgage Bankers Association's National Secondary Market conference in May, Griff Straw, president of Chicago-based Solidifi U.S. Inc. and a former Freddie Mac executive, dissected the depth and scope of the Redwood Trust securitization.
"Redwood Trust's weighted average FICO score was 768, and the lowest was 702," Straw says. "Eighty percent of the loans were refi, and 20 percent were purchase. They had 255 loans, with an average loan balance of $933,000. Don't you think each and every one of those loans was scrutinized? That was scrubbed and scrubbed again."
Redwood Trust's securitization was oversubscribed by six times. Clayton's Beale adds that due diligence was key to the success of the endeavor. "Investors in that transaction had reason to be confident," she says.
Of course, the Redwood Trust example leads to another question: Where is the next private-label triumph?
"We've been hearing that jumbo lending will be the first new opportunity," says Stern. "Wall Street, in particular, is looking at the non-agency jumbo market. Redwood Trust was one successful issue, but we haven't had any since then."
"There are several entities looking to issue," says Tom Millon, president and CEO of Capital Markets Cooperative, based in Ponte Vedra Beach, Fla. "These are the cleanest of the clean. The problem, though, is finding the loans."
A great deal of the uncertainty and expectation surrounding the RMBS market rests on the ultimate fate of the GSEs. "Whatever road it takes, it needs to be fixed in order to bring the market back to pre-crisis liquidity levels," Brown says.
But the absence of a GSE game plan only adds to the uncertainty of the product's viability.
"People do not want to take the chance of going back into RMBS," warns Dr. Craig Pirrong, professor of finance at the University of Houston's Bauer College of Business. "They are waiting until Washington determines how the GSEs are dealt with."
Nicholas observes that even if the administration unveils its plans in early 2011, there will still be a long stretch until the plans are fully implemented. "That makes it look like there will be a couple of years of lackluster activity in the RMBS market," he says.
However, the administration's plans will first have to be approved by Congress. Bill Bradway, managing director of Bradway Research LLC in Boston, observes that the issue is being addressed by a Washington power scheme that divides the Congress between the two increasingly intransigent parties.
"The issue will not be resolved very much until the new Congress comes in January," he says. "It will all depend on how the election turns out and what kind of a balance emerges if there is a power shift."
Nonetheless, there is also the possibility that the much-awaited reform might be on the skimpy side. A.W. Pickel III, president and CEO at LeaderOne Financial Corp. in Overland Park, Kan., is skeptical that GSE reform will result in any significant change.
"I don't think we will see reform," he predicts. "Not substantially – otherwise, you risk upsetting the whole apple cart."
George Mason University's Sanders notes that even when GSE reform is finally unveiled, the Dodd-Frank Act will guarantee a continued federal government dominance of the market.
"The legislation is going to identify a plain-vanilla mortgage for the industry," he explains. "Of course, this will be the 30-year, fixed-rate mortgage. Essentially, any other innovative mortgage product will be deemed either predatory or systemically dangerous. So, the 30-year fixed-rate mortgage will require massive federal support, given its risk in regard to inflation and interest-rate increases. As a result, Fannie, Freddie and the FHA will have their existence guaranteed. Add in the preferential capital treatment that banks get for holding Fannie and Freddie paper, and the dream of returning to a competitive RMBS market fades to black."
(Please address all comments regarding this article to Phil Hall, editor of Secondary Marketing Executive, at hallp@sme-online.com.)
