The need for private capital to return to mortgage financing is a major discussion point in the future of U.S. housing. REITs are an ideal vehicle for bringing in that private capital. However, before this can occur, a couple of things need to happen, said Calvin Schnure, a mortgage market economist at the National Association of Real Estate Investment Trusts (NAREIT).
First the mortgage sector has to "return to more normal market credit conditions," he said. "Right now the mortgage market is heavily influenced by distressed assets, and there are the normal-arms' length transactions that reflect a more typical credit risk. People who are modeling credit exposure can't figure out how to price this because there is so much uncertainty with it. It's nearly impossible to determine a reasonable price for mortgage credit risk, and related to that is the reasonable level of capital required for a private-sector investor."
Schnure also said that there is a need for more certainty on the regulatory environment. "We need to see what the blueprints are for the structure before we start building on how the market is going to look."
Still, REITs are quite a good way to bring private capital back into the mortgage market.
Redwood Trust has come to market with three securitizations backed by newly originated Jumbo mortgages totaling close to $900 million. The company is planning to do more deals in 2012 and is expecting to issue its fourth transaction early 1Q12.
"Our investor-friendly governance and structures have set the bar for private-label securitizations going forward," said Brett Nicholas, executive vice president and chief operating and investment officer at Redwood Trust. "The performance of these past three deals has been excellent and no one's missed a payment. There are no delinquencies or losses."
The company is structured as a REIT for tax purposes and has very little in common with other agency and commercial REITs. Redwood has a conduit lined up with an increasing number of originators throughout the U.S. that are mainly regional banks and large independent mortgage companies.
"First, our own home-cooked investments retain investments from Sequoia transactions," Nicholas explained. "Secondly, we have a unique perspective into the ever-changing mortgage origination business, which allows us to monitor at the street level what is really going on with origination practices and loan quality."
Another key difference between Redwood and some of the other REITs is that the Jumbo issuer is internally managed, which means that the company gets paid off of financial results and not off of how much equity the company has under management, explained Martin Hughes, president, chief executive officer and director at Redwood.
According to Hughes, now is the right time in the cycle to invest in high-quality residential and commercial mortgage loans. "Housing and commercial real estate have undergone significant price changes over the last couple of years," he said. "We believe those assets are in the process of bottoming. And then, the second part of the formula is really not that difficult. It gets back to disciplined underwriting. It gets down to full documentation. It gets down to payments. It gets down to borrowers that can afford the mortgages that they're in. So we do believe it's the right time in the cycle."
So far, since the credit crisis, no other non-agency RMBS deals have been done except for the Redwood Trust Sequoia Mortgage transactions. Banks are not expected to re-enter the private-label space in any meaningful way anytime soon. "It's conceivable that a few deals may get done, but if that is true its probably to test the securitization plumbing at their institutions to make sure that they can securitize under the new rules versus needing to securitize," said Mike McMahon, managing director at Redwood Trust. He noted that the Federal Reserve's H3 report that the commercial banking industry has $1.5 trillion of excess deposits, which is an unprecedented amount. This means that banks are flush with liquidity and are looking for profitable assets.
"Generally banks securitize assets as a means to finance the assets when they don't have balance sheet room or liquidity, but the unprecedented amount of liquidity present in the banking system today means there is no economic reason for the banks to do any meaningful amount of securitization," he said.
Still, REITs are expected to play a major role as investors in 2012. The Federal Housing Finance Agency and Freddie Mac have publicly stated that they are working on pilots and ways to explore selling risk to the private sector. They are talking with a number of investors; Redwood is one of the buyers to whom they are talking, according to Hughes.
McMahon believes that when the banking industry eventually heals itself, although probably not in 2012, the excess liquidity will come out of this sector. The economics of securitization versus holding loans on the balance sheet will also come closer in line.
"At that point, since banks are the primary originators of the loans, it would make sense for them to be the primary securitizers," McMahon said. "It also makes sense for banks to sell the subordinate securities that are highly capital- sensitive from a regulatory standpoint and that REITs should be the natural buyers."
For now, the muted levels of new originations on both the residential and commercial sectors means there is little ability, at least in the near term, to manufacture investments through financial engineering. "If you're sitting, waiting to buy investments that are coming down your Bloomberg transit, well you're going to be competing with trillions of dollars on banks' balance sheets and fixed-income funds. So, bottom line, it's going to be really, really difficult to find easy returns in the commercial and residential space."
On the regulatory front, the REIT sector has been hit by a Securities and Exchange Commission (SEC) investigation over whether the vehicles should still enjoy their exemption under the Investment Company Act of 1940 (ICA).
Last Aug. 31, the SEC issued a concept release seeking public comment regarding REIT status under the ICA as a company that acquires mortgages and mortgage-related instruments. Currently, mortgage REITs are excluded from ICA regulation.
Commentators warn that revoking the ICA exemption would impose tight leverage restrictions on mortgage REITs, reducing their ability to accumulate mortgage assets and generate profits for investors. The Mortgage Bankers Association (MBA) noted that the mere issuance of the concept release has had a "chilling effect" on the mortgage REIT sector. "Such a change has the potential to reduce investor interest in mortgage REITs, thereby restricting a critical source of liquidity" for the mortgage market, the MBA said in a comment letter.
