The landscape for non-agency RMBS has dramatically changed and, given the variables that banks must contemplate, it is unlikely that 2011 will see the clarity needed to drive origination volumes in the non-agency space.
"It's really a tale of two markets," said Paul Jablansky, managing director and senior non-agency MBS and consumer ABS strategist at the Royal Bank of Scotland (RBS), at last month's American Securitization Forum (ASF) sunset seminar on the future of the RMBS market. "We have the best of times in the secondary and, in a sense, the worst of times in the primary market."
Of the $48 billion of issuance so far in 2010, RBS estimated that $44 billion was re-remic activity and thus did not mean the origination of new mortgages.
Its isn't because of a lack of product. In fact, Baron Silverstein, managing director at Bank of America Merrill Lynch, said at the same ASF meeting that banks still have the capability of originating non-agency mortgages, and borrowers can still get loans from any number of financial institutions.
"Today it's not impossible for many people who are buying nonconforming mortgages to get a loan and if, in fact, you make a comparison, banks are competing and looking to drive down spreads," said Silverstein, who added that borrowers could get rates as good as 5% in some cases. "They're very cost-effective rates in today's market."
However, making the case for securitization's cost effectiveness in the current market environment is more challenging.
Silverstein explained that the cost of origination - that is the cost of making a loan versus where a bank would be able to execute in the non-agency market - has so far proved not to be the best funding strategy. Banks instead feel more comfortable raising corporate debt and using that capital to fund more mortgages.
"When you look at securitization in the non-agency space, because of the dislocation of the market and the inability to easily access the market and because bank's have excess funding liquidity, it means that banks are more comfortable just holding onto mortgage assets and holding onto that risk," he said.
Making the Case for Securitization
Part of the reason securitization paper flow has been more prominent on the consumer ABS side is because most of these transactions have essentially been funding trades where the issuer holds on to the risk, placing the senior securities or, in some cases, the mezzanine piece on the capital markets in order to get a certain amount of leverage.
"They place those securities in there so they can know what funding costs are and can continue to run their business," Silverstein said.
The story on the non-agency side also improves when you look at the performance of secondary market trading. This side of the securitization market has seen tremendous performance. "Additionally, the technicals have been positive and the market has seen extremely robust returns," Jablansky said.
JPMorgan Securities analysts expect a strong start across non-agency credit products in January, as investor demand meets limited supply from sellers. They expect yields will drop by 1% throughout the market, but prime and Alt-A fixed declines will be larger than credit floaters.
"Prime and Alt-A fixed-rate bonds are our favored sectors," JPMorgan analysts wrote in their 2011 outlook report on the sector. "Investors will increase their use of leverage in 2011, with prime paper leading the charge. Fast prepays in the high teens will also help returns as prime paper will de-lever more rapidly than other sectors."
Regulatory Changes on Three Fronts
The only activity that exits now and reasonably for the foreseeable future is the securitization of legacy assets but the up and coming regulatory changes might hinder that effort.
Peter Sack, managing director at Credit Suisse, said at the ASF seminar that of the $50 billion of new issues in non-agency RMBS, 99.75% of that activity has been dominated by the securitization of legacy loans.
"There is a primary market that is effectively secondary trading," Sack said. "Although comparatively smaller, it is not meaningless and it does provide price discovery and a fair amount of liquidity."
The worry is that the Securities and Exchange Commission's Reg AB II could effectively put an end to legacy securitizations. What could be especially problematic for legacy assets is the idea that new issuance of 144A deals would have to meet the same disclosure requirements of publicly registered deals.
Most market players believe these requirements cannot be met by legacy asset structured deals.
"If that is the case, then it limits the potential for the market even further in 2011, and that $50 billion of this year could easily become arguably a $250 million securitization market - the rule could disrupt what little market there is," Sack said. "That would be bad for buyers of this paper who have deals on senior bonds because they could see prices increase from 60 basis points to the high 80s. Any impairment to the liquidity that those deals provided would impact financing for REITS and it would impact financings for the acquisition of non bank financial institutions."
Sack added that there is always a solution, although he does not believe that the regulators' purpose is to create a market where 144As become synthetic securitizations of CDS in an SPV. Currently, it is the opposite direction in which the market is trying to move, he said.
Market players said that, while the Federal Deposit Insurance Corp.'s Safe Harbor also presents some challenges for the market, unlike Reg AB II, it's likely that issuers will be able to conduct securitizations that won't need to rely on the provision. However, to the extent that the issuer is required to rely on the Safe Harbor for existing assets, it's likely that for the deals backed by these loans, meeting the conditions would be difficult.
Risk retention rules can also trigger consolidation of an entire securitization (the Financial Accounting Standards Board's SFAS 166/167) or can lead to much higher capital requirements than that held against whole loans.
GSE Reforms Pave the Road Ahead
The next big question that will potentially impact RMBS issuance volumes is what shape GSE reforms will take. Any implementation strategy that would consider the non-agency market as the place to offload loans sold into the GSEs can be a catalyst to awaken primary market volumes.
"That is the 800-pound gorilla that has to be situated first and then we have a shot of restarting the non-agency market," Ralph Daloisio, managing director at Natixis, said at the ASF gathering.
Market players said that the government is likely to make a proposal on how they will strategize reform over the next six months and hopefully those reforms will consider lowering limits on nonconforming loans as well as look at the non-agency securitization market as the place to offload loans sold into the GSEs.
However, Daloisio said that even with clarity on GSE reform, the environment for making mortgages must also evolve at the same time.
"Making a simple mortgage loan is confusing," he said. "Why? Because it used to be that there was some utility for homeownership by the homeowner and it was priority debt to get repaid. It's no longer the case. There are a large number of strategic defaulters in the current environment with government policy that seemingly works to keep those strategic defaulters in their homes."