After two years of hibernation, the non-agency RMBS may be re-emerging.

However, large institutional investors such as the California Public Employees Retirement System (CalPERS) are hesitant to participate until they are reassured their first-lien holdings remain prioritized in the capital structure.

Mortgage cramdown legislation, empowering judges to adjust mortgage terms to give borrowers relief, has been revived by Congress at least a few times.

While so far that hasn't succeeded, the U.S. Treasury's Home Affordable Modification Program (HAMP), expanded a few months ago, addresses only first-lien debt holders. It requires various price tests that could result in investors in that debt facing cut interest rates, loan forbearance or principal reduction.

Since the program does not address holders of second-lien debt, such as home equity loans, by default first-lien debt holders take the first hit when mortgages are modified, upsetting RMBS investors.

"Until there is clarification on this issue, we're going to treat first mortgage, non-agency MBS as second liens, because that's basically what they've become," said Curtis Ishii, senior investment officer for global fixed-income at CalPERS.

Ishii said that in recent discussions in Washington, D.C., with bank regulators, they appeared to be aware of the issue but hesitant about changing course because many of those second liens are held by the nation's largest banks - the likes of Citigroup and Bank of America. Writing down second-lien debt fully before first-lien is affected could severely impact their already weak capital conditions.

"From a first-lien-holder perspective, we don't think that's right, because this is after the fact. This is very similar to what you see in emerging markets," Ishii said. "These kinds of uncertainties jeopardize not just the non-agency ABS market but the whole securitization market."

Ishii said the giant pension fund sold its non-agency RMBS positions - amounting to $3 billion or $4 billion a few weeks ago - when the market rallied. "We're pretty much done with that market. We're in the agency market, but we're out of non-agency," Ishii said.

CalPERS is not alone in its discontent. "The government right now is trying to make first-lien [debt] holders take the hit on mortgages they bought while second-lien holders are not being written off," a director in the investment arm of a major insurance company said. "We absolutely will not invest in the [non-agency] mortgage market unless we feel we have a first-lien position."

Ishii said CalPERS has written a letter to the Treasury Department stating its support for lien prioritization and ultimately U.S. contract law. Ishii noted that the strength of U.S. markets is founded in the country's political and legal stability.

"We're willing to write down principal or take forbearance, but for non-agency [debt] we require that second liens get taken out first. Then we'll do our part," Ishii said.

Ishii added that while non-agency loans make up a small part of the MBS market compared to those guaranteed by Fannie Mae and Freddie Mac, giving priority to second-lien holdings is bound to have spillover effects in the way loans are priced in other markets.

Pension funds and insurance companies are among the most conservative institutional investors, but they pack plenty of financial firepower. In the last six to nine months, a handful of RMBS deals have been completed, including the heavily oversubscribed offering by Redwood Trust on April 28. Ishii said, however, that CalPERS simply isn't interested in buying more RMBS until it receives assurances that resolve its concerns.

"I haven't even looked at recent transactions, and my mortgage guy hasn't either. We're out until this is clarified, and we're staying with GNMAs, FHLMC Golds and FNMAs," Ishii said.

That bodes poorly for a revival of regular issuance in the non-agency RMBS market, despite nascent signs of recovery.

"You can't do it without the big buckets," said Matthew Tomiak, a partner at 12th Street Capital, which specializes in ABS and MBS.

The big institutions' concerns coincide with indications that the dormant RMBS market may be reviving. Tomiak said his firm is increasingly talking to sponsors about potential deals, and the bigger players are as well.

"We have a number of deals in the hopper," says a bulge bracket executive, who added that there's strong demand for the paper.

Jon Daurio, CEO and chairman of Kondaur Capital Corp., a loan servicer that purchases scratch-and-dent loans experiencing documentation deficiencies, delinquencies or even default, agreed that the market is buzzing. "We've gotten more calls to consider securitization in the past six weeks than ever before."

The bulge bracket executive noted other obstacles are slowing down deals, such as reluctance by the rating agencies to rate transactions. "The hardest part isn't necessarily selling the bonds, but getting a commitment from the rating agencies to look at a deal," he said.

A handful of non-agency RMBS deals have been completed or are currently under consideration, and Redwood Trust's April 28 securitization of $238 million in newly originated jumbo prime loans does appear to reflect that investor demand, even from more traditional institutions.

The deal was oversubscribed by 2.5 times and priced within two hours at 3.75%, or 25 basis points lower than anticipated. The sponsor retained an 11.5% slice across the 'AAA'-rated and subordinate tranches.

"At 3.75% [yield], that doesn't sound like a hedge-fund-type of deal, and the average FICO score of the collateral in the pool is around 750," notes Paul Marchese, senior managing director at Clayton, which provides loan support services including an electronic platform to buy and sell loans.

Marchese added, "It was really pristine, clean paper. I think they tried to take as much risk out as possible."

Redwood is reportedly working on a similar deal comprising Jumbo prime loans. And it has established a program - similar to Fannie Mae or Freddie Mac - to buy mortgage loans when they are originated, locking in a price before the mortgages close, if they meet specified criteria.

Marchese said Redwood went "above and beyond to make the changes the market is looking for," including representations and warranties in the securities documentation that echo those developed by the American Securitzation Forum's Project RESTART, which was initiated two years ago to foster investor confidence. Reps and warranties outline when a security can be returned to the issuer in the form of a buy back when it is defective and reps and warranties are breached.

"In the last meltdown, a lot of investors were frustrated trying to get information from trustees to even exercise the reps and warranties," Marchese said, adding that the Redwood offering addresses that issue by requiring binding arbitration between investors and the issuer when issues arise.

The fact that the Redwood offering comprised newly originated loans has bolstered optimism for the return of non-agency RMBS. Michael Youngblood, principal of Five Bridges Advisors, which provides valuation, data management and other mortgage-related services, says future MBS transactions are likely going to have to closely resemble Redwood. "I would think it's entirely too premature to experiment with Alt-A or subprime mortgage loan types, or pools mixing performing, sub-performing, and non-performing loans," Youngblood said.

However, most outstanding non-agency loans are seasoned and fit those descriptions. Some sponsors are now considering securitizing that paper.

Executives at Walter Investments, which specializes in smaller, often subprime mortgage loans concentrated in the Southeast where there was less of a pricing bubble, said in its analyst earnings call May 6 that it was considering a securitization.

The Private National Mortgage Acceptance Co., known as PennyMac, is further along. It has gone on a whole-loan purchasing spree this year, including nonperforming loans, and plans to issue a $98 million MBS deal by the end of the second quarter.

There is already precedent for RMBS including dicier subprime and non-performing loans. Arch Bay Capital, a specialty mortgage-service company owned by hedge fund York Capital Management, completed an RMBS offering of subprime loans in late January that was underwritten by Morgan Stanley and garnered a 'AAA' rating from DBRS on a $57 million portion of it.

Wells Fargo, from which Arch Bay bought a $600 million pool of largely nonperforming loans last fall, acts as the trustee and custodian on the deal. DBRS's rating report noted that 21% of the deal's loans are 30 days delinquent and carry a weighted average FICO score of 627. "The 'AAA' rating in this transaction reflects the 75% of credit enhancement provided by subordination, overcollateralization and monthly excess spread," the DBRS report said.

Vericrest Financial issued $207 million in RMBS late last year, rated 'A' by DBRS and comprising seasoned subprime mortgages it bought from CIT Group that carried an average-weighted FICO score of 571, a coupon rate of 6.53%, and credit enhancement of 60%. Other recent sponsors include Provident Funding Associates, which issued $267 million in MBS through the Station Place Securitization Trust, and American General, a subsidiary of American International Group.

Depending largely on how much Arch Bay paid for the fixed- and adjustable rate first-lien loans, seasoned an average of 32 months and secured by one- to four-family residential properties, there may be little room for profit on the deal.

Although Redwood retained far less of its offering, its profit margins also appear thin. Bose George, an analyst at Keefe Bruyette & Woods, calculated the sponsor's return on equity at between 6% and 9%. "Since it is an equity investment by the company, it's not a very good return. The normal goal is at least double that level," George said.

Given the apparently tight returns on recent deals, there may be more attempts to kick start the MBS market and bolster confidence than indications of regular issuance returning.

Daurio added that currently deals require too many restrictions on how his firm manages its portfolio of loans, and it's still economically more attractive to finance his business through private equity funds than securitization. "I would love to securitize if the economics ever made sense," Daurio said.

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