Between the time when mortgages are originated, and the end of the month when they are securitized, the assets are waiting in limbo. The originating finance company will eventually recoup its total outlays when the pool is securitized. Meanwhile, by issuing commercial paper, it can cover about 98% of its loans.
For many years, mortgage originators funded the warehouse period through reverse repurchase (repo) agreements. Broker dealers, however, could quickly pull lines of credit at the least hint of trouble, leaving originators vulnerable. As a consequence, mortgage originators have always been open to other financing options.
By the late 1990s, some of the healthiest financing companies, such as Centex Corp. and American Home, started single-seller conduits for warehousing their own mortgages. Some larger organizations, like Countrywide Financial and GMAC-RFC, soon included other firms' mortgages in their multi-seller vehicles. Could further smaller financing companies one day join the ranks?
"Investors are always concerned with the financial strength of the sponsor of the program," said Andrew Jones, managing director at Dominion Bond Rating Service. "It might be difficult for the smallest mortgage originators to tap the ABCP market directly." The market could even consolidate in the case of a downturn, Jones added. "If proceeds from securitization contract, as a result of spread widening, we would likely see a consolidation of originators, which could lead to a reduction in the number of corresponding single-seller conduits."
Still, current players are still establishing new programs or increasing the size of existing ones. "If the residential real estate market is slowing, it's not yet showing up in funding facilities," said Everett Rutan, senior vice president at Moody's Investors Service. Of course, he pointed out, "while we may be seeing commitment amounts, we will not be able to ascertain the actual issuance for at least a couple of months. In fact, capacity appears to be increasing faster than usage."
Swaps are a key element of ABCP, for hedging against credit and market risk. While commercial paper normally rolls over, if the assets should lose value, no one would reinvest and the paper would not roll. So buyers demand protection against the chance that loans might default or that market value might change, with fluctuating interest rates.
There are various downsides to obtaining swaps: They take time and trouble to get credit approvals, and they generally expire after about three years. Jones suggested the possibility of a new "haircut" approach. "We see a growing interest in evaluating the market risk from a statistical perspective, using overcollateralization rather than market-value swaps as the means to cover the market-value risk inherent in these programs," he said.
So far, GMAC-RFC is one of the few programs to use a haircut. "People discuss the idea, but they are complicated, especially for whole loans, " said Rutan. A representative of a large bank that's active in providing swaps agreed that the concept is intriguing, but one that could be challenging to execute. The haircut would be significant, probably in the 89% to 90% range for the subprime market. "That would translate into a lot of money," he said.
Permanent (versus warehouse) financing is another cutting-edge development. "Warehouse financing involves aging requirements, so the mortgages cannot remain longer than a year or so in the pool," said Deborah Seife, managing director at Fitch Ratings. "With permanent financing, there is no such limitation."
Long Beach Mortgage Company, as sponsor, has pioneered its Strand Program, using commercial paper to fund whole loans to term. It is notable that no huge change has been needed for enhancement levels in the transaction, as structured by Lehman Brothers. Rating agencies focus on any increase in delinquencies or defaulting loans that result in credit losses. "At the end of the day, we care most about how CP investors would be paid off in a meltdown, and we rate to the wind-down," said Seife.
Credit enhancement analysis therefore depends on the length of any wind-down phase and the type of event that may trigger default, which is usually a percentage change in delinquency level. Since the rate of increase is often highest in newly originated pools, older pools may show higher absolute levels but a flatter curve in terms of rate change. It is the steepness that counts for credit enhancement.
The lofty levels of ABCP issuance, which had reached $948 billion by Jan. 11 this year, took many by surprise over the course of 2005. The continued health of ABCP is clearly driven by the performance of the mortgage market and spread compression. In the same way, innovations in mortgage product, such as 40-year mortgages or negative amortization, lead to new variations of warehousing facilities. "The facilities must be amended to permit them," said Rutan.
A decline in the mortgage arena would not necessarily result in less commercial paper issuance. Originators have long learned the value of preserving flexibility. Most retain bank and repo lines, in addition to CP facilities, yet do not issue enough product now to utilize all those lines. "They are paying for the liquidity of extra capacity and multiple sources of funding, to be ready to use the least expensive," said Rutan. What matters is the relative cost structure. Commercial paper could turn out to be the cheapest alternative, which could keep issuance levels up.
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