To understand the role private-label mortgage financing, MBS players must first wait and see what the government's next move will be. It is not that securitization is not happening. It is just that all the activity in the market is via the GSEs.

However, the consensus within Congress is that the current system is unsustainable and there is a need to re-balance the share that the government takes in terms of providing liquidity versus the private marketplace.

"Securitization is the liquidity pipe for the housing and finance marketplace," said Mark Fleming, CoreLogic chief economist. "Securitization is how the market works and how money is pushed through the process and that is here to stay."

Achieving that balance via conforming loan limit decreases, which has been discussed in a number of bills, has proved politically challenging to do. Congress recently restored the Federal Housing Administration's (FHA) maximum loan limit to $729,750, but left the Fannie Mae and Freddie Mac limit capped at $625,500. This gives FHA lenders a clear advantage in the $625,500 to $729,750 space since the agency can securitize those loans through Ginnie Mae.

"Ultimately that is what the problem has been over the last couple of years," Fleming said. "It's been a classic case of the government crowding out the private market with elevated loan limits. With the GSEs being able to finance a large degree of homes in the U.S., there just hasn't been enough space for private capital to work." For the private-label space, the most obvious place to begin would be in the prime Jumbo market. The reduction of the loan limits at the beginning of October created a little more leg room for non-agencies. However, despite the government being mandated out of that market, Fleming said there are a lot of other issues that will prevent private capital from entering the picture.

Most of the problem has to do with the lack of demand for those kinds of mortgages. A CoreLogic analysis for the Mortgage Bankers Association on the reduction of the loan limits found that currently about 4% of the origination market is nonconforming, above the 417K loan limit. Additionally, about 2% are in the Jumbo performing bucket from the 417K up to 700K+ range that is being reduced and 2% are in classic Jumbo.

"There is not a lot of origination going on, but among the origination that is happening, you are basically talking about 4% of the Jumbo market above 417K, and the government still takes part of that through the GSEs," Fleming stated. What is even more interesting, according to Fleming, is the outstanding stock of loans in the Jumbo conforming range.

The vast majority of the outstanding loans, he said, are nonconforming Jumbos. In other words, this means people who obtained loans not from the GSEs in the past and who have had ample opportunity and rate incentives to refinance into a Jumbo conforming-type product have opted not to.

"For a typical Jumbo loan, you have at times in the past couple of years over a percent spread difference between what your outstanding interest rate is versus the Jumbo conforming limit so clearly in the money from a rate perspective," Fleming said."Any negative equity issues could also be adjusted via [the Home Affordable Refinance Program (HARP)] program. If they were interested, they could go through a program like that."

So what has held up refinancings? Fleming believes that underemployment is a big issue. Many borrowers may or may not have qualified based on the debt-to-income ratio on their original loans. Some couples, for instance, now know that they are unlikely to have an acceptable DTI if one of the spouses has lost a job or is working for less money. Thus the underemployment issue impacts their ability to qualify due to the lack of a stable income.

Fleming also pointed out the problems linked to second liens. The rules around refinancing is that having a second or a simultaneous second are very different.

For instance, the maximum loan amount drops dramatically if borrowers decide to consolidate a second lien that was not originated simultaneous to the first."There are impediments even though you have the GSEs moving out of the space and creating the gap for the private market to come into," Fleming said. "I think there are impediments on the demand side of people wanting to get those types of loans even if there was private capital there."


G-Fees on the Up?

The next piece of the puzzle - raising the guarantee fee to crowd out the GSEs to get private capital flowing - will also take some careful maneuvering to get the right formula.

There are signs that the government wants to get it right. The Senate last month, for instance, added a g-fee increase for Ginnie Mae MBS to the payroll tax bill, passing the measure by an overwhelming margin of 89-10. The language was added to the bill after heavy lobbying from the mortgage insurance industry that pushed for the Ginnie Mae fee hike, claiming the Federal Housing Administration would have a competitive advantage and field more business if the g-fees for Fannie and Freddie MBS were raised without a corresponding increase on Ginnie Mae MBS.

Due to the Senate vote, it is almost certain that a g-fee hike for Fannie, Freddie and Ginnie will be included in the final bill, which lawmakers have been hammering out in the last few weeks.

The lower g-fees have meant that essentially the provider is offering a discounted product so that private capital cannot compete. However, some industry players are concerned that higher g-fees can create a scenario where all the really good credit would go to private label and marginal credit would go to the GSEs, creating a downward spiral of bias credit going onto the GSEs' balance sheets.

This, in turn, will send losses upward, which would mean that g-fees would have to increase further and, as a result, more risk would be placed on the government balance sheet, according to Michael Bright, senior financial advisor to Senator Bob Corker(R-TN).

JPMorgan Securities analysts estimated that g-fees would need to rise substantially so that the extra interest will raise senior bond pricing enough to bring execution to par. "If you start to reduce loan-level limits, you don't allow that provider to play in certain segments of the market," Fleming stated. "What should happen is that we should see a realization where the spread between the conforming and the private markets should be very different, in large part accounting for the recognition of higher credit risks."


Blueprint for the Future

It is encouraging that legislators in the last weeks of 2011 have made some real strides toward laying the blueprint of what a private-label mortgage financing market can look like.

There are several opinions on how best to move the market forward, but the general consensus is that the government must reduce its role and the private market must step in where the government leaves off.

The bill sponsored by Rep. Scott Garrett, R-NJ, authorizes the Federal Housing Finance Agency (FHFA) to establish underwriting standards for categories of mortgages that could be securitized through the to-be-announced (TBA) market.

The legislation also requires the GSE regulator and the Securities and Exchange Commission to draw up standardized pooling and servicing documents, along with representations and warranties that require binding arbitration to resolve disputes between investors, issuers and servicers.

The Garrett bill prohibits regulators from requiring servicers to write down the principal amount of a mortgage and repeals the risk retention requirements in the Dodd-Frank Act. It also clarifies the "qualified mortgage" provisions in the Dodd-Frank Act and directs regulators to provide lenders with a safe harbor from lawsuits when they originate "high-quality" mortgages that meet FHFA underwriting standards.

Corker has also introduced legislation where the government would guarantee only some component of the mortgage loan that would be less than 100%.

The idea establishes a risk-sharing structure between the GSEs and the private market and allows the FHA to determine whether the subordinate piece of the mortgage loan will be prorata or treated as a first-loss piece. "In a standard structure where everything goes delinquent, the A-piece investor gets their 90% back in principle paid for by the agencies, and the B-piece investor stands in line with the GSEs to recover whatever sales of proceeds," Bright said. "You can perfect information from the market on where they would price the credit risk that is analogous to what Fannie and Freddie are taking on."

However, reducing the government's role while maintaining the TBA market is yet another piece of the puzzle that must be resolved. One thing is certain - without a government guarantee, a TBA market could not exist because rate investors need the security provided by the government's presence in the market.

"Most of the money out there is conservative by nature and has preference for rates investment versus credit investment," said Ralph Daloisio, managing director at Natixis at an American Securitization Forum sunset seminar on private mortgage finance legislation held in December. "As of today, it is not sure if there is enough institutional credit structure that can either intellectually or technologically be able to adequately price even a very homogenous pool of mortgages with credit risk," he said. "The flipside to that is that maybe the market doesn't have the infrastructure because the government has been such an elephant in the system."

Moving away from a government-backed mortgage market would mean that initially the market would lose the benefits of the TBA market. "There are clearly benefits to the TBA market," Daloisio said. "On the one hand, it allows borrowers a lot more flexibility in terms of locking in rates, and on the other, it allows originators a lot more risk-management control. At the very least, it promotes a more certain and efficient functioning system."

Jordan Schwartz, a partner at Cadwalader, Wickersham & Taft who also spoke at the ASF event, said that to maintain some type of TBA market, the government guarantee would have to be replaced with some form of credit enhancement, as is the case with traditional senior/subordinate structures. The challenge, however, is locking in a rate when the loan is being sold in two pieces, one of which can be sold quickly while the other that takes time to assess.


Shadow Inventory

Fleming, speaking at the Information Management Network's ABS East event held last October, said that more than 1.6 million shadow inventory homes are still waiting to enter the foreclosure mill. He added that this estimate was for the immediate future; a longer-term look provided a bleaker tally of 10 to 11 million homes still forming part of this inventory.

"No one has the clear crystal ball on what the future will look like," Fleming said in an interview with ASR. "In terms of the housing market, we have been bouncing along the bottom for the last year or two and economists didn't really realize the magnitude of the pulling forward of demand caused by the tax credit of 2010. It really put a floor on the crisis by stimulating a lot of demand. In 2011, we've really suffered the hangover, as it's been really hard to find buyers and a lot of demand for houses."

The shadow inventory will continue to be a major concern for home prices over the next several years. JPMorgan Securities analysts have estimated that home prices should bottom, down another 6%, in 1H12, with distressed sales hitting 40% of all existing home sales. "We expect distressed liquidations to increase marginally in 2012 compared with 2011 liquidation levels as servicers run out of options to help distressed borrowers and increase foreclosure filing rates," Nomura Securities analysts said. "Our forecast is that national home prices will drop by 6% to 8% through the first quarter of 2013, followed by flat home price growth through the third quarter of 2015."

Fleming explained that the housing market at the moment is plagued by a deflationary expectation, where prospective borrowers are holding off on buying houses because they believe it will be cheaper in six months. That outlook combined with a fair amount of uncertainty and lack of confidence in the economy make it harder for borrowers to buy a big ticket item such as a home.

This is why growing the homeownership rate has proved very expensive. According to Daloisio, the rate of homeownership today is 60%. For the better part of 20 years, it fluctuated between 60% and 65%, and in the seven years up to the credit crisis it rose to 69%."The stakes are relatively significant because the ability to maintain homeownership is contingent to run a consumer-driven economy," he said.

Yet another piece of the private-market mortgage financing puzzle that has not been discussed as much is how all the U.S. policy intervention - like [Home Affordable Modification Program] modifications - that has already filtered into the private sector RMBS market will be treated once the government steps out of the game.

"Discussion of a private-sector model that could replace the GSE model has that companion piece," Daloisio said. "At some point and time when we get serious about how we are going to do this, we will need to see that companion piece addressed."

After the regulatory uncertainty is cleared and the new rules of the game are set, mortgage loans should be more expensive. If banks have to retain risk and potentially hold capital against the entire retained subordinate, securitization could be a capital-intensive activity, reducing the return on equity, JPMorgan analysts said.

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