Two Harbors Investment Corp. plans to offer its first issue of private-label RMBS late this year, joining a growing number of REITs that are prepping for a reduction - likely a gradual one over the years - in government-guaranteed mortgages.

"We want to be in position so that as the securitization (for Fannie Mae and Freddie Mac) market opens up, agency loan limits come down, and more borrowers go to private market, we can capture market share," said Bill Roth, co-chief investment officer at Two Harbors.

That means building the infrastructure to issue RMBS in greater scale when the mortgage market recovers and Fannie and Freddie as well as the Federal Housing Administration (FHA) - now owning or guaranteeing more than 90% of new mortgages - inevitably pull back. The first step back will occur on Oct. 1, when Fannie and Freddie's conforming loan limits will be reduced to $625,500 from $729,750, still well above the $417,000 limit in effect before Congress allowed the mortgage giants to increase the limits in February 2008.

In May, Two Harbors announced hiring Diane Wold, who managed GMAC Residential Capital Corp.'s structured finance, investment banking and business planning functions, to bolster its securitization knowledge base.

Its first offering, comprising high-quality Jumbo loans, will provide it with hands-on experience and a Roladex of institutional investors and Wall Street players to grease the execution of successive deals.

When new issuance will arrive in significant volume, however, remains anybody's guess. For now, the mortgage market's shaky foundation makes government guaranteed paper the most prudent investment for some institutions. And for those with a greater appetite for risk, the returns on existing RMBS that was originated during the housing boom are far more attractive than anything new issuance can provide.

"We have room to grow on the agency side but very limited room to expand the non-agency portfolio and only at very attractive yields," said Nancy Mueller Handal, who oversees insurer MetLife's $45 billion RMBS portfolio, which is 75% agency bonds and the rest non-agency.

Asset-manager TCW Group's clients have varying levels of risk tolerance, and so its RMBS funds' allocations to non-agency RMBS also vary widely. But issuance of non-agency paper currently holds little appeal from a return standpoint. "The secondary [market] paper trades at such attractive loss-adjusted yields that new issuance just can't compete from a risk and return standpoint," said Bryan Whalen, managing director of U.S. fixed-income at TCW.

Only two private-label deals have been issued over the last two years, both relatively small securitizations of high-quality Jumbo loans by Redwood Trust. While the deals were successful, they were viewed by many as more attempts to jumpstart the market than economically attractive transactions.

About 20% of Two Harbor's assets were in non-agency paper as of March 31. Roth noted that Redwood's 'AAA'-rated bonds, comprising high-quality Jumbo loans similar to what Two Harbors plans to securitize, priced at much lower yields than what's available from legacy paper, much of which is distressed and can be purchased at steep discounts.

Nevertheless, there may be a significant upside in the lower rated portions. Fitch Ratings rated 92% of Redwood's deal 'AAA'-the other two big agencies published unsolicited dissenting opinions - and the remaining five classes successive notches lower.

"Historically, the losses on those types of loans originated today have been well below 1%," Roth said. He added that given their recent history, the rating agencies are taking an extremely conservative approach to rating deals. "The bonds rated below 'AAA' today we think will perform well and provide attractive yields on a go-forward basis."

However, when those yields catch up to those of legacy RMBS remains an open question. Roth noted that the volume of existing bonds will inevitably shrink as loans are pre-paid and others are liquidated. "Over time, [legacy RMBS will] go away, although it may take several years," he said. Reducing supply should ultimately increase demand and valuations, leading to lower yields on legacy paper.

Whalen said there is approximately $1.6 billion in non-agency RMBS outstanding today, a massive amount that suggests that digesting legacy RMBS is likely to be a lengthy process. Whalen added that the fate of the GSEs is at the hands of politicians as well as factors impacting mortgages such as potentially rising interest rates, which are likely going to play out over the next 18 to 24 months.

"At this point in time, we believe we'll need at a minimum 20% or 25% appreciation in legacy valuations to start incenting money elsewhere," Whalen said.

Even if yields on non-agency RMBS do become competitive with legacy paper, a lingering question is whether there will be sufficient demand for private-label RMBS to replace issuance from the GSEs when they decide - or are pushed - to reduce their roles in the mortgage market. Banks are likely going to be saddled with higher capital requirements, if not sooner by U.S. regulators then later under the Basel Accord. And anticipated regulations stemming from the Dodd-Frank Act may end up tightly defining qualified residential mortgages or QRMs in a securitization, making it harder to avoid retaining 5% of the transaction, and further dampening banks' appetites for RMBS.

"We think retention differentiates REITs from other types of institutions. REITs are absolutely set up to retain credit risk without additional capital restraints," Roth said. "If there's one thing that makes REITs the ideal vehicle [to play a lead role in the mortgage market], that's it."

Insurance companies and other more traditional asset managers' bylaws often limit their allocations to private-label RMBS, and those restrictions have been reinforced if not increased by lessons learned from the recent credit crisis.

"Like many other institutional investors, we are able to take a good deal of liquid interest-rate risk but much less illiquid mortgage credit risk," said Handel at MetLife.

That leaves REITs as the most likely candidates to fill in any mortgage market gaps. Major asset managers such as PIMCO and TCW have established REITs and filed for IPOs to raise capital, as have at least eight other REITs - most recently Springleaf REIT and Orchid Island Capital. The success of those IPOs will provide a strong indication of whether investors see REITs as fueling a mortgage rebound around the corner. Credit Suisse notes that REITs raised $6 billion in capital during the first quarter, enabling them to buy $48 billion in RMBS this year if they maintain their current leverage of eight times.

"However, we believe their total demand for MBS is likely to exceed the above as they continue to raise more capital in the coming months, although the recent pace may not be sustained," states a Credit Suisse report in March.

In any case, REITs do hold some distinct advantages over other potential RMBS buyers. "The REIT vehicle, if set up and done properly, doesn't pay federal income tax," noted Thomas Humphreys, a partner at Morrison Foerster. "We've seen an increased interest in REIT structures. But first you have to raise capital and organize a pipeline of mortgage originators you can buy mortgages from, and you have to be sure you can sell or securitize the mortgages once you've originated them."

Two Harbors raised the capital through an IPO in May and is currently "in conversations" with lenders to set up loan origination pipelines. "The most important type of lender is a firm that has a retail network; someone who generates loans nationally for diversification; and someone who is already originating a reasonable amount of product," said Roth. "We're looking at prime Jumbos."

Big Wall Street players view REITs as essential to a mortgage-market recovery.

"We see REITs as playing a very important role in the future of mortgage finance, particularly once there's a resolution as to how Fannie and Freddie will evolve," said Timothy Bowler, a managing director in Goldman Sachs' financing group.

He added that his firm is starting to see REITs currently focused only on agency RMBS moving toward more of a "hybrid" model, where they are building the credit expertise to invest in non-agency bonds. "Certainly, when we talk to REITs, they are focused on moving away from an agency-only model."

Bowler said that Goldman sees three reasons for REITs' growing importance going forward. First, existing RMBS assets have favorable enough pricing and leverage characteristics for REITs to meet their dividend targets and, in a virtuous circle, attract additional capital. Second, they will be able to buy assets without the capital concerns faced by banks.

And third, "REITs should develop over time the operational advantages and infrastructure to enable them to very efficiently assess credit and interest-rate risk," Bowler said. "REITs are uniquely positioned to develop that expertise in-house because they're primarily focused on mortgage products."

If politics end up pulling the government out of the mortgage market faster and further than expected, REITs may have to pull much of the mortgage financing weight if home prices are to remain stable.

Although outcomes in Washington, D.C., are never predictable, even ultra-conservative politicians appear to recognize the essential role the GSEs and FHA play in today's mortgage market and that reducing that role will have to take place over many years.

Even then, it's likely they will continue to play a significant role. "We are not in favor of a fully private market, and we would not replace our agency allocation with private label," Handal said. "In particular, we like 30-year, agency-backed paper, as it is not only good for the consumer, particularly in a rising interest rate environment, but also provides diversification away from credit risk and, as an insurance company, helps match against our liabilities nicely."

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