Mortgage Resolution Partners (MRP) is the latest in a long list of challenges to a broader recovery in the market for private label residential mortgage-backed securities (RMBS), which, five years after the financial crisis, is finally gaining traction.  

Describing itself as a “community advisory firm,” the alternative investment manager has shopped around a plan it finances to several cities in California that were hit hard by the housing crisis and still have numerous residents whose underwater mortgages put them at risk of foreclosure.

Richmond, a small city in the San Francisco Bay area, is the first municipality to decide to pursue the program. It gave servicers until Aug. 13 to agree to sell more than 600 loans at steeply discounted prices, but there were no takers. So the mayor has begun the process of getting approval to compensate lenders for the loans that the city plans to confiscate using eminent domain. The intent is to replace them with financing that borrowers can more easily afford.

The scheme is attractive to homeowners, who stand to see their principal reduced significantly. And the city argues that it will reduce the potential for falling home values and blight that often accompany a slew of foreclosures. That of course is a boon for any political leaders deciding whether to pursue the strategy.
But it unnerves current and potential future investors in mortgage bonds at a time when a consensus has emerged across political party lines that the federal government’s 90% share of the mortgage financing market must be significantly reduced and replaced by private capital.

The concern is apparent by the array of prominent institutions already lining up against the initiative by Richmond, a city with just over 100,000 and a median household income of under $52,000. On Aug. 8, bond giants Pacific Investment Management Co. (Pimco), Blackrock and Doubleline joined Fannie Mae and Freddie Mac in a lawsuit seeking an injunction against the city and MRP, claiming the plan could result in investors losing as much as $200 million. 

On the same day, the Federal Housing Finance Agency said it would order Fannie and Freddie, which it regulates, to limit or stop buying loans from any jurisdiction using eminent domain to cease mortgages. And in a separate court, BNY Mellon sued Richmond and MRP.

The urgency for bondholders stems from the unique California provision called “quick take,” which allows for MRP and Richmond to seize and restructure the loans immediately, before the case is litigated and ruled on in the courts

“The notion that I have assets on the books that can be called away—at a discount to par no less—and they can actually be premium assets, is very troubling,” said Kevin Chavers, managing director specializing in mortgages at Blackrock and a member of the asset manager’s government relations team.

The eminent domain issue is only the latest in a list of developments since the housing bubble deflated that raise concerns among major investors, whose reliable participation will be necessary to bolster private-label RMBS volume sufficiently to replace government involvement in the mortgage market. Much of their dismay stems from the lack of standardization in today’s market, requiring investors to perform burdensome due diligence or demand higher pricing that may stymie issuers. Those issues include the securities’ widely varying representations (reps) and warranties, the current parity between first-lien and second-lien debt, and the uncertainty around which mortgages will be classified as qualified residential mortgages (QRMs), and therefore avoid yet-to-be-finalized requirements for retaining risk.

“In our view, the major issue is the fact that there’s no standardization in the industry, and in some cases it’s worse than before the crisis,” said Andrew McCormick, head of T. Rowe Price’s active taxable bond team
In the near-term, there are also market-driven challenges, such as volatile pricing and the chicken vs. egg dilemma faced by a market that remains too small to draw major sources of capital on a regular basis.

As an issue, eminent domain falls under the lack-of-standardization umbrella—governments have traditionally applied eminent domain to properties, not loans—and its legality has yet to be tested. Further complicating matters is the fact that, while under-water mortgages are more prone to defaults, more than 70% of the Richmond borrowers are current in their payments. 

“If successful, MRP’s loan seizure program would remove predominantly-performing mortgage loans from trusts, forcing a loss on millions of savers and retirees nationwide,” noted law firm Ropes & Gray in a statement regarding the Richmond proceedings.

The larger uncertainty posed by municipalities’ growing interest in eminent domain becomes one more risk factor for investors to price into deals, and one that’s difficult to model. Chavers noted that since the seized mortgages would likely be replaced by Federal Housing Authority (FHA) loans, one solution may be for the regulator to prohibit the use of its loans in such a manner, although the agency has yet to indicate any such intention. Lawmakers could also step in.

“Legislation that prevented this from happening would certainly calm the anxiety and frustrations of private-label RMBS investors,” Chavers said.

Any such bill, however, may be a long way off. Only recently has legislation emerged that addresses the risk lumped onto institutional investors with the arrival of the Home Affordable Modification Program (HAMP), created by the Financial Stability Act of 2009. That program sought to aid struggling homeowners by lowering their monthly payments. However, it focused on modifying first-lien mortgages rather than the second-lien debt that sat on the big banks balances sheets.

“Not only were you dis-servicing investors without giving them a seat at the table, but you had borrowers restructuring their secured indebtedness, which was typically the cheapest form of debt,” Chavers said, adding, “Auto and home equity loans and credit cards, usually higher cost debt, were left alone.”

New-issue RMBS done since the financial crisis, including the approximately $12 billion in deals so far this year, have primarily pooled pristine jumbo mortgages taken out by high-net-worth individuals who are unlikely to default on their mortgages. Since the lien-priority issue only becomes relevant when defaults occur, investors have little concern about it impacting so-called RMBS 2.0.

However, a private-label RMBS market restricted to securitizing pristine jumbo mortgages won’t help much in reducing the role of Fannie and Freddie—the aim of bills now making rounds on Capitol Hill. To do that, deals will have to pool mortgages from the larger universe of borrowers, including those with lower credit scores and fewer liquid assets. And that ultimately means more defaults, reviving the relevance of lien priority.

Lien priority, a pillar of the capital markets, was assumed to be an impermeable standard before the financial crisis. Now, however, investors must price the risk of its absence into spreads until measures are taken to ensure the government can never again invert the capital structure investors rely on, and that assurance is likely going to have to come from the government itself.

Legislation introduced by Senators Bob Corker (R-Tenn.) and Mark Warner (D-Va.) in June is mostly aimed at reducing the mortgage market’s reliance on a government guarantee, but a lonely provision tucked into the bill does address the lien issue. It would require second-lien lenders to obtain approval of first-lien holders if a credit transaction increases the borrower’s combined leverage-to-value (LTV) to 80% or more. Texas already has as a similar law.

Earlier this year, Rep. Scott Garrett (R-NJ) was seeking to include a provision he had introduced a few years ago into a broader bill that House Financial Services Committee Chairman Jeb Hensarling was putting together. That provision would have given the servicer of the first-lien loans the right to charge borrowers an additional fee if they take on more debt that raises the LTV above 80%. The bill would have also have required the holder of a new mortgage or other lien to notify the servicer of the borrower’s primary mortgage, and it would have prevented government agencies from pursuing forced write downs of securitized mortgage loans.

Hensarling’s bill, introduced in mid-July, aims to remove the government guarantee from the mortgage market altogether, placing even more reliance on the private-label RMBS to fill the void. Ironically, however, it does not include Garrett’s provision or other language directly related to the lien-priority issue.

“This systemic issue of first- and second-lien priority would require some sort of legislation to make a material change, and it’s hard to get anything legislated today,” said David Lyle, managing director and head of residential mortgage credit at Invesco.

The fate of Fannie and Freddie also weighs heavily on the private-label RMBS market. The Hensarling bill’s elimination of a federal mortgage guarantee would likely introduce significant volatility into the mortgage-loan market, many investors fear, and it could also mean the disappearance of the 30-year mortgage and significantly higher rates.

McCormick said T. Rowe Price is in favor of a more gradual approach that provides a “weaning off” period, along the lines of the Corker-Warner bill. It would create a securitization platform that guarantees up to 90% of the value of RMBS, leaving the private market to cover the first 10% of loss.

“We think something like that would help because it would allow us to create standards,” McCormick said.
He noted that securities issued from the platform representing the first-loss credit risk would likely have standard reps and warranties and servicing practices and protocols, much like agency RMBS today. “And that would take a lot of the uncertainty out of the picture and potentially get a critical mass to form” a more consistent market for investors, McCormick said.

Reps and warranties and servicing are two areas where investors view standards as sorely missing. In December 2009 the American Securitization Forum (ASF) issued “model” reps and warranties, which determine under which conditions sponsors are obligated to repurchase RMBS. Credit rating agencies provided their own versions. Today, however, reps and warranties remain all over the map.

Tom Deutsch, executive director of the ASF, said the disparity in reps and warranties stems partly from RMBS issuers having different loan origination systems or different originators they purchase loans from. Originators whose systems can better control fraud, for example, are more likely to provide a strong fraud representation. These differences “create challenges for investors to reconcile what price they’re willing to pay for RMBS and the conditions that go along with it,” Deutsch said.

They also create a lot of work. 

“It’s very difficult to ever imagine the market getting to scale,” said McCormick, “if every deal requires going through hundreds of pages of legalese to look at the breakdowns of loans. It becomes a very burdensome task and one that investors will do for a certain price, but probably not a price that creates a large, vibrant market.”

Chavers said that deals’ varying reps and warranties unreasonably shifts liability to investors. “Yes, the investor has responsibility to do due diligence and decide how to allocate risk, but the manufacturer of the product should own the risk for a manufacturing or design defect,” he said.

The latest reps and warranties dispute centers around sunset provisions. Sponsors of several new deals have sought periods of three years or less in which the reps and warranties apply, arguing faulty reps and warranties would impact deals early on and any later defaults would stem from credit issues. Bank sponsors in particular face burdensome capital requirements for RMBS under new Basel III rules, fueling their desire for the shorter periods.

The courts are in early stages of addressing reps and warranties issues arising in the wake of the housing bubble meltdown. However, noted Isaac Gradman, an attorney at Perry, Johnson, Anderson, Miller & Moskowitz, law is backward looking, applying to legacy RMBS and not new issues.

“The precedents that have ensued can show how to write a better contract, but they won’t necessarily lead to standardization,” Gradman said.

Nevertheless, to the extent that courts uphold the reps and warranties that institutional investors relied on in legacy deals, these investors should take comfort in the rule of law. Court rulings may also provide a template for the creation of more standardized reps and warranties. For example, the courts have allowed a trial to proceed that will determine whether to approve a settlement requested by trustee BNY Mellon — viewed as insufficient by some investors — of claims that its client Bank of America breached reps and warranties.

“One of the key things we need for securitization to work is an independent trustee who actually is monitoring the deal and making sure participants are upholding their end of the bargain,” Gradman said.
More directly, law firm Scott & Scott had complaints upheld earlier this year that allege BNY Mellon, as trustee, failed to protect investors under the Trustee Indenture Act of 1939.

“It is important for retirement funds that widely invested in MBS during 2005 – 2007, and then lost billions of dollars, to know that the TIA has a longer statute of limitations—six years—and does not require investors to show fraud to recover,” Scott & Scott states on its website.

Lyle said some investors may be overly cautious, using the uncertainties around issues such as reps and warranties as a rationale to avoid buying RMBS.

“At some point investors need to take a broader perspective and look at some of the mitigating factors ...,” Lyle said, calling the due-diligence on nearly 100% of the mortgages pooled in RMBS today by third-party firms “a huge mitigator to rep-and-warranties risk.”

Third-party vendors providing due-diligence services include CoreLogic, Clayton Holdings, Digital Risk and Allonhill.

Other areas where investors still see a lack of standardization include servicing and risk retention. Chavers said the government again displayed disregard for investor interests when the Office of the Comptroller of the Currency reached an agreement with eight major banker servicers in April 2011.

“There was acknowledgement that servicers had mis-serviced these loans to the detriment of borrowers, but there was no acknowledgement that they could then meet their settlement obligations by writing down assets that are, in fact, held by other investors,” he said.

In addition, servicer practices vary widely, requiring significantly more due diligence than if servicing were standardized, and the servicer on the pooled loans can change with little warning. That’s become problematic in recent years because some nonbank servicers have been especially aggressive in pursuing mortgage modifications that appear to be more in their own interests than investors’.

“When investors were figuring out the value of a bond before the crisis, the servicer was probably worth hardly anything; that’s not true anymore,” McCormick said.

Redwood Trust has always retained the bottom subordinated tranches of the deals it has issued, and since the financial crisis it has by far been the biggest issuer of private-label RMBS, completing more than 10 deals so far this year. Other issuers this year include J.P. Morgan, Credit Suisse, Nomura and Shellpoint Partners. Mike McMahon, managing director at Redwood, said the firm’s strategy creates a strong “alignment of interests” with investors in the deals’ triple-A-rated tranches.

Bank sponsors of RMBS deals, however, face burdensome capital requirements for those types of assets, making retention of the subordinated portion less attractive. Moreover, the risk retention proposal by six federal agencies would allow them to retain higher-rated portions of deals that arguably give them less “skin in the game.” And if the agencies’ qualified residential mortgage definition echoes the definition for the qualified mortgage, as recommended in the Aug. 28 proposal, most RMBS would not be subject to risk retention at all.

Whatever shape the QRM finally takes, investors will price accordingly and aligning it with QM at least provides more certainty, according to Lyle.

The private-label market is also facing market-related challenges. Issuance peaked in 2005, at $740 billion, and just $6 billion was issued last year, mostly by Redwood. Although market observers once had hopes for volume reaching as high as $30 billion this year, the increase in long-term rates has tapered estimates to closer to $15 billion. Even the higher estimate, however, is a pittance compared to the heyday, and hardly enough to warrant more than an opportunistic glance by most large institutional investors.

Part of the solution may arrive when Fannie and Freddie to lower their loan limits, making more mortgages available for private-label securitization. Even so, the chicken vs. the egg dilemma of investors avoiding the market because it is insufficiently large may persist for a while.

The hopes behind the higher volume number were partly based on the ever tightening spreads deals garnered, dropping below 100 basis points on triple-A-rated paper early this year, potentially drawing more issuers to lower cost funding. But since May 22, when Federal Reserve Chairman Ben Bernanke suggested that the central bank might ease up on monetary stimulus, the trend has reversed. Spreads on triple-A private-label RMBS have steadily widened, to approximately 275 basis points in recent deals.  “So everybody who bought a new-issue deal earlier this year has had negative performance. It leaves a bad taste in their mouths until they see the tone turn around,” Lyle said.

That, of course, applies to institutions that have already dipped their toes in the market. Wider spreads, assuming the trend is not toward significantly further widening, would likely draw greater interest in the securities from other investors, perhaps the vast bulk, who have viewed RMBS pricing as too tight and have opted to invest in less risky alternatives with comparable returns.

“Senior deals in the new-issue RMBS market need to be roughly 25 basis points wider in spread to be more attractive versus alternatives in the securitized market,” McCormick said.

Lyle concurs that there is likely “a lot of incremental demand not far behind where spreads are now,” or anywhere between 25 basis points and 100 basis points wider than current levels.

“That would make us significantly more interested. I can’t say exactly what the number is, but anytime spreads move wider it draws interest to take another look,” he said. “However, if spreads continue to move wider, we’re not going to just blindly add bonds. We need to see some stability and positive performance. That would be very beneficial for the growth of this market.”

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