Buyers of private-label mortgage backed securities still have a beef with the federal mortgage modification plan, which allows investors with a second-lien on distressed properties to jump ahead of first-lien holders in terms of payment priority.

However efforts to revive legislation to reassert the priority of first-lien holders could receive a warmer reception, given banks improved health and policymakers stated goal of shift mortgage financing to the private sector.

The Home Affordable Modification Program (HAMP) altered primary mortgage loans backing RMBS transactions without touching those borrowers’ second-lien debt, typically home-equity loans. That gave practical priority to the second-lien debt.

It’s hard to say definitively how much this inversion of lien priority has slowed the revival of the private label RMBS. There are plenty of other things holding the market back, not to mention the lack of high-quality loans that can be used as collateral and disagreements about the appropriate representations and warranties as to their quality.

In fact, deal making has slowly picked up steam. Until recently, Redwood Trust had been the lone regular issuer of RMBS backed by previously unsecuritized mortgages. Those mortgages have been high quality jumbo loans with low loan-to-value ratios and high borrower credit scores that are in little danger of requiring loan modifications, and they represent only a small slice of the mortgage market and so a potentially revived RMBS market.

However Credit Suisse issued a $415 million deal earlier this year backed by similarly high-quality mortgages. And JP Morgan is currently in the market with its first RMBS offering in years, a $616 million deal that’s backed by high quality mortgages but, according to Moody’s Investors Services, contains some structural weaknesses.

JP Morgan recently forecasted that private-label RMBS volume could reach $30 billion this year, five times the $6 billion seen in 2012. The private-label market’s volume peaked in 2005, at $740 billion.

Still, lien priority remains a critical issue for many potential investors. “Until we get a bit more clarification [on lien priority], that’s probably going to limit how much non-agency product we’ll see,” said Arnie Phillips, senior portfolio manager for global fixed-income at the Sacramento-based California Public Employees Retirement System (Calpers).

No Compensation for Uncertainty

Calpers, once one of the biggest investors in private-label RMBS, reportedly liquidated a portfolio of more than $3 billion non-agency bonds in 2010. At the time, Curtis Ishii, senior investment officer for global fixed-income, told Asset Sales Report that the pension fund was “pretty much done with that market.”

Calpers may have softened its position since 2010; Phillips told ASR that the pension fund would still consider investing in RMBS. “A lot of it comes down to pricing. If lien priority hasn’t been rectified, then we just have to get compensated for it,” he said. “It’s not a deal killer, but the hurdle rate is very high for us to be interested.”

Pricing for Redwood’s recent deals, however, has been extremely tight, as some investors with starving RMBS allocations have pounced on the limited supply. Whether those investors represent sufficient capital to grow the non-agency RMBS market enough to draw mortgage financing away from the GSEs, remains to be seen, especially if big institutional investors see little value in the non-agency market.

“The last couple of RMBS deals have yielded 50 basis points or less than Fannie Mae jumbos---that’s insane,” said Scott Simon, who heads up mortgage- and asset-backed securities investing at Pacific Investment Management Co.

So what efforts are afoot to restore priority to the claims of primary mortgage holders? Tom Deutsch, executive director of the American Securitization Forum, said investors would like to see the issue addressed nationwide, rather than on a state-by-state basis, and that leaves the ball in legislators’ court.

“Legislative initiatives are likely the best hope,” he said, adding “I’m not aware of any initiatives from regulatory bodies that would affect lien priority at this point.”

Deutsch said there are proposals being discussed on Capitol Hill that focus on the originator of the second-lien loan either getting permission from the first-lien debt holder or paying some kind of enhanced risk premium to the first-lien lender.

“If you have a first-lien mortgage with an 80% LTV and take out a 20% LTV second-lien loan, you would have zero equity in your house and you’re likely to default on both loans, and that reduces the net-net value of the first-lien mortgage,” he said.

Reviving Reform Legislation

Maggie Seidel, a spokeswoman for Rep. Scott Garrett (R-NJ), chairman of the Financial Service Committee’s Subcommittee on Capital Markets and Government-Sponsored Enterprises,  confirmed that the congressman plans to pursue legislation he originally introduced in December 2011 aimed at bolstering the priority of primary mortgages. “We do plan on pursuing this again in the current congress, as part of a comprehensive mortgage financing bill,” she said.

Seidel declined to provide further detail about the forthcoming bill or when it will be introduced.
However, Rep. Jeb Hensarling (R-Tex), chairman of the House Financial Service Committee, wrapped up a series of hearings on March 20 that addressed the issue of housing finance reform. A staffer on that committee said the chairman is working with other committee members on a reform bill, although it remains uncertain when such a bill will be introduced. That bill is a likely vehicle for some or all of the provisions in Garrett’s earlier bill.

Sen. Bob Corker (R-Tenn.), who is a member of the U.S. Senate Banking Housing & Urban Affairs Committee, is reportedly prepping similar legislation. His office did not respond to inquiries by press time.

Garrett’s 2011 bill proposed giving the servicer of the first-lien loans the right to charge borrowers an additional fee if they take on additional debt that raises the LTV above 80%--presumably RMBS investors could pressure servicers to exert that right. The bill would have also 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.

Texas law already prohibits originating second-lien loans when the combined LTV of the first- and second-lien would be higher than 80%; and according to CoreLogic, the state’s overall default rates were a third of those in other states. A Corelogic spokesperson declined to comment on the impact of the law on default rates, saying it is not possible to draw conclusions from such limited data.

Garrett’s bill quickly died, but at the time, banks were still desperately seeking to build up capital. Worries about the health of U.S. banks were further compounded by potential fallout from the European sovereign debt crisis and the debt-ceiling crisis in the U.S.

Such a bill might be an easier sell now that the Federal Reserve has signed off on the capital plans of most banks that are the most active mortgage servicers.

However, it remains to be seen whether banks can be induced to write down the value of second-liens that they hold on their books, rather than securitize, particularly when the second liens themselves are still current.

Laurence Platt, a partner at K&L Gates, noted that borrowers delinquent on primary mortgage loans often stay current on their second-lien debt. And since the banks that are the biggest mortgage servicers often have provided the second-lien debt and hold it on their books, there’s little incentive for those banks to write down these-loans down if they are current.

“The government can’t really tell them they have to accept modifications of the second-lien loans they hold, particularly when the loans are current,” Platt said. “It’s one of the great conundrums out there.”

As a result, for existing RMBS, the issue may ultimately have to fade with attrition, as the mortgages backing them are refinanced or reach maturity. Congressional members including Hensarling as well as White House officials have expressed the desire to see mortgage financing move to the private sector and away from Fannie Mae and Freddie Mac. That will be more difficult, however, if potential investors in private-label RMBS are not assured that any first-lien debt they buy would receive priority in a workout.

Adding to the concerns of potential private-label RMBS investors, home equity loans are making a comeback, with J.P. Morgan and other banks saw their originations increase by double digits in 2012 over the prior year, and new lenders such as Discover Financial Services have recently entering the business.

Mike McMahon, a managing director at Mill Valley, CA-headquartered Redwood, said his firm’s success “depends in large part on the [investor in AAA-rated RMBS] coming back to the market. We’ve done several billion dollars’ worth of deals, but that’s a rounding error,” he said.— By John Hintze

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