Regulators must test the markets to see if the private label market can absorb the business that might come from reducing GSE conforming loan limits, said Martin Hughes, president and chief executive officer at Redwood Trust, today. Hughes made these remarks while testifying in front of the U.S. Senate hearing on the state of the securitization markets.

Hughes said that the scaremongering that has followed discussion of GSE reform has effectively prevented testing that would determine how changes would be handled by the private label sector. However, he believes that private capital would step in to take up positions that are no longer eligible to be covered by Fannie Mae and Freddie Mac.

"The first step  toward reform is to allow the loan limits to come down to see what happens," said Hughes. "The second step is to bring up guarantee fees to market rates."

Senate Talks Risk Retention

Redwood Trust is so far the only company to sponsor a securitization of newly originated residential mortgage loans without government support since the market froze in 2008.  The company has already completed two securitizations. In his testimony today, Hughes said that Redwood plans to complete two more securitizations this year.

For Redwood, the solution has been to address the concerns and interests of triple-A investors who, in the wake of the financial crisis, had lost confidence that their rights and interests would be respected and, consequently, that their investments would be safe and secure.

He also noted that the company has put skin-the-game as a way to reassure investors. The company takes on a 5% horizontal slice of the risk retention, which essentially means it retains the bottom part of the deal.

For instance, Hughes explained that in a $100 million transaction where 10% of the offering was below triple-A, with a horizontal slice, the issuer keeps on most of the risk. "With a vertical slice only 1% would be on the bottom tier with the balance sitting on top, which means very little teeth on the actual loss the issuer takes," he said.

American Securitization Forum (ASF) executive director Tom Deutsch also testified at the hearing today. He said that for banks subject to capital requirements, the option of vertical slicing risk retention into securitization deals is the only way to make using this capital markets tool viable.

He explained structural challenges on holding a horizontal slice would effectively mean that banks, who also service the loan, would have to consolidate the entire face value of the transaction as regulated by accounting ruled FAS 166 and FAS 167.

"Unless they change those rules, if regulators only require horizontal risk retention banks would be unable to securitize," he said.

CREFC Testimony

Lisa Pendergast, president of the CRE Finance Council (CREFC), also testified today. She said that the CMBS market is recovering with $35 billion in CMBS expected to be issued in 2011, increasing from $12 billion in 2010. However, she stated that this recovery is nascent. By contrast, $240 billion of CMBS was issued in 2007, comprising close to 50% of all CRE financing.

Since the market is at an early stage of the recovery, she urged regulators to take a deliberative approach in crafting the final implementing rules for Dodd-Frank as these apply to risk retention for securitized mortgages as well as clarify or revise certain provisions.

“CREFC supports the basic framework for CMBS within the proposed rules,” Pendergast said. “However, there are fundamental aspects within the proposal that have the potential to render the CMBS market unviable. Given the complexity, the rulemaking process must be an iterative one rather than a ‘one-and-done’ proposition,” she said.

Specifically, Pendergast asked the Senate panel to urge regulators to move with appropriate deliberation in the rulemaking process. “The statutorily imposed Dodd-Frank rulemaking schedule creates needless time pressure on regulators," she said. 

Instead she asked the Senators to urge the regulators to extend the current June 10 rulemaking response date, then re-propose the draft rule.

SIFMA Comment

Meanwhile, the Securities Industry and Financial Markets Association (SIFMA) issued a statement from Ken Bentsen, executive vice president, public policy and advocacy the trade association, on the hearing.

"SIFMA welcomes the Senate Banking Subcommittee on Securities, Insurance and Investment holding a hearing on the state of the securitization markets," Bentsen said. "Securitization has been a crucial financing tool for providing credit to every sector of the general economy, yet the market continues to be hampered by a lack of investor confidence and overall uncertainty surrounding the future of the system."

He warned that certain elements of the recently proposed rules on risk retention under Dodd-Frank can negatively impact the market, specially  mentioning the premium capture provisions. He said that these have the potential to take out securitization as a funding source in many markets by effectively regulating, and diminishing a securitization transaction's profitability,

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