When it comes to the future of mortgage securitizations, it's safe to say the entire business is up for grabs, but nowhere is that more apparent than in the market for issuing bonds backed by "nonqualified" residential loans.

Of course, it might be argued that (currently) the business of issuing MBS backed by nonprime mortgages is nonexistent, that is, except for last year's $238 million jumbo MBS deal from Redwood Trust, a publicly traded REIT based in Mill Valley, Calif.

As reported in National Mortgage News several times, the number of firms planning and plotting Jumbo conduits is long and growing, but with important detail: no one has issued a bond since Redwood in April 2010. A handful of private jumbo deals have come to market and Redwood is planning to issue its second jumbo MBS by the end of March.

But there is plenty of jockeying among depositories, REITs and trade group officials regarding how the different regulatory agencies will write the risk retention rules regarding the 5% chunk of "skin in the game" that bank issuers will have to keep if they want to play in the jumbo and nonconforming MBS space.

The Federal Deposit Insurance Corp. (FDIC), Securities and Exchange Commission (SEC), Federal Reserve and other agencies are weighing two different risk retention models for jumbos (and other nonprime) products: “vertical” and “horizontal.”

If a vertical risk retention model is used that means the issuer would own a percentage of each tranche — from the unrated tranche all the way through single-Bs and then up to the highest rated 'AAA' piece. Under the horizontal risk retention model, the issuer is required to keep the lowest-rated tranche (the most subordinated bond) which is also first in line to absorb credit losses.

Under one analysis being circulated in Washington, on a $250 million Jumbo MBS, the issuer with vertical risk retention is on the hook for $7.5 million in losses (because it has the first loss position) compared to just $450,000 under a vertical risk retention.

The vertical "hit" is so low because the issuer is on the hook for a "Democratic" sharing of losses in each tranche: rated or unrated. And it's possible, under the vertical model that no losses will occur at all in the higher-rated tranches.

Confused? The whole debate gets even more complicated. Under current Federal Accounting Standards Board rules, an issuer that retains even a 5% risk piece must go through what is called "consolidation" which means if the horizontal model is used, banks will have to treat any issued security as a financing, which means they'll face even higher capital requirements outside of the 5% requirement.

The implication for commercial bank issuers of MBS is clear under the horizontal model: it will make being an MBS issuer uneconomical, ceding the entire market over to nonbank issuers, including firms like Redwood and others that have been salivating at the prospect of a true revival in jumbo securitizations. (Redwood declined to comment for this story.)

But several veteran players in the MBS market do not blame Redwood for trying. In fact, some also blame certain banks, such as Wells Fargo — the nation's largest issuer of GNMA MBS, by the way—for trying to game the system as well.

Wells is lobbying regulators for a vertical risk retention rule — but not only that, it wants the “qualified residential mortgage” language written in such a way that it creates a narrow class of “prime” mortgages. If that happens, it will result in more nonprime loans — mortgages that Wells will put in bonds it issues. Wells, as most mortgage bankers know, has a major advantage because of its position as the nation's largest funder of all home mortgages, not to mention a well-capitalized megabank with a huge market share and dozens of seasoned executives and traders who understand the MBS business inside and out.

Wells made a big splash in mid-November when it wrote to all the regulatory agencies arguing for a QRM that encompasses only loans with high FICO scores and hefty downpayments. In the same "Wells letter" the bank also lobbied for a vertical risk retention model.

Needless to say, Wells apparently has the ear of several regulators including the FDIC. One lobbyist in the debate, requesting anonymity, told me that the Federal Reserve, Treasury and SEC favor the horizontal risk retention model, but are taking orders from "up above." In other words: the FDIC, the agency that will ultimately decide the issue.

Tom Deutsch, executive director of the American Securitization Forum, has been following risk retention closely, and doesn't see the issue in such black-and-white terms. He thinks regulators should offer MBS sponsors the choice of using either horizontal or vertical or some combination of either.

Then again, the megabanks will take the path of lower capital requirements by picking vertical. In about two weeks, the industry will see the actual rule on risk retention and then the jockeying for advantage will begin in earnest.

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