Issuance of nonagency, U.S. residential mortgage-backed securities remains moribund for the seventh consecutive year, due to several reasons, including regulatory uncertainty, new standards for servicers, and macroeconomic factors, such as interest rates and housing prices. Through July of this year, issuance, at $7.5 billion, is on track to be below the nonagency new issuance amounting to $16.91 billion for all of 2013. And market participants should be well aware that issuance is nowhere near levels seen between 2000 and 2007.
The challenges facing the private-label RMBS market can be classified under five categories: regulatory hurdles, stability of counterparties, the representation and warranties framework, exogenous variables, and technical factors. That said, the role of the federal government in reforming the government-sponsored enterprises probably will have the biggest influence on the size of the private-label RMBS market. Nonagency RMBS securities currently make up only 12.8% of the combined agency and nonagency mortgage-backed securities market. Reducing the footprint of Fannie Mae and Freddie Mac will allow for great participation in the private-label RMBS market.
An important step in the GSE reform was undertaken last year with the introduction of the “Housing Finance Reform and Taxpayer Protection Act” bill in the Senate. The legislation, voted out of the Senate Banking Committee in May, would replace Fannie Mae and Freddie Mac with the Federal Mortgage Insurance Corp., which would be setup as an independent agency of the federal government. However, despite bipartisan support for GSE reform, the bill has stalled in the Senate, and there is uncertainty about passage in the House.
In the meantime, as the market awaits what action, if any, Congress will take, lower guarantee fees charged by the GSEs weaken the economics of private-label securitization, because the lower fees make it harder for private capital to compete with the GSEs in making new loans. Similarly, higher conforming loan limits allow the GSEs to make loans in areas that otherwise would have been served by private capital. The GSEs’ current loan maximum of $625,500 in high-cost areas and $417,000 in all other areas continues to be higher than the precrisis levels. For example, the limit was $333,700 in 2004. The Federal Housing Finance Agency last December proposed reducing the current limits by four percent, which is a good start; however, the limits would have to be further lowered to provide any significant boost to private capital.
Also on the regulatory front, the qualified mortgage rule, which went into effect in January, implemented “ability to repay” requirements adopted under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The QM rule creates a safe harbor for issuers from the liability of violating the ATR requirements. This safe harbor exists as long as the issuers originate non-high-priced loans that do not carry any non-QM credit characteristics. The regulation has had an obvious impact on restricting some lending activity, and no securitizations with non-QM loans have closed as of August.
Furthermore, the GSEs have been granted a temporary exemption from certain QM regulations. They are exempt up until the time they exit federal conservatorship or receivership or on January 10, 2021, whichever occurs first. While this exemption maintains certain QM guidelines and is meant to be a transitional measure designed to prevent any dislocations in the agency market, it has anecdotally further limited lending to QM borrowers in the private-label market, thus reducing the volume of loans available for securitization.
The private-label market also awaits the final rules with respect to qualified residential mortgages. Loans that meet QRM definition will be exempt from the risk-retention requirement from the Dodd-Frank Act. If QRM turns out to be more restrictive than QM, the pool of private-label securitizable loans could shrink further. The QRM rule is currently under proposal, and there is some uncertainty about the outcome of the final ruling. The rule will require RMBS issuers to retain risk for loans that do not meet the QRM definition. While it is expected that QRM will be aligned with QM, there continues to be uncertainty among issuers.
Stability of Counterparties
The strength of counterparties plays a vital role in the qualitative assessment of RMBS transactions. As newer originators enter the mortgage loan origination business, clarity on their processes, business operations, and underwriting standards could help RMBS issuance.
Third-party oversight and monitoring of the performance of various counterparties that include originators, servicers, and due-diligence providers are important in RMBS transactions. A common industry framework to assess counterparty performance could facilitate RMBS issuance. Also, given the entry of new players in the residential mortgage market postcrisis, it is imperative that there are common benchmarks by which counterparties are measured. For example, servicers are now subject to new servicing standards that went into effect in January. While this is a good start, similar uniformity in performance standards for other counterparties would provide more clarity about the counterparties’ roles in RMBS transactions.
Representation and Warranties Framework
Standardization of the representations and warranties framework across transactions will be an important step in providing clarity to the investors about the buyback remedies available on transactions. The ongoing settlements that involved issuers paying penalties to resolve investor demand for repurchases on legacy RMBS transactions have left issuers scarred and they have adopted a conservative stand when granting RW to RMBS investors. Investors, on the other hand, have been resistant to any reduction in the scope of RW coverage, as they view this as limiting the issuers’ and originators’ long-term liability in transactions. Issuers and investors have locked horns over the recent introduction of sunset provisions in RMBS transactions, where the RW expires after a fixed period of time. A unified RW framework that is acceptable to issuers, investors and other market participants is needed for a fully functioning RMBS new-issue market.
Exogenous and Technical Variables
Home prices appear to have bottomed out in many regions. Rising home prices will reduce the number of borrowers who are underwater, improving borrower confidence. With more equity in their homes, borrowers are less likely to strategically default and more likely to make their monthly payment or to refinance into a more suitable loan. Rising home prices also give servicers more options to liquidate or modify bad loans.
A loan originator’s decision between selling (whole-loan execution) or securitizing (via new-issue RMBS) a loan is based on the best outcome between the two choices. The economic feasibility of new-issue RMBS by issuers therefore depends on their whole-loan execution. The higher the price issuers have to pay for collateral, the less economical securitization issuance becomes as compared to the price that they might receive via a whole-loan sale. For example, recent RMBS transactions have had 100% due diligence. This adds substantial costs to RMBS securitization, and the issuers might find it more attractive to hold the loans instead. A framework that balances investor protection with reasonable due-diligence requirements might be a more desirable outcome from a practical standpoint. Until securitization offers a higher yield than whole-loan sales, it is unlikely there will be any meaningful increase in the pace of new-issue RMBS.
Separately, bond spreads demanded by investors have a material impact on the feasibility of new-issue RMBS. If bond spreads widen to a point that is not supported by the underlying mortgage coupons, it will not be economical for lenders to securitize loans. As confidence in the residential market improves, investors should require lower spreads, which will lead to an increase in RMBS new-issue volume.
Finally, quantitative easing consisted of the Federal Reserve purchasing massive amounts of mortgage-backed securities and Treasuries, which decreased the supply of RMBS available for private investors, and therefore reduced spreads and improved the economics of new RMBS issuance. The continued reduction and the planned phase out of QE could possibly result in widening spreads, causing a drop in new-issue volume.
The pool of investors willing to buy nonagency RMBS is relatively small given the above-mentioned uncertainties. Many investors are sitting on the sidelines as they seek clarity on regulatory and policy changes before investing in nonagency RMBS. Mortgage loans backing recent RMBS transactions have been originated in an unprecedentedly tight lending market amid a low interest-rate environment. Issuers and investors can expect to see RMBS that are backed by mortgage loans originated in a more traditional lending environment. This, combined with greater clarity on regulations from the government, should result in an increase in new-issue RMBS volume.
Brian Grow is Managing Director of RMBS, and Gaurav Singhania is Senior Vice President of RMBS, at Morningstar Credit Ratings, LLC, a nationally recognized statistical rating organization, which recently published its methodology for rating U.S. RMBS transactions. They can be reached at firstname.lastname@example.org and email@example.com.