The U.S. Treasury isn't rushing the issue on GSE reform. For the securitization industry, the government's slow pace has turned out to be ideal.
The industry, after all, still has to grapple with the laundry list of issues that hinder its future growth and make the economics of private-label mortgage financing unappealing in the near term.
At the core of the housing financing reform debate is reducing the government's role in the mortgage market. That role is currently significant with the GSEs providing over 90% of mortgage financing largely through the credit guaranty that is wrapped around agency MBS.
The Dodd-Frank white paper required a resolution statement to be made at the end of January. However, the Obama administration has missed its Jan. 31 deadline to come up with the resolution and it is likely the report will be delayed until mid-February.
The larger issue delaying housing finance reform is the fragile state of the housing market. Fannie Mae and Freddie Mac constitute a huge amount of origination and the challenge is coming to a consensus on what alternatives would work in the middle of a housing crisis. "No one wants to be the one who resolves the GSEs at the expense of setting back housing recovery," said Paul Jablansky, senior consumer ABS and non-agency residential strategist at the Royal Bank of Scotland (RBS).
Instead, it's increasingly likely that the U.S. government will have to stay involved in housing finance to avoid its disruption and any reform the GSEs undergo will likely call for an orderly wind down of these entities over the longer term.
"There is no way to transition $5 trillion of risk to the private markets quickly," Barclays Capital analysts said. "Any housing finance solution will need to be a slow process that uses several private channels."
One issue all parties agree on is that running the GSEs as public corporations with incentives to generate returns of public corporations but having the benefit of government funding doesn't work and is likely to end. Jablansky believes that the Obama administration is most likely to support a continued role for the GSEs. Both parties are most of all driven by a strong incentive to avoid disrupting the housing market, and implementing anything that will make it more difficult for borrowers to get credit will probably be delayed.
The Obama administration might like to also explicitly guaranty agency MBS, although there remain concerns over the optics of that and the impact on the federal government's balance sheet given that the government would be viewed as actually providing an explicit, not implicit, guaranty on $4 trillion of loans. Realistically, Jablansky said that the government will guaranty only the loss amount, which is just a fraction of the total loan amount. The administration is also likely to support an expanded role for Ginnie Mae.
The Obama administration is unlikely to go for a quick reduction of the GSEs MBS portfolio and will likely want to see it wind down on its own.
One of the most widely suggested proposals aired at the Treasury's housing conference in late 2010 - and a commonly mentioned topic during the various congressional hearings on potential forms of the GSEs - was the Private Lender Cooperative Utility (PLCU) model, which is endorsed by the Mortgage Bankers Association.
According to the Federal Reserve Bank, under this model, securitization would be carried out by a mortgage securitization cooperative that would replace the GSEs. Only members would be eligible to sell mortgages to the securitization cooperative and the federal government would provide an explicit guaranty on the MBS issued by the cooperative in exchange for a guaranty fee ultimately paid by the banks.
Several securitization entities would be established, and they would be collectively owned and capitalized by originating banks. The banks would then, in turn, sell mortgage loans to the collectives, which would securitize them. The resulting MBS sold to investors would bear an explicit guaranty, for which the government would charge a guaranty fee - this cost could be passed along to the originators, or ultimately, the borrower.
According to Barclays analysts, arguments favoring this model have highlighted the strong involvement of the private sector, as well as its multilayered approach to protecting the taxpayer.
"This model's main advantage is its resemblance to the existing framework," they said. "Banks already have precedent for capitalizing a collectively owned mortgage funding entity in the form of the [Federal Home Loan Bank System]. Furthermore, the GSEs already represent the vast majority of mortgage market share, and investors should have few qualms about explicitly guaranteed MBS issued by these entities, as evidenced by demand for GNMAs."
Laurie Goodman, senior managing director at Amherst Securities Group, said with highly restrictive credit availability for mortgage finance, introducing reform into the existing infrastructure would be less disruptive to housing recovery.
"It's easy to say that the present system doesn't work but coming up with an alternative in the middle of a crisis is more difficult," Goodman said while speaking at an American Enterprise Institute (AEI)-hosted roundtable discussionon the future of the housing finance.
Instead, she believes the better route would be to "fix what is broken and not to throw the current system away entirely." Goodman said that a hybrid model could work to mend the broken system of too loosely defined line of what constitutes public and private label issuance. Under the hybrid model she envisions, one key difference would be that the government would not be pricing risk at cost to taxpayers. "A government guaranty on catastrophic risk creates a problem because what we've learned is that the government doesn't know how to price risk. Pricing should be done entirely by the private market," she said.
She also explained the PLCU model could encourage the market to eventually be dominated by only large banks and create entities that down the line can be considered "too big to fail."
It is likely that the Treasury will in the end support an enhanced, mixed public-private model with Democrats in the administration. Meanwhile, Congress is consistently supporting the retention of some government involvement in housing finance.
However, there are some industry players who believe that the reform should abolish the GSEs altogether.
AEI released a white paper on housing finance reform arguing that any system created with guarantees is bound to fail because the government cannot price that insurance protection properly. The paper calls for the government to gradually reduce the role that Fannie Mae and Freddie Mac play in the mortgage market so that their role is ultimately taken on by the private sector.
Jim Lockhart, vice chairman at WL Ross & Co,, who also spoke on the AEI-sponsored event said that he believes the future of the GSEs should be in the private sector. However, getting the government out of the mortgage market altogether will take a transition period lasting at least five years. He supports risk-related government insurance, but on a prepaid basis. He added that any backstop should kick in well after all else is paid, but not as a measure of first resort.
"We need a market with MBS that have common terms, unlike what we see now with the differences between underwriting in Fannie and Freddie paper, and we need certain rules in place for trustee and servicers," Lockhart said. "Originators need to have more "skin in the game" and we also need to see some sort of investor skin in the game much like the [Federal Deposit Insurance Corp.] model where any institutional investor would be subject to a form of upfront loss."
Jumbos Coming Back?
One of the key challenges for private label RMBS has been the very limited origination of nonconforming mortgages loans available.
In October 2010, the U.S. Congress extended a provision that set the conforming loan limit to $729,750 for a single-family home through fiscal year 2011. The private label banking industry has long argued that the nonconforming loan limit's extension has served to keep Jumbo activity sequestered in the GSE space. Industry players believe that once the upper limit shrinks, it can open up opportunity for the private market. "Once conforming loan limits were raised to $729,750, all houses up to $1 million effectively became eligible for a government guaranty," Barclays analysts said. "Moreover, risk weights for the purpose of regulatory capital are lower for agency securities than for loans."
According to Jablansky, it is likely that the Obama administration will move to slowly lower limits on conforming loans and, to the extent that they must deal with a Republican House, conforming loan limits are likely to at least fall to $625,000 from $729,750 once the extension expires in September.
"Republicans are expected to push for nonconforming levels to come down as soon as possible to $625,000 from the current $729,750 for the single-family home and ultimately, they would want to see levels reduced to the usual pre-crisis conforming limit at $417,000," he said.
Even a slight reduction in limits is likely to spur some business for private lenders who have had little access to the so-called Jumbo borrowers that traditionally funded these mortgages through the private-label market.
However, a reduction might not be enough to spur activity in private-label mortgage securitizations.
While the GSEs have more than 90% share of mortgage financing, the other 10% of mortgages have found funding through the private-label market.
Lockhart said that a Google engine search for 30-year, fixed-rate mortgages today would bring up a number of lenders outside of the GSEs.
It's All About the Economics
None of this loan origination activity, however, has filtered through the non-agency RMBS market.
"While I think it is unlikely that Congress will extend the current legislation on higher loan limits when it expires in September of this year, it won't change the fact that many banks right now are opting to hold on to limited numbers of nonconforming loan origination as investments rather that sell them into securitizations," said Tom Deutsch, executive director of the American Securitization Forum.
With deposit funding at an all-time high, banks have this money to use instead, explained Deutsch. It would take a shift in consumer savings, a move that would drive money away from deposits, to incentivize banks back into alternative funding strategies like securitization.
The bottom line is that agency paper provides more favorable execution than private-label securitization.
According to Barclays analysts, "good credit" conforming loans are being originated at about 5% WAC. For a typical 93-7 senior-sub structure that rating agencies would require for a private-label securitization, the loan could be originated at about 5.25% WAC.
Even with a concerted effort to shift mortgage financing away from the GSEs, banks must still be able to do risk-based pricing on loans. "The irony is that banks have lots of cash, as most have already taken into consideration the capital requirement charges up to Basel 3," said Greg Reiter, managing director in agency residential security strategy at RBS."So it isn't that they can't make loans; it's that they want to make loans at a profit."
A bigger issue that would more meaningfully impact the appeal of private-label mortgage funding for banks would be a rise in interest rates. However, Reiter said that for the same reasons politicians will not rush into GSE reform, they would also rather avoid triggering interest rates and thereby making mortgages even more expensive and housing affordability less accessible to borrowers.
"The private market has to run on profit," Reiter said. "They are ultimately answering to shareholders and in order for mortgages to make sense, interest rates have to be raised to cover business. The problem is that risk-based pricing isn't happening and rates need to go up for profit to be made."
If rates were to pick up from where they are now, it would be a positive from an RMBS standpoint, particularly for investors who are desperately trying to get yield to begin to find private-label mortgages more attractive, explained Paul Bossidy, CEO at Clayton Holdings.
Securitization's Future Still Uncertain
Still another pressing issue is that the private-label space is getting clarification on the definition of a qualified residential mortgage (QRM) under Dodd-Frank as well as the risk retention requirements.
What constitutes a QRM will help define risk retention, which can tie in with what the policy objectives of the future GSE loan limit and guidelines should look like since the risk retention requirements will ultimately define how much volume banks will be able to take on.
"It's not just the uncertainty about how these mortgages will be counted; it's also the fact that once its clarified it's likely that banks will want to get that little bit extra to ensure profit and with that borrowers will see the costs go up on loans," RBS' Reiter said.
Certainly private-sector funding isn't solely contingent on the health of the securitization market. There is the alternative of balance sheet funding and also - depending on legislation - the development of a U.S. covered bond market.
According to Clayton's Bossidy, banks don't have the balance sheet capacity for a mass quantity of mortgage product, and if future private-label mortgage financing is to be sustained, other vehicles of funding need to support balance sheet funding.
"The most likely scenario is that banks would consider various funding alternatives to fill the void left by the GSEs stepping out; securitization alone won't fill that void," said Rui Pereira, head of U.S. RMBS at Fitch Ratings.
The Future Is Here
As the wheel on GSE reform trudges slowly along, the private-label market is already implementing reforms of its own. Private-label mortgage banking's more strenuous borrower requirements already reflect some of the lessons learned in the housing finance crisis. There have also been great strides made in general underwriting standards. Banks are already looking at loan limits and are, in many cases, requiring borrowers to have 20% or even 30% equity to cover losses. New regulatory requirements also mean that there is much more security that exists by way of checks and balances.
"Since the market shut down over three years ago there has been lots of soul searching in the industry, and there has been a tremendous amount of progress," Bossidy said.
He pointed to the strides made by the rating agencies with regard to reworking their ratings process across the board and will come to the new market much better prepared. "If GSEs cut back their footprint and some issues get done privately in terms of transparency, the quality that goes into these new securitization deals will go a long way to show investors the improvements that have already been made," he said.
Over time substituting the system with only high-quality mortgages and conforming loan limits would eliminate the need for GSEs altogether. "The question is: Has Fannie and Freddie kept out the private sector or are they there because the private sector won't step in?"