Securitization Experts Recommend Changes to Congress

The HousernSubcommittee on Capital Markets and Government Sponsored Enterprises took itsrnmicrophones to New York City on Wednesday for a field hearing on “FacilitatingrnContinued Investor Demand in the U.S. Mortgage Market without a GovernmentrnGuarantee.”  The representativesrnheard testimony from four secondary market participants: Marty Hughes, CEO of Redwood Trust, Inc., a publicly traded companyrnthat invests in mortgage credit risk; Jonathan Lie Berman of Angelo, Gordonrn& Co speaking on behalf of the Association of Mortgage Investors (AMI);rnJoshua Rosner, Managing Director, Graham Fisher & Co. and Ajay Rajadhyaksha, Managing Director, Barclays Capital. </p

Hughesrntold the committee members that the origination half of the private mortgagernmarket is functioning well. The top ten jumbo mortgage lenders originated $25rnbillion in the first quarter of the year and $30 billion in the in the 4^{th</supquarter of 2010.  The segment of thernprivate market that is not functioning well, he said, is privaternsecuritization.  </p}

Fixing the mortgage market isrnsimplified if looked at in its component parts, i.e., distinguishing between primernand the non-prime segments and the reforms needed for each.  We need to restore basic functioning to thernprime segment, 90 percent of the market, and design reforms to prevent abusesrnin the subprime segment.  A regulationrndesigned to do one can do great harm if applied to both, something nowrnhappening with Dodd-Frank rulemaking. rnRegulators should first focus on the larger prime market and leave therncomplexities related to risk retention, premium capture, qualified mortgagesrnand conflicts of interest to the reform of the subprime market.</p

Hughes Said there are threernhurdles to restarting the private residential mortgage-backed securities (RMBS)rnmarket.  First, there is no financial incentive for bankrnoriginators to securitize mortgage loans. There are currently excess reserves in the banking system of $1.6rntrillion and those reserves are earning at a rate of 0.25 percent.  Excessive reserves and low rates have reducedrnthe cost of funds for the 50 largest banks to an average of 0.81 percent and givenrnbanks a strong incentive to hold loans that cannot be sold to the GSEs to earnrnthe spread between mortgage yields and the cost of funds.  This lack of incentive will self-correctrnover time and with an improving economy, but it is critical that regulators andrnindustry practitioners address structural issues so that there will be arnfunctioning private RMBS market. </p

Second,rnthe government is crowding out the private market through programs thatrnmake 90 percent of borrowers eligible for a below-market-rate guaranteedrnmortgage loan.  Private capital cannotrncompete with government subsidized mortgage programs.</p

Allowing the temporary increasernin conforming loan limits to expire at the end of September would be a goodrnfirst step toward reducing the government’s participation in the mortgagernmarket and scaling back government subsidies that do not pass on the full costrnof the risk assumed would permit a private market to flourish.  Hughes said his company advocates testing thernprivate market by first lowering the upper limit from $729,750 to $625,500 representingrnabout 2 percent of industry originations. rnThere is ample liquidity and origination capacity to allow banks to steprninto this small breach.  As the marketrnbegins to recover there should be further measured reduction in the conformingrnloan limit. He noted that, with housing prices now down over 30 percent fromrntheir peak, it would seem logical to reduce the loan limit by the same amountrnover time.</p

Third, therernis a need to resolve several key regulatory and market issues includingrnreform of underwriting and servicing standards, greater investor protections,rnand addressing the second mortgage problem. rnHughes said that regulators took a well intentioned approach to craftingrna new set of risk retention rules by applying it to cover the entirernsecuritization market.  However therndifferences between prime and subprime markets make it very difficult to applyrna one-size-fits-all set of rules and the new ones are “effectivelyrnsubprime-centric” and will be overly and unnecessarily harsh when applied tornprime securitization structures.   </p

Hughes said his company supportsrnthe horizontal slice form of risk retention which requires a sponsor to retainrnall of the first-loss securities and places the sponsor’s entire investment atrnrisk.  The other three forms result inrnsubstantially less of the sponsor’s investment in the first risk position,rnreducing the incentive to sponsor quality securitizations.</p

Redwood Trust supports thernintention of the proposed definition of a qualified residential mortgage (QRM)rnbut believes it is too restrictive, supporting the concept of “common sense”rnunderwriting, similar to those used by the GSEs prior to the period leading tornthe credit bubble.  </p

Berman told the hearing that there are a number of marketrnproblems which presenting obstacles for private capital to return to thernsecuritization space:  </p<ul class="unIndentedList"<liMarket opacity, an asymmetry of information, andrna thorough a lack of transparency; </li<liPoor underwriting standards; </li<liA lack of standardization and uniformityrnconcerning the transaction documents; </li<liNumerous conflicts-of-interest among servicersrnand their affiliates; </li<liAntiquated, defective, and improper mortgagernservicing practices; and,</li<liA lack of effective legal remedies available torninvestors for violations of RMBS contractual obligations and other rightsrnarising under state and federal law. </li</ul

Hughes pointed to the riskrninherent in second mortgages and said that, when discussing retained risk, itrnis also necessary to make sure that the borrower has “skin in the game”.  He recommended a Federal law that wouldrnprohibit any second mortgage on a residential property with the consent of thernfirst mortgage holder or a requirement that a second mortgage would not pushrnthe combined loan-to-value over 80 percent. rn</p

Bermanrnsuggested treating MBS separately from other asset classes in an effort tornrestore the housing sector.  “Thernproblems impacting investors by the malfeasance of servicers and theirrnaffiliates are numerous,” he said.  Manyrnservicers are conflicted, such as when the servicer and the master servicer arernthe same.  Servicers may not be servicingrnmortgages properly, thus harming the interests of both investors and homeownersrnand originators and issuers may not bernhonoring their contractual representations about what they sold; sometimes therndocuments and their terminology are valueless or meaningless.</p

Rosner said securitizationrnmarkets too often operate in a “Wild West” environment where the rules arernoften opaque, standards vary, and useful and timely disclosures  of the performance of the collateral at loanrnlevel is hard to come by.  “Asymmetry ofrninformation, between buyer and seller, is the standard.” </p

Both Berman and Rosner offered similar recommendations tornenhance transparency and securitization practices within capital markets:</p<ul class="unIndentedList"<liProvide loan-level information for investors,rnratings agencies and regulators to evaluate the collateral and its expectedrnperformance and provide monthly disclosure of collateral informationrnpost-market in an electronically manageable and standardized format.</li<liRequire a "cooling off period" so investors havernsufficient time for loan level due diligence;</li<liMake deal documents publicly availablernsufficiently in advance of investor decisions;</li<liDevelop standard pooling and servicingrnagreements with model representations and warranties as an industry minimum standard for all assetrnclasses;</li<liDevelop clear standard definitions forrnsecuritization markets;</li<liDirectly address conflicts of interests of servicersrnby imposing direct fiduciary duties to investors and/or separating thoserneconomic interests.</li<liRequire substantive provisions to protectrnasset-backed security holders in securitization agreements.</li<liDirect ratings agencies to use loan-level datarnon their initial ratings and update their assumptions and ratings over time.</li</ul

Rosner said that even now we havernnot started a real discussion about housing policy or the recreation of thernmortgage finance industry but, as they are two different subjects, legislators mustrnnot be permitted to use private markets as tools of social policy. He advocatedrnfor grandfathering the existing mortgage tax deduction but replacing it with arnmechanism such as a tax-free housing personal savings account similar to HealthrnSavings Accounts or 529 accounts which would be used for the future housingrnexpenses of first-time homebuyers or first-time renters.  Another possibility is an equity principalrntax credit for future mortgage originations which could target the mostrnunderserved households with a subsidy or tax credit based on the yearlyrnreduction in mortgage principal balance.</p

Rajadhyaksha suggested that,rnon the issuance front we must rationalize various regulatory regimes thatrnmandate capital requirements and take into account the investors’ cost-basis inrnthe security as well as expected losses when mandating those requirements.rnThere must also be a reduction of legal uncertain especially with regard tornrepo and warranty enforcement mechanisms and the enforceability/transferabilityrnof the related mortgage notes. Risk retention and disclosure rules must bernclarified and risk retention should focus on the origination point where creditrndecisions are truly made.</p

On the disclosure side the Mortgage Electronic RegistrationrnSystem (MERS) must be legalized and the process to correctly transfer loansrnstreamlined and made uniform across states. rnThere must also be a timely and transparent way to enforce repo andrnwarranties. </p

The uncertainty around servicing must be eliminated byrncreating standards similar to those needed by the FHA and FHFA.  There should be a mandated periodic releasernof information about the loss-mitigation efforts of servicers and standardizedrninformation on repurchases and requests for each securitizer/originator.  He would also mandate that the deal waterfall model be made available to all investorsrnin an accessible manner such as an Index CDI and penalties be imposed forrnincorrectly modeled securities.</p

Rajadhyaksha said for decadesrnthe GSEs have hedged their interest rate risk actively in the capital marketsrnbut their bigger hazard has always been the credit risk in their guarantee poolrnwhich was not hedged even as the size of that pool grew.  He recommended that the GSEs sell arnportion of the credit risk in their existing guarantee business to the privaternsector.   This would transfer some of thernrisk from the taxpayer to the private sector but more importantly would establishrna benchmark against which the private sector can price mortgage credit.

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