The housing market and mortgage banking industry continue to realize significant improvements. Home prices are rising, driven in part by low-cost financing that benefits highly qualified borrowers, and default rates continue to decline. Even so, the private-label market for residential mortgage-backed securities (RMBS) remains absent from the recovery.
Dr. Seuss, in his classic book, Oh, the Places You’ll Go!, describes boom times and down times that the pro- tagonist will likely experience on his way to success that is “98 and ¾ percent guaranteed.”
The “most useless place” along this journey is The Waiting Place, where everyone just waits for circumstances to change. It seems that mortgage- backed, private-label securities (PLS) will be stuck in The Waiting Place again in 2016, for the ninth consecutive year. Although the market has no need for “snow to snow” or “hair to grow,” as the story goes, every party to the process anxiously awaits the Seussian promise of “Another Chance” at a “Better Break.”
Waiting affects everyone
Each participant, and potential partici- pant, in the mortgage process is harmed by the failure to restart the PLS market. This is because the expansion of the private-label market necessarily coincides with the expansion of credit access.
The current market has been a boon to highly qualified borrowers benefiting from historically inexpensive access to capital. The mortgage loans originated to these borrowers range from low risk (near-pristine credit) to practically no risk (near-pristine credit coupled with low loan-to-value [LTV] ratios), and are happily retained on the balance sheets of banks or absorbed by government- sponsored enterprises (GSEs).
Most PLS activity has similarly focused on low-risk deals comprised of jumbo loans, but that market has limited growth potential. As such, any substan- tial increase in the PLS market must come from the origination of loans that carry relatively higher risk.
If undertaken properly, the broad- ening of the PLS market and expansion of credit benefits all market actors. Mortgage originators of all sizes would welcome the increased volume and re- sulting revenue, assuming most of the risk could be transferred to PLS investors. Similarly, mortgage servicers currently operating in an environment of tight margins would benefit from an increased and steady supply of performing loans.
The two sets of participants who would benefit most—investors and consumers—are currently waiting on the sidelines. Investors seeking slightly higher yields than could be obtained in the current market would benefit from the reintroduction or expansion of particular products. Specifically, alternative-A products limited to mortgage loans secured by a primary residence and adjustable-rate loans to borrowers in appreciating markets could expand access to credit without substantial, additional risk.
The reintroduction of these or similar programs would also help borrowers who are currently locked out of the real estate market. If the expansion is based on a sensible analysis of risk, PLS in- vestors would become the vehicle that releases capital to currently marginalized consumers.
Finally, the real estate market as a whole would benefit from the expansion of credit provided by a sensible restart to PLS issuances. Greater access would lead to new buyers and, likely, increased property turnover boosting the entire market.
Reasons for waiting
Yet it seems that the inability to quantify risk fully and assign the risk within deal documents has prevented rating agencies, originators, investors and trustees from rushing back to the PLS marketplace. At least three key factors make it challenging to define the actual risk associated with relatively riskier loans.
First, the tectonic shift in the regulatory environment has created uncertainty in the market regarding both assignee lia- bility and repurchase risk. The Truth in Lending Act (TILA)–Real Estate Settlement Procedures Act (RESPA) Integrated Dis- closure rule (TRID), in particular, is too fresh to allow an understanding of the Consumer Financial Protection Bureau’s (CFPB’s) enforcement tactics and focus. Until greater clarity exists, investors face unknown assignee liability and origina- tors face unknown repurchase risk pursuant to regulatory compliance repre- sentations and warranties.
Second, the parties who would participate in the restart of the PLS market continue to fight about loss causation during the unraveling of the previous market. It is challenging to convince originators and potential investors to agree, in writing, to the steps necessary to prevent losses when many of those parties still have litigation pending re- lating to issuances from 2004 to 2007.
As parties continue to debate whether unacceptable credit risk during the prior market was primarily caused by investors craving products that necessarily carried that risk, or by originators’ systemic failure to properly analyze borrowers’ eligibility for those programs, agreements on future protocols remain somewhat aspirational.
Finally, and most importantly, until a model can be implemented that protects investors through heightened due diligence, greater clarity and more consistent documentation, latent risks still exist in the PLS deal structure
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Key stakeholders have come together to design the foundation of a PLS restart, notably within the Structured Finance Industry Group’s (SFIG’s) RMBS 3.0 Task Force and the U.S. Department of Treasury’s PLS initiative. The work from these groups, and specifically the industry standards proposed by the SFIG in November 2015, is thorough and very valuable.
For instance, the apparent industry coalescence around the concept of a “deal agent” who can protect the interests of investors provides a centerpiece for a new model. But, as many acknowledge, finding the necessary funds to compensate this party will be challenging. It also will be difficult to find parties who are free of conflicts of interest and have the diverse skill set needed to supervise property management companies, analyze servicing reports, conduct loan file reviews to measure compliance with representations and warranties, handle very large numbers of docu- ments and data, and complete the many other disparate tasks.
The best efforts of these groups have been impressive but have also led to complex plans that will take time to implement, relegating the market to more time in The Waiting Place.
Cost of waiting
The urgency to solve these problems is growing. As parties seek to define and assign risk fully, it seems probable that the overall risk level is actually growing.
A borrower with little alternative eq-
uity or minimal disposable income (i.e., a higher-risk borrower), facing the prospect of making payments in a declining market that will not result in equity realization, is less able to ride out that declining market than borrowers with stronger profiles. Unfortunately, these higher-risk borrowers have been largely excluded from the significant appreciation that has occurred in many real estate markets over the last five years. As such, these borrowers are not developing an “equity cushion” that could soften the blow of a future market downturn.
It is certainly a failure of policy to keep these borrowers in The Waiting Place, but it is also a risk to the system if they are only permitted to join at or near the peak of the current increase in real estate prices.
Conclusion
If the real estate market is going to find Dr. Seuss’s “bright places where Boom Bands are playing” and ride a sustainable growth curve, it is imperative that the PLS market escape The Waiting Place. Parties will need to assume risk in the short term, even before that risk is completely knowable, or the opportunity to make the market more inclusive and sustainable may be missed.