Securitization Experts Recommend Changes to Congress


The House
Subcommittee on Capital Markets and Government Sponsored Enterprises took its
microphones to New York City on Wednesday for a field hearing on “Facilitating
Continued Investor Demand in the U.S. Mortgage Market without a Government
.”  The representatives
heard testimony from four secondary market participants: Marty Hughes, CEO of Redwood Trust, Inc., a publicly traded company
that invests in mortgage credit risk; Jonathan Lie Berman of Angelo, Gordon
Co speaking on behalf of the Association of Mortgage Investors (AMI);
Joshua Rosner, Managing Director, Graham Fisher Co. and Ajay Rajadhyaksha, Managing Director, Barclays Capital.

told the committee members that the origination half of the private mortgage
market is functioning well. The top ten jumbo mortgage lenders originated $25
billion in the first quarter of the year and $30 billion in the in the 4th
quarter of 2010.  The segment of the
private market that is not functioning well, he said, is private

Fixing the mortgage market is
simplified if looked at in its component parts, i.e., distinguishing between prime
and the non-prime segments and the reforms needed for each.  We need to restore basic functioning to the
prime segment, 90 percent of the market, and design reforms to prevent abuses
in the subprime segment.  A regulation
designed to do one can do great harm if applied to both, something now
happening with Dodd-Frank rulemaking. 
Regulators should first focus on the larger prime market and leave the
complexities related to risk retention, premium capture, qualified mortgages
and conflicts of interest to the reform of the subprime market.

Hughes Said there are three
hurdles to restarting the private residential mortgage-backed securities (RMBS)
market.  First, there is no financial incentive for bank
originators to securitize mortgage loans
. There are currently excess reserves in the banking system of $1.6
trillion and those reserves are earning at a rate of 0.25 percent.  Excessive reserves and low rates have reduced
the cost of funds for the 50 largest banks to an average of 0.81 percent and given
banks a strong incentive to hold loans that cannot be sold to the GSEs to earn
the spread between mortgage yields and the cost of funds.  This lack of incentive will self-correct
over time and with an improving economy, but it is critical that regulators and
industry practitioners address structural issues so that there will be a
functioning private RMBS market.

the government is crowding out the private market through programs that
make 90 percent of borrowers eligible for a below-market-rate guaranteed
mortgage loan.  Private capital cannot
compete with government subsidized mortgage programs.

Allowing the temporary increase
in conforming loan limits to expire at the end of September would be a good
first step toward reducing the government’s participation in the mortgage
market and scaling back government subsidies that do not pass on the full cost
of the risk assumed would permit a private market to flourish.  Hughes said his company advocates testing the
private market by first lowering the upper limit from $729,750 to $625,500 representing
about 2 percent of industry originations. 
There is ample liquidity and origination capacity to allow banks to step
into this small breach.  As the market
begins to recover there should be further measured reduction in the conforming
loan limit. He noted that, with housing prices now down over 30 percent from
their peak, it would seem logical to reduce the loan limit by the same amount
over time.

Third, there
is a need to resolve several key regulatory and market issues
reform of underwriting and servicing standards, greater investor protections,
and addressing the second mortgage problem. 
Hughes said that regulators took a well intentioned approach to crafting
a new set of risk retention rules by applying it to cover the entire
securitization market.  However the
differences between prime and subprime markets make it very difficult to apply
a one-size-fits-all set of rules and the new ones are “effectively
subprime-centric” and will be overly and unnecessarily harsh when applied to
prime securitization structures.   

Hughes said his company supports
the horizontal slice form of risk retention which requires a sponsor to retain
all of the first-loss securities and places the sponsor’s entire investment at
risk.  The other three forms result in
substantially less of the sponsor’s investment in the first risk position,
reducing the incentive to sponsor quality securitizations.

Redwood Trust supports the
intention of the proposed definition of a qualified residential mortgage (QRM)
but believes it is too restrictive, supporting the concept of “common sense”
underwriting, similar to those used by the GSEs prior to the period leading to
the credit bubble. 

Berman told the hearing that there are a number of market
problems which presenting obstacles for private capital to return to the
securitization space: 

  • Market opacity, an asymmetry of information, and
    a thorough a lack of transparency;
  • Poor underwriting standards;
  • A lack of standardization and uniformity
    concerning the transaction documents;
  • Numerous conflicts-of-interest among servicers
    and their affiliates;
  • Antiquated, defective, and improper mortgage
    servicing practices; and,
  • A lack of effective legal remedies available to
    investors for violations of RMBS contractual obligations and other rights
    arising under state and federal law.

Hughes pointed to the risk
inherent in second mortgages and said that, when discussing retained risk, it
is also necessary to make sure that the borrower has “skin in the game”.  He recommended a Federal law that would
prohibit any second mortgage on a residential property with the consent of the
first mortgage holder or a requirement that a second mortgage would not push
the combined loan-to-value over 80 percent. 

suggested treating MBS separately from other asset classes in an effort to
restore the housing sector.  “The
problems impacting investors by the malfeasance of servicers and their
affiliates are numerous,” he said.  Many
servicers are conflicted, such as when the servicer and the master servicer are
the same.  Servicers may not be servicing
mortgages properly, thus harming the interests of both investors and homeowners
and originators and issuers may not be
honoring their contractual representations about what they sold; sometimes the
documents and their terminology are valueless or meaningless.

Rosner said securitization
markets too often operate in a “Wild West” environment where the rules are
often opaque, standards vary, and useful and timely disclosures  of the performance of the collateral at loan
level is hard to come by.  “Asymmetry of
information, between buyer and seller, is the standard.”

Both Berman and Rosner offered similar recommendations to
enhance transparency and securitization practices within capital markets:

  • Provide loan-level information for investors,
    ratings agencies and regulators to evaluate the collateral and its expected
    performance and provide monthly disclosure of collateral information
    post-market in an electronically manageable and standardized format.
  • Require a “cooling off period” so investors have
    sufficient time for loan level due diligence;
  • Make deal documents publicly available
    sufficiently in advance of investor decisions;
  • Develop standard pooling and servicing
    agreements with model representations and warranties as an industry minimum standard for all asset
  • Develop clear standard definitions for
    securitization markets;
  • Directly address conflicts of interests of servicers
    by imposing direct fiduciary duties to investors and/or separating those
    economic interests.
  • Require substantive provisions to protect
    asset-backed security holders in securitization agreements.
  • Direct ratings agencies to use loan-level data
    on their initial ratings and update their assumptions and ratings over time.

Rosner said that even now we have
not started a real discussion about housing policy or the recreation of the
mortgage finance industry but, as they are two different subjects, legislators must
not be permitted to use private markets as tools of social policy. He advocated
for grandfathering the existing mortgage tax deduction but replacing it with a
mechanism such as a tax-free housing personal savings account similar to Health
Savings Accounts or 529 accounts which would be used for the future housing
expenses of first-time homebuyers or first-time renters.  Another possibility is an equity principal
tax credit for future mortgage originations which could target the most
underserved households with a subsidy or tax credit based on the yearly
reduction in mortgage principal balance.

Rajadhyaksha suggested that,
on the issuance front we must rationalize various regulatory regimes that
mandate capital requirements and take into account the investors’ cost-basis in
the security as well as expected losses when mandating those requirements.
There must also be a reduction of legal uncertain especially with regard to
repo and warranty enforcement mechanisms and the enforceability/transferability
of the related mortgage notes. Risk retention and disclosure rules must be
clarified and risk retention should focus on the origination point where credit
decisions are truly made.

On the disclosure side the Mortgage Electronic Registration
System (MERS) must be legalized and the process to correctly transfer loans
streamlined and made uniform across states. 
There must also be a timely and transparent way to enforce repo and

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

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

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