Enhanced credit-agency analysis and disclosure, better underwriting and data, and growing consensus on best practices for issuers have yet to lead to a rebound in the private-label residential mortgage-backed securities market. Many years after the meltdown, it remains a work in progress.
By Robert Stowe England
The wheels came off the new issues market for private-label residential mortgage-backed securities (RMBS) way back in August 2007. Since then there have been improvements by issuers working in conjunction with investors, as well as better data and disclosures in the credit-rating process.
However, until there is significant buy-in from investors--the engine that drives the market--the private-label RMBS market will not see a revival. So far, investors are not impressed enough with retooling efforts to push the market forward.
“There’s a general reluctance of investors overall to embrace any residential mortgage-backed securities that don’t have a government guarantee, because nearly eight years ago they were burned terribly by the subprime mortgage crisis,” says Guy Cecala, president of Inside Mortgage Finance, Bethesda, Maryland.
In 2007, the market collapsed and RMBS values plunged and portfolios were sold for less than 30 cents on the dollar.
“Emerging after that, the private-label or non-agency RMBS effectively had a skull and crossbones on it, as far as investors are concerned,” Cecala adds.
What the numbers say
New issuance volumes are the best measures of the state of the RMBS market. During 2014 there were $35.1 billion in new private-label RMBS issues. Of that, only $10 billion was for new jumbo prime mortgages, $887 million for subprime and $1.6 billion for alternative-A, according to Inside Mortgage Finance. Nearly all the other issues represented resecuritizations of previously existing mortgages.
The current RMBS market is a mere shadow of its former self if you look back to the boom years before 2007.
“Back then, it was more than a trillion-dollar market. Now it’s a $10 billion market--a footnote,” says William Frey, principal and chief executive officer of Greenwich Financial Services, Greenwich, Connecticut, a family office asset manager (private company that manages investments and trusts for a single family) and author of Way Too Big to Fail, a 2011 book that identifies what policies and legal protections for bond holders are needed to bring investors back to the RMBS market.
The non-agency RMBS issuance market peaked at $1.19 trillion in 2005 and had another top year in 2006, with $1.15 trillion in new issues, according to Inside Mortgage Finance.
After the August 2007 collapse, volumes nosedived to levels below $100 billion and were limited mostly to resecuritizations. Since then, issuance volume has remained low, dropping to $21.1 billion in 2011 before rising modestly to the $30 billion range in the last two years.
Looking more broadly at the mortgage-backed securities (MBS) market--both residential and commercial--it has been a tale of two cities since the crash of August 2007.
Subprime RMBS was the epicenter of the crash, but a loss of investor confidence also took down the commercial mortgage-backed securities (CMBS) market and the non-mortgage side of the asset-backed securities (ABS) market, which includes assets like automobile loans and credit-card receivables. Both the CMBS and ABS markets have rebounded (see sidebar on the rebound in CMBS).
RMBS deals not economic
There is fairly widespread agreement that the No. 1 reason the RMBS market has not revived is that “it’s not economic” to do securitization deals.
“Banks have a very good bid for portfolio [jumbo] loans and it’s harder for private-label to compete with that,” says Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute, Washington, D.C.
Grant Bailey, head of RMBS at Fitch Ratings, New York, agrees. “I think that all these structural improvements we talked about--I don’t think this is the major obstacle to higher volume in the private-label sector. I think it’s really fundamentally the economic incentives,” he says.
“The big one is that the banks don’t really have a strong economic incentive to securitize. It’s profitable for them to keep it [mortgages] on balance sheet,” Bailey says.
Challenges also exist in pricing in some of the risks in RMBS jumbo transactions. For example, because the deals are on properties with borrowers who have very high credit profiles, “it’s very hard to price the prepayment risk because these types of borrowers can prepay at will when it’s in their interest,” says Bailey. “And they might not prepay for a long time if interest rates move in the other direction.”
If the question is how do you revive the RMBS market, the answer is invariably “higher yields” from a range of market participants. Higher yields will make deals economic and “lure investors back” into the market,” says Cecala.
For now, however, higher yields are out of the question because the competition from portfolio lenders that want to keep the loans on their books. Portfolio lenders are able to offer lower rates to consumer because the cost structure is better for portfolio lenders than it currently is for securitizations, both agency and non-agency.
“Portfolio loans don’t have to be priced off the 10-year Treasury, like mortgage-backed securities do,” Cecala explains. “They can be priced off the bank or financial institution’s cost of funds, which is the rate they pay on deposits.”
The average rate paid on deposits is now about 0.2 percent, while a jumbo portfolio lender can make a jumbo mortgage at 4 percent. “That’s a 3.8 percent margin off their cost of funds. It’s very, very profitable,” says Cecala.
“In many cases, jumbo mortgages are priced the same or even lower than conforming mortgages,” he adds. That is due to the fact that the jumbos are priced off cost of funds from deposits while an agency MBS is priced off the yield on the 10-Treasury.
“That has created somewhat of a disconnect between prime jumbo loan pricing and conforming mortgages,” says Cecala.
The weakness in the RMBS position can be seen in the fact that last year’s $10 billion in new jumbo RMBS issuance was dwarfed by the $235 billion overall size of the jumbo origination market, according to data from Inside Mortgage Finance.
“It was basically 4 percent of jumbo originations last year--96 percent weren’t RMBS,” says Cecala.
Do not expect issuance volume to rise significantly anytime soon, according to market observers. “While we see some good fundamentals going into this year, we don’t see a substantial change in the volume of new RMBS issuance,” says James Wiemken, head of structured finance ratings at Standard & Poor’s (S&P), New York.
S&P expects issuance volumes for jumbo RMBS to rise from approximately $9 billion last year--by the rating agency’s estimate--to $15 billion in 2015.
Wiemken, while acknowledging the “big role” portfolio lenders played last year, nevertheless sees market conditions this year shifting slightly in favor of RMBS. The longer term is even more promising, he says.
After the big run-up in jumbo portfolio lending by banks, portfolio lenders could eventually come close to the capacity of their balance sheets to continue to add loans at the same pace.
“There is a limit to that. At some point, as the supply of loans grows, that capacity could become a constraining factor,” says Wiemken. This could open the door to higher RMBS issuance volumes.
Some relaxation of the “almost super-prime levels” of credit in the jumbo market could also be a spur for more jumbo RMBS issues, according to Wiemken.
“Not only have loans been underwritten to incredibly high [credit quality] standards, you had RMBS transactions with 100 percent loan-level due diligence,” he says.
“As economic activity picks up, the question becomes could that lead lenders to relax their underwriting standards and expand credit to meet market needs?,” wonders Wiemken.
At current yields, jumbo RMBS face another competitor for investor dollars--agency securities.
“If you’re an investor, you’re looking at getting the same yield on private-label RMBS that you can receive from a government-guaranteed security--Fannie Mae, Freddie Mac, Ginnie Mae,” says Cecala. “Why would you take the non-agency?”
Absent a government guarantee, the jumbo RMBS needs a higher yield to attract investors who will otherwise prefer the government-guaranteed securities.
“They need to be making 5 percent mortgages, or even better 6 percent mortgages, going into these non-agency MBS so the yield can be higher,” Cecala says.
Prospects for a rebound
Some market observers pin their hopes for an RMBS rebound on the advent of higher interest rates when the Fed begins to raise its Federal Funds Rate later this year, as Fed Chair Janet Yellen has signaled.
But that’s not the whole story, says Cecala. The cost of funds for portfolio lenders would also have to rise for it to make a difference.
“We’d have to get out of that differential between the 10-year Treasury and the cost of funds, and the economy would have to improve significantly and the Fed would have to raise the Federal Funds Rate overall before that happens,” says Cecala.
One possible way for the rebound to occur sooner would be to see a resurrection of non-prime or subprime mortgages that carry higher yields.
“There are a handful of lenders that are making loans to people who came out of bankruptcy or who had a foreclosure. They would love to be able to securitize those loans,” says Cecala.
The new nonprime lenders are mostly nonbanking portfolio lenders funded by investors. The lenders attract investments from private-equity funds that are looking for the higher yields. They are offering higher-rate mortgages with rates from 7.5 percent to more than 10 percent to borrowers who went through a foreclosure, bankruptcy or short sale and who have gotten back on their feet and have good cash flow but still have low credit scores.
With down payments of from 25 percent to 40 percent and a recovering housing market, these loans look attractive to investors, according to Cecala.
One of the new entrants to subprime lending is Citadel Servicing Corporation, Irvine, California. The company entered the subprime lending market in 2013 after raising $200 million from investors. According to Citadel’s January 2015 rate sheet, the company offered a 7.5 percent rate for home purchase mortgages with at least 20 percent down and FICO® scores between 650 and 699 to borrowers who may have had a bankruptcy or a foreclosure more than two years prior or who may have had a short sale more than a year earlier. The same loan is available for a refinance if the loan-to-value ratio (LTV) is 75 percent or lower.
Athas Capital Group, Calabasas, California, is another lender that has been offering subprime loans since 2013. In mid-February, Athas Capital was offering an 8.625 percent rate plus 2 points for a home purchase loan to borrowers with a FICO of 650 to 699 with a down payment of 25 percent.
A refi with a similar FICO score would require a loan-to-value of 70 percent. Any foreclosures and bankruptcies must have occurred three years prior and any short sales two years prior for a borrower to be eligible for this loan. These loans are limited to California, Arizona, Oregon, Idaho, Colorado, Utah and Texas.
The rating agency perspective
A newcomer to the RMBS market, Morningstar Credit Ratings LLC, New York, sees signs that the RMBS market is on the cusp of expanding into non-Qualified Mortgage (non-QM) lending.
This rating agency was launched in Horsham, Pennsylvania, in 2007 as RealPoint LLC. It became a nationally recognized statistical rating organization (NRSRO) in 2008 and was acquired as a subsidiary of Morningstar in 2010, changing its name to Morningstar Credit Ratings in 2011. It is now headquartered in New York but retains offices in Horsham.
Morningstar rated its first CMBS new issuance transaction in 2009, and then in 2011 it diversified into RMBS. So far the agency has rated all 19 marketed single-family rental RMBS deals backed by residential properties, including two multiborrower transactions.
Morningstar has also been studying the details of RMBS deals made in recent years to evaluate them on how they would be rated by Morningstar. Details on those deals are available to all NRSROs on password-secured websites thanks to the provisions of the Rule 17g-5, which is the conflict-of-interest provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
The conflict of interest referenced by 17g-5 is the one that exists for the rating agency when any issuer, sponsor or underwriter of the issuer pays the rating agency to do the rating. The credit-rating agency business remains one that is built on the issuer-pays model, and most market observers do not expect that to change.
Rule 17g-5 requires rating agencies to post all the information they receive from issuers for each deal they do on a password-secure website available to all NRSROs “to manage the conflict of interest,” according to a document on Rule 17g-5 by Chapman and Cutler LLP, a law firm based in Washington, D.C.
“The point of the website is so that any NRSRO can access the information that was used to rate the deal and then they can potentially issue unsolicited ratings,” according to Brian Grow, managing director for RMBS at Morningstar Credit Ratings. So far there have been very few unsolicited ratings offered to issuers by rating agencies.
In 2014, rating agencies had access to a wealth of information available from issuer websites tied to new deals. Credit Suisse was the top issuer of private-label RMBS with $6.5 billion in issues in 20 deals, according to Asset-Backed Alert.
J.P. Morgan was second with $4.51 billion in 18 deals. Morgan Stanley ranked third with $2.01 billion in issues on 12 deals and Citigroup ranked fourth with $1.99 billion. Two more Wall Street firms had more than $1 billion in new issues: Bank of America with $1.89 billion in 11 deals and Nomura with $1.07 billion in seven deals.
Morningstar is using the information available on issuer websites to provide feedback to issuers on post-crisis deals rated by other rating agencies. “Right now we’re using it to build a track record, specifically on the jumbo side,” Grow explains. Having access to the site allows Morningstar and others to provide feedback on what they think about the quality of the diligence provided, according to Grow. Any NRSRO can look through the loans and the underwriting guidelines of originators in conduit deals to evaluate them independently, as well as see third-party reviews of the files.
The leading RMBS rating agency last year was not one of the big three but one of the relative newcomers--DBRS, formerly known as the Dominion Bond Rating Service, based in Toronto with an office in New York. DBRS rated $16.4 billion in 71 private-label RMBS deals, according to Asset-Backed Alert.
S&P came in second, rating $9 billion in 27 deals. Fitch Ratings ranked third in the issuance sweepstakes, rating $5.02 billion is new issues in 16 deals. Kroll Bond Rating Agency Inc., New York, set up in 2010, ranked fourth last year, rating $4.2 billion in 13 deals. Moody’s Investors Service, New York, was fifth with $977 million in three deals.
Gearing up for non-QM RMBS
Morningstar has been in contact with issuers and potential issuers of non-Qualified Mortgage loans, and Morningstar has published criteria on how it would go about rating non-QM deals--a segment of the market where there has been virtually no issuance.
“I think RMBS is at a good point to rebound and I think we’re ready for it,” says Grow.
Before the crisis, credit-rating agencies may have relied on their status as an NRSRO “to have deals continuously come in to be rated,” says Grow. That is not the case anymore. “Right now we are very cognizant that we need to have investor buy-in,” he says.
This has led Morningstar to reach out to investors on the 15 deals that it has analyzed over the years since 2010 to “to get their buy-in so we are sought out on the next deal,” Grow says.
The ability of rating agencies to provide more information sought by investors on potential future private-label RMBS deals is one way that will help the market recover, according to Grow. Investors are looking for exposure to the RMBS market to get the yields available. But when it comes to private-label, “they are not just blankly trusting the information they’re getting,” says Grow. “They’re asking questions. They want somebody who can sit there and explain what data we’re getting, what the data means and what are models are producing,” he says.
Morningstar has seen a slow evolution and improvement in investor attitudes toward the new RMBS issues it has analyzed in the last five years. In 2010 and 2011, for example, deals had to be “very overenhanced” in terms of the structure of the deal to get investors on board, says Grow.
The deals done in 2012 and 2013 “are still overenhanced, but it’s gotten much tighter” in terms of bringing the level of enhancement investors demand closer to what the models suggest. “I think what that tells you is that investors are much more confident and they’re starting back to this space,” Grow says.
One reason investors have been able to get comfortable with deals rated by Morningstar, according to Grow, is because they were single-family rental securitizations, which are more like CMBS--a market that has been able to attract many of its former investors.
Grow thinks improved investor confidence in rental deals is laying the groundwork for the next step for private-label RMBS: the securitization of non-QM loans.
As the housing market and the economy rebound, Gaurav Singhania, senior vice president at Morningstar, expects issuers to put together RMBS deals involving borrowers with credit scores in the mid-600s--so called A-minus credits. “That doesn’t necessarily mean subprime,” he says. “It means you lend sensibly to borrowers who have lower FICOs by compensating with some mitigating factor, either a high down payment or you verify the income and assets completely and you make sure the debt-to-incomes are reasonable and supported within QM guidelines,” he says.
There may even be interest in borrowers with FICOs in the low 600s “if you get the borrower in the right house,” says Singhania. “The issue is really getting comfortable with the non-QM market,” he says.
Best practices and data integrity
One barrier to reviving investor confidence in private-label RMBS is the substantive differences in current market practices among issuers that make it difficult for investors to evaluate new issues. To reduce these differences, the Structured Finance Industry Group (SFIG), Washington, D.C., in 2013 launched an initiative called RMBS 3.0 to further develop best-practices standards.
The initiative is chaired by Eric Kaplan, managing director of New York-based Shellpoint Partners LLC. Last summer, the group published the first of its “green papers,” which are preliminary documents aimed at stimulating further debate and discussion.
Thanks to efforts like those at SFIG, the industry is making progress in standardization. “There’s been significant improvement in the data integrity of information being provided for loans being securitized,” says Fitch Ratings’ Bailey.
Several industry groups have worked to identify what fields of information should be provided at origination and how they should be provided, he explains. Issuers have worked with investors to meet the standard layout they have agreed should be provided with new issues. As a result, issuers provide detailed loan-level information to credit-rating agencies and to investors--information that is separate from that provided in presale reports, according to Bailey.
New transactions today also typically come with a third-party review.
“An independent company re-underwrites the loan, and checks the information in the file versus the information the issuer is providing on the loan-level tape,” says Bailey.
The company also does its own estimated value of the property. The whole effort is undertaken “to make sure the underwriting is what the lender represented it to be and the information being used to analyze the pool is reliable,” says Bailey.
The need for standardization is based in part on reducing the challenge faced by investors in doing due diligence when deals can have moving parts that can be very different, but it is difficult to tease out those differences by reading a presale report, according to the Urban Institute’s Goodman.
“The reality is that investors aren’t going to read through 900 pages of information in the presale report,” says Goodman. “That’s why the rating agency gets phone calls. They are asked to summarize the information in the presale report,” she adds.
Standardization helps reveal the key differences in deals.
“Investors fear that some smart law firm has buried something on page 97, and investors are not necessarily going to find it without standardization,” says Goodman. By being able to highlight those differences, standardization can help investors get a better handle on the risks and rewards in a given deal.
Rating criteria and methodology
Credit-rating agencies have also made improvements in how they go about evaluating a deal and assigning a rating, according to Bailey. There have been fundamental procedural changes that incorporate more independent opinions and stepped-up model evaluation.
“There has also been quite a bit of investment in enhancing analysis at Fitch with our home-price model, our loss model and our cash-flow model,” Bailey says.
Unlike before the crisis, rating agencies analyze the loans and predict how borrowers will behave and the extent of loan losses in a range of scenarios. “There’s much more transparency on the part of the rating agencies in disclosing loss assumptions and, importantly, the assumptions underlying those loss assumptions,” Bailey says.
The role of the credit-rating agency in the structuring of RMBS deals has been diminished from what it was before the crisis, according to Michele Patterson, senior director at Kroll Bond Rating Agency.
“Rating agencies actually used to determine what credit-enhancement levels could be,” she says. “We’re not going to tell you what loans you include or not. We’re not going to tell you how to structure your deal. You can show us pretty much anything and we’ll look at it and provide feedback.”
The increase in the number of NRSROs from three to 10, with six active in the RMBS market, has been beneficial, according to Patterson.
“There are a lot more rating agencies in the market. That’s a great thing. Competition is good. It has added a lot more transparency to the market which was not there before,” Patterson says.
Before the crisis, rating agencies did not do presale reports. Today all the rating agencies put out very thorough presale reports “across the board,” she says. These presale reports provide detail on the transaction, the collateral and the structure, as well as comparisons with similar transactions in the market, Patterson explains.
“Obviously investors should be doing their own research and compare deals themselves, but the presale report is a good snapshot from a ratings standpoint of how we view this transaction,” Patterson says.
In spite of the improvements in data, underwriting and transparency in the ratings process, ultimately rating agencies have to restore the faith of investors in their ratings, according to Goodman. “You can argue that investors should do their own due diligence. The reality is they are going to rely on ratings,” she says.
Goodman believes that a recent initiative of the Treasury Department has, in fact, helped improve confidence in rating agencies.
Treasury’s credit-rating agency exercise
Last year Treasury asked six unnamed rating agencies to analyze six hypothetical pools of residential mortgage loans and produce a report with loss expectations for each rating category, from AAA to B. Treasury defined the pools using collateral backing a pool of Freddie Mac loans from the fourth quarter of 2013.
The hope was that the analyses from six individual rating agencies would provide some degree of confidence in the overall ability of rating agencies to rate private-label RMBS. “The loss expectations and subordination levels estimated in this exercise give market participants valuable insight into the potential capital structure of private-label securitizations composed of diverse pools of collateral,” Treasury stated in its report on the exercise in February 2015.
“What it was meant to do was to prove the potential for the private-label market and give investors some comfort as to how ratings agencies would rate these products,” says Goodman. More specifically, the exercise was meant to show how rating agencies would rate various types of loans, from jumbo to QM loans. “They tweaked it enough to simulate it as a private-label,” she explains.
What did the exercise show? “Clearly it shows that loans that are pristine, whether they are agency or not, are going to get lower subordination levels,” Goodman says.
As for the ratings of non-QM loans, “the market had no idea what they would be,” says Goodman. “They turned out to be conservative but not catastrophically conservative,” she says, which would have made such deals less attractive because of the high subordination levels required. “This was very, very positive” for the outlook for RMBS, says Goodman.
Nearly everyone agrees there’s room for further improvement in the ratings process. Robert Litan, a nonresident senior fellow and the former director of economics studies at the Brookings Institution, Washington, D.C., argues that ratings aimed at structured products need a different way of rating than the traditional letter-grade categories.
“Investors would have a lot more information if those ratings were numerical,” says Litan--such as offering a rating range from zero to 100 rather than the letter grades from AAA to B that are now used.
“On a scale of zero to 100, 100 would represent zero risk of default and 98 percent would represent 2 percent risk of default, and so on,” he says. “The reason is we think that conveys a lot more information and we know the rating agencies have that cardinal ranking, zero to 100. They’re doing that, but they’re stuffing it into the [letter grade]. They’re not telling you everything they know, or least what they think they know,” says Litan.
If the agencies do not voluntarily adopt such a system, then some agency of the federal government, whether it’s the Office of Credit Ratings at the Securities and Exchange Commission (SEC) or the Treasury’s Financial Stability Oversight Council, “ought to publish a benchmark system on how you could do such a scale,” says Litan. “Until we have that information in this market, we’re not going to have the transparency we deserve.”
Litan contends that numerical ratings that capture a probability of default are one way to compensate for the fact that the rating business will, of necessity, remain based on the issuer-pay business model. While rating agencies have not abandoned the letter-grade system, some of them are, in fact, providing the kind of information Litan would like to see.
“The rating scale [of AAA to B] is your first filter,” says Morningstar’s Grow. “But if you dig into our presale reports, we actually publish for each rating category a very numeric analysis of what percentage we expect to default, what percentage could default and still have the tranche OK, and what percentage would be lost. So there is a numeric analysis done before the ratings,” he says.
Conflict of interest
In spite of all the improvements to disclosure, standardization and the ratings process, the fact remains there is an underlying conflict of interest of having issuers pay for ratings. This is at the heart of investor doubts when it comes to RMBS.
Issuers and credit-rating agencies are aware of this concern and see a need to address it. “There is still kind of a struggle” to align incentives for all the parties involved in the transaction, according to Fitch’s Bailey. “That’s something the industry is still working on,” he adds.
Several RMBS issuers are discussing the concept of a deal agent with investors, according to Fitch.
The deal agent would be an independent party written into the transaction documents who would have access to information that a trustee or servicer would have. “This party would really be an investor representative, and make decisions and monitor the transaction in a way that would ideally protect investor interests,” says Bailey. The presence of a deal agency could thus “protect investors from some of those conflicts of interest that still exist,” Bailey says.
There is also a continuing investor fear about political risk, based on some of the settlements with state attorneys general and the Department of Justice. Bailey sees this fear as one of the key factors holding back the recovery of the private-label RMBS market.
“Investors feel like the cost of the settlements in many ways were paid for by investors, not necessarily by lenders, who were perceived to have made the errors to begin with,” says Bailey.
“Investors felt burned by that and are concerned there’s a risk that could happen again in the future,” he adds.
The presence of political risk around the pool trust is another reason there has been talk about having a deal agent to act as “an entity in the trust who could work to protect investors’ interests,” Bailey says.
Greenwich Financial’s Frey sees political risk from potential future settlements in the wake of another market decline as the paramount concern for investors. The fear is future settlements will mimic those of recent years.
“All the settlements had the same basic theme: Let the banks modify the loans and prop up the second liens at the expense of the first,” Frey says. For the RMBS market to thrive, he says, investors need clear and firm legal protections--which he contends were tossed aside in negotiations between lenders and servicers on one hand, and the states and the federal government on the other.
“They were punishing the wrong guys. But the reason they were doing that is that the banks had so many second liens--if they gave the first lien priority, the banks would have been insolvent,” Frey says.
Investors still do not have full confidence that in the future, despite what’s written into contracts, first liens will have legal priority over second liens. “The fact that second liens can continue to affect incentives for first-lien interests remains a concern for RMBS,” Bailey says.
There is rising optimism in some quarters about the RMBS market, coupled with the fact some of the rating agencies expect to see private-label RMBS issuance volumes rise modestly. Still others say the market could potentially soon witness the beginning of some non-QM securitizations. Yet even against that backdrop, most experts do not expect any significant RMBS comeback anytime soon.
To be sure, there will continue to be a concerted effort to pave the way to a revival, including efforts by Treasury, as well as those by the Securities Finance Industry Group and others.
“Ultimately those efforts are going to pay off. But it’s going to take a while,” says Goodman. MB
Copyright © 2015 Mortgage Banking Magazine
Reprinted With Permission