A financial industry publication recently reported, “Carrington Mortgage, Citadel Servicing and New Penn Financial are planning securitizations of newly originated subprime mortgages.” The publication went on to say in breathless tones that “[t]he offerings, on the slate for 2014, would confirm recent predictions that deals would soon start flowing in the asset class…”
Sadly, the news report was largely erroneous.
First, the asset class known as “subprime” mortgage securities has been legislated out of existence. While it is true that firms like Carrington and others intend to issue private-label securities based upon newly issued mortgages that are not qualified mortgages under the rules set by the CFPB, we are not likely to see anything like subprime residential mortgage backed securities (RMBS) because nobody is making subprime loans.
Indeed, the closest thing to subprime RMBS you are likely to see in today’s market are the securitizations that are backed by distressed assets.
So far, predictions of a rebound in private-label RMBS, prime or otherwise, have been very widely off the mark. In 2006, approximately $1.5 trillion of non-agency collateral was eligible for securitization.
Out of approximately $1.8 trillion in overall mortgage origination volume in 2012, only about 10% — or around $180 billion — was non-agency and therefore eligible for private-label securitization. And only about $5 billion of that — all backed by prime mortgages — was actually securitized last year, according to Fitch. The remaining volume was kept on bank balance sheets.
And when the new rules mandated by Dodd- Frank go into effect this month, the volumes of private-label RMBS are likely to fall even further.
Virtually none of the loans originated by commercial banks today would even qualify as “just below prime,” much less subprime. The average FICO score for bank production is well into the 700s, and virtually all of these loans are QM-eligible and destined to be sold into the conforming or agency markets.
Indeed, most of the loan production of nonbanks like Carrington is also destined for the conforming or agency market as well. The few private RMBS deals that have been done in the past several years have been comprised of prime jumbo loans, with low LTVs and relatively high FICO scores for the borrowers.
Roadblocks remain for private-label securitization
There are several significant issues blocking a return of a private-label RMBS market for newly originated mortgage loans, period, much less a below-prime market:
- Legacy losses: Double-digit losses of private- label RMBS due to the subprime crisis and subsequent litigation have driven many investors out of the private securitization market. Looking at 2007 private-label RMBS production, first lien exposures, the cumulative losses ranged between 25-30%. Many investors are simply unwilling to look at any private-label deals given the recent history.
- Legal and regulatory issues: Underwriters remain uncertain regarding rules and regulations for non-agency loan originations. Commercial banks are unwilling to sponsor RMBS deals with all but the highest quality collateral, FICOs well above 750 for most jumbo RMBS deals brought in 2012 and 2013.
- Market rates: Fed policies of zero interest rates and quantitative easing have removed most of the price incentive for RMBS sponsors. Assethungry banks are now bidding through agency yields for non-agency jumbo loans. As a result, new private RMBS issuance volumes have fallen steadily since June. The example of Shellpoint Partners in October canceling a long-planned private-label RMBS illustrates just how the Fed’s manipulation of the credit markets is preventing private capital from reentering the RMBS market.
HousingWire reported that Shellpoint intends to continue its efforts in the non-agency market and plans to monitor the secondary markets as they evolve: “This is not a decision we’re undertaking lightly,” said Bob Magee, chief investment officer of Shellpoint, “but at some point we can’t ignore best execution. The current RMBS bid is not competitive with the whole loan bid, even accounting for the qualitative cost of pausing our RMBS program. There is a substantial pricing disconnect between the whole loan and new issue RMBS secondary markets. We went very far down the road on SAFT 2013-2 — in fact we planned to close next week — hoping that the disconnect would ease, but the realities of the current market are clear.”
So while the stated intent of the Fed’s quantitative easing programs is to foster credit expansion, in fact the Fed’s purchases of Treasury bonds and agency mortgage paper is actually keeping nonbank capital out of the market.
Regulatory changes compound difficulties
Asset-starved commercial banks, which have seen yields on earning assets plummet over the past year, are increasingly aggressive about bidding for loans because of a dearth of lending opportunities. But the appetite of banks for non-QM paper is limited by regulatory constraints, another reason why it will be hard to rebuild the market for private RMBS. For example:
- Basel III capital requirements place heavy costs on banks holding non-agency, non-QM loans vs. agency/conventional or QM/QRM exposures. Non-QM loans will carry a 100% risk weight under Basel III, plus a charge for liquidity because of the long duration of the asset.
- Non-agency AAA mortgage or RMBS holdings require 4x the capital for banks than a conventional, FHA exposure. Higher implied leverage (~ 200x vs. ~ 50x), lower required capital (5% RWA vs. 20% RWA) make returns on conventional and agency exposures far higher for commercial banks than non-QM mortgages. Or, stated in plain English, the bank can buy 4x the GNMAs compared to non-QM loans for the same capital allocation.
But the effects of Basel III on bank lending are only part of the problem. The provisions of Dodd-Frank also create serious obstacles for issuers of RMBS other than for the sorts of pristine prime deals that we have seen so far.
Here is the short list of some of the major issues created by Dodd-Frank:
The ability-to-repay (ATR) rules in Dodd-Frank create uncertainty for issuers of and investors in non-agency RMBS. Borrowers may be able to bring significant federal and/or state law claims against lenders/assignees that will cost $50,000 or more to litigate and/or settle.
While in the past private-label RMBS issuers have generally paid for costs and damages incurred by securitization trusts as a result of predatory lending laws, QM/ATR raises new risk scenarios for non-QM loans that must be considered by investors. The investors in RMBS may have to shoulder the expenses relating to consumer litigation.
Litigation regarding non-QM, nonprime loans may result in substantial expense and ultimately delay foreclosure, greatly affecting overall risk/return for non-agency RMBS.
But there are even more, additional provisions of Dodd-Frank that go into effect in January 2014 that will inhibit or prevent entirely the return of nonprime RMBS. Indeed, contrary to the happy talk you hear from members of the media, the issuance of private RMBS of all types may actually decline in 2014. For example:
- The skin-in-the-game provisions of Dodd-Frank effectively tax below- prime and jumbo mortgages sold into RMBS, while exempting the QM/ QRM/agency market entirely.
- Dodd-Frank places disproportionate impact on some consumers, including 1) below-prime and 2) prime, non-conforming borrowers. Skin-in- the-game is a tax that could be worth between half a point and a full point annually in higher loan costs for mortgage notes sold into RMBS.
- Punitive foreclosure abuse and securities fraud settlements add to operational expense for all legacy mortgage exposures, and increase reluctance to originate new, non-QM/ QRM RMBS.
- The 2010 change by the Federal Deposit Insurance Corporation of legal safe harbor for true sale treatment for bank securitizations also acts as a significant impediment to bank-issued non-agency RMBS. In order to be considered “sales” of assets, all future bank RMBS will require analysis regarding whether fraudulent transfer occurred and whether the RMBS would be considered “isolated” from the bank in the event of an FDIC resolution.
- Shearman and Sterling wrote in 2010 regarding the change of the FDIC’s safe harbor rule: “In September 2010, the FDIC amended its safe harbor for securitizations by banks — the FDIC clarified that in a receivership of an insured depository institution, it would not seek to repudiate any asset transfer as burdensome if the securitization met certain criteria. These safe harbor criteria go beyond the usual requirements for a true sale, requiring that securitizations be subject to risk retention, reporting, and disclosure requirements, and, in some cases, requirements for simplified structures.”
The Dodd-Frank skin-in-the-game rules and other provisions of the reform legislation may affect the willingness and economic ability of commercial banks to sponsor private RMBS for below- prime borrowers.
Whole loan sales, loan participations, and other types of non-securities vehicles may be a superior take-out channel for below- prime lenders as compared to private label RMBS after the end of 2013.
