There is a lot to be said about transparency, efficacy, and financial ingenuity in the U.S. mortgage securities markets. I, like most who were brought up in the U.S. residential markets, believe that the seamless and transparent transfer of risk into the capital markets is both normal and expected. This risk transfer has fueled everything from housing growth to homeownership rates and personal wealth for generations. Unfortunately, the same capital markets machine that created so much financial opportunity over the years also was responsible for the single greatest evaporation of wealth in the history of mankind.
Since the mid-eighties, several severe market dislocations have temporarily disrupted that flow of capital (the 1987 stock market crash, Long-Term Capital Management, the Russian Debt crisis, the technology bubble, etc.). Luckily, as each of those past crises have faded (and the capital markets have eventually returned to "normal"), the transfer of residential mortgage risk begun anew. Past disruptions have given birth to new sets of rules, regulations, hedging instruments and lessons that have provided various levels of comfort and security to the markets in general, and investors in particular. And to be clear, it is the "investor" that drives the markets (all markets). Without the investor, there is no capital market. Without demand, there is no supply. Without the widespread availability of funds in the U.S. to buy newly originated residential private label, mortgage securities, there will never be a robust and sustainable housing market.
Nearly seven years since the current housing crisis began; we are still a long way from calling the U.S. residential capital markets "liquid." Loans are as safe as I’ve ever seen, and delinquency rates on new origination are minuscule, but securitization is still largely absent. Moreover, lenders are as diligent as they have ever been (knowing full well they operate under both a microscope, and a new set of rigid rules), and loan servicing while not perfect has benefited greatly from new technology, capital investment, and scrutiny. Yet end investors continue to steer clear of this particular asset class.
Why then, are investors not particularly interested in new issue residential, private label securitization in the U.S.? The answer becomes apparent after only the briefest of conversations with a handful of large money managers. Residential institutional investors are a smarter bunch these days. They now do their own homework, they hire the right research teams and risk managers, provide the proper infrastructure and rely a lot less on third-party service providers (like rating agencies and oversight companies) than in the past. They can also efficiently hedge all types of potential risk, from interest rate risk and credit risk to counterparty risk. Unfortunately, the risk that cannot be measured is the risk that some regulators or other "powers that be" may not defer to the rule of law at the appropriate time (which is typically the worst time) or do that which is in the best interest of the asset holder.
The investor in any mortgage asset looks largely to two variables when determining the value of a pool of loans: (1) the ability to predict cash flows, and (2) the ability to secure (or seize) that particular asset in a timely fashion if (1) goes awry.
Foreclosure timelines of up to three years, a legal system that has made a cottage industry of supporting "payment avoidance", and a regulatory environment that typically turns to the deepest corporate pockets when providing consumer relief regardless of fault, accountability or responsibility, have created the ultimate barrier to entry for investors.
Finally, institutions that do rely (at least peripherally) on the findings of the various rating agencies are discovering that the credit enhancement "pendulum" that had swung too far in one direction by 2007, is now permanently plastered in the other direction. I believe this has less to do with inherent risk and more to do with the fear of potential liability. It’s better to be overly and unreasonably cautious than sensibly conservative.
So, is it actually possible to create liquidity, reasonable investment returns and a residential securitization structure and platform conducive to widespread investor participation anywhere in the northern hemisphere? The answer is yes, and the place to look is Canada. But before you start converting your U.S. dollars to Canadian or trading in your wingtips for Sorel Caribou boots; consider the following: As a country, they will have none of it at least not in the traditional U.S.-style structure.
Not only do Canadian investors, issuers, rating agencies and regulators understand the simple notion of layered risk, but when a small handful of Canadian lenders were approached by U.S. mortgage companies back in 2006 to originate and funnel NINA (no income, no asset), and NINJA (no income, no job, and no asset) loans south of the border with the promise of untold riches; they told those companies where to shove those riches. Canadian lenders still prefer to make the right loan to the right borrower for the right long-term reasons. Truth be told, there were a few who did take the bait in 2006, but they are nowhere to be found today as terms like "pipeline protection" meant little in a housing meltdown, and as a result, drove many out of business.
Frank Pallotta is chief executive of Ramsey, N.J.-based CMF Management Co. LLC.
