The emergence of a robust private-label mortgage-backed securities issuance market, beyond a limited supply of high grade jumbo MBS, is unlikely to occur soon.
This sector is constrained by numerous and often complex issues, which span across the mortgage lifecycle, and affect a wide array of market participants, including homeowners; real estate agents; homebuilders; lenders; private mortgage insurers; securities issuers; trustees; mortgage servicers; and investors.
The issuance of new private-label MBS virtually stopped with the bursting of the housing bubble and the massive waves of mortgage defaults. Since then, non-agency MBS issuance has been largely confined to a few securities backed by high quality jumbo loans (those that exceed loan limits at Fannie Mae, Freddie Mac and the Federal Housing Administration). These, however, make up a negligible share of the overall MBS market; less than $14 billion in jumbo MBS were issued in 2013, versus almost $1.6 trillion of agency MBS. More than $270 billion in jumbo loans were originated in 2013, but most were absorbed into bank portfolios or were sold as whole loans.
Most firms avoid issuing jumbo MBS and the securities suffer from a lack of standardization. So far this year, Credit Suisse issued two jumbo MBS and JPMorgan Chase issued one, while Redwood Trust is currently selling its first jumbo MBS of the year, but said it expects 2014 issuance to fall short of last year's. Occasionally, other MBS are issued that are backed by higher quality older loans. For example, in February Citigroup issued a $379 million non-agency MBS consisting of seasoned loans that were originated in 2003 and 2004 with strong credit scores, as well as low debt-to-income and combined loan-to-value ratios.
There are at least 7 reasons why private MBS issuance remains weak.
Weak Investor Appetite
Investor appetite for non-agency MBS has been severely curtailed due to fear of credit losses and capital implications. While investors of agency MBS were shielded from credit losses, holders of private-label MBS suffered considerable losses in principal and market value. In addition, concerns remain over local jurisdictions exercising eminent domain by seizing distressed properties.
New Laws and Rules
Laws and regulations, which are designed to mitigate the risk to consumers and the financial system, are restraining the non-agency MBS market. The Dodd-Frank Act, which among other things established a general framework for qualified mortgages and qualified residential mortgages; strengthened consumer protection laws; established the Consumer Financial Protection Bureau; and strengthened capital and liquidity requirements for banks and bank holding companies. Also, ratings agencies have established criteria specifying that loans included in new non-agency MBS, which fall outside of the safe harbor for QM, will be assigned higher loss expectations and more credit enhancement.
The new laws, regulations and the increased oversight coupled with regulatory probes, lawsuits, mortgage insurance rescissions, and forced buybacks have been costly. As such, lenders generally prefer agency-guaranteed loans. Outstanding balances of non-agency MBS peaked around $2.8 trillion in the second quarter of 2007 and declined to about $1 trillion by December 2013, according to the Federal Reserve.
Apprehensive Securities Issuers
Many MBS issuers have been penalized for their MBS securitization practices. Some are still facing lawsuits and regulatory scrutiny. The QRM rule, including risk retention, and the new disclosure requirements for non-agency MBS have not been finalized by the Securities and Exchange Commission.
Higher qualifying standards and reduced availability of more affordable, but often riskier mortgage products disqualify many potential borrowers. The supply of new loans is constricted as many consumers have weaker balance sheets, credit profiles and incomes. Young people experience limited employment opportunities while student debt has ballooned with the average college graduate racking up $29,400 in student debt in 2012, up from $18,750 in 2004, according to the Institute for College Access & Success. Furthermore, 13.3%, or 6.5 million, homes with a mortgage were still in negative equity, according to CoreLogic.
Agency MBS Has the Edge
Agency MBS benefits from government guarantees, monetary policy actions, investment guidelines, more favorable risk weighting, QM treatment, exemption from risk-retention requirements, and entrenched market presence. Additionally, as the agencies are generating income for the U.S. Treasury, there is some deceleration in political impetus to alter the status quo.
Housing System Overhaul Is Needed, But Hard to Do
Tactical solutions are not enough; instead, a major overhaul of the housing finance system is required. While a successful reengineering effort may help unleash private capital, it will not happen soon due to competing housing policy priorities and other challenges. On March 11, the Senate Banking committee announced a bipartisan plan, representing a positive first step. But, even if the appropriate legislative solution is eventually reached, a massive overhaul to one of the most important sectors of the economy, the housing industry, will require a long time to implement.
As such, don't count on a significant resurgence in private-label MBS in the near term, even with eventual agreement on meaningful housing reform.
Alex Kangelaris is the CEO and managing partner at Wall Street Emprises LLC. He has more than 25 years of mortgage industry and capital markets experience.