New Attitude and Risk Pricing Add to Hopes

Despite recovery concerns at least one insider sees the glass as half full in the mortgage market. Real estate risk exposure factors affecting mortgage lenders, servicers and investors right now remain the same.

Risk, including commercial and residential mortgage-backed securities risk, has not changed, says David Tobin, principal of New York-based Mission Capital Advisors LLC, a boutique financial advisory firm established in 2002 to offer expertise on residential and commercial portfolio valuations and sales of both asset classes. “What has changed is the way we price risk.” It is the fundamental difference in today’s market, which he sees in a recovery mode.

Reasons to be optimistic include the drive to improve future lending and servicing fundamentals. It will unavoidably improve the quality of mortgage-backed securities and consequently improve mortgage banks’ ability to leverage more liquidity into the market—which in turn will speed up the housing market recovery.

If in 2005 and 2006 the securitization of subprime or alt-A single-family mortgages was acceptable and a 2% subordination protecting the senior bond was the norm, now subprime is unacceptable and RE market experts like Tobin are debating whether a 5% to 10% subordination would have cushioned the crisis, as what would be the norm in risk management going forward is still a work in progress. 

Tobin argues that even if one puts aside deficiencies in underwriting and makes the assumption that the mortgage market can and will implement sound underwriting standards, “more loans are likely to default than people expect and allowance has to be made for that.”

What may further change in risk management since sensitivity to risk exposure is now enhanced by the crisis is probably a temporary restraint. This year and beyond as lenders and investors return to the market in both the residential single-family mortgage space and the commercial space, there will always be lenders who are a little more aggressive and willing to compete through reduced interest rates or riskier underwriting criteria that increase the delinquency risk of particular loans. At the same time, he says, there will always be mortgage investors willing to take on a little more risk when they buy the bonds so they can improve the return.

“There will be a long memory of this crisis. People will start doing 100% loan-to-value loans again. They just will not make the assumption that they will be paid back again, so they’ll set aside a reserve of 5%, 10%, or whatever other number,” he says. “It is all predicated on selling the senior bonds. The dog is going to wag the tail. The tail is not going to wag the dog like it has been doing in the past six or seven years.”

It means senior bondholders are going to determine the amount of subordination they require in order to invest in those senior bonds. And outside of the securitization market, senior lenders will determine the amount of equity or subordinate debt they require in order to originate loans.

The goal of returning to the basics of lending and servicing will not mean aborting structured credit products. In his view the reason the market got so out of hand was because of the structured investment vehicles and off-balance-sheet investment vehicles used to buy so many super senior and AAA bonds, “creating artificial demand” for those bonds and many other types of credit structured products and CDOs. “It was the effect of the credit default swap.”

As the market starts to recover, more investors buy bonds and banks lend money and service loans.

Tobin says it also means that “all the mezzanine, preferred equity and subordinate risk may still get sliced up and diced and traded around, because that’s where the risk should be.”

Also those who underwrite the credit understand the RE fundamentals and are willing to make that credit bet should be able to. “Fundamentally structured credit is a good thing and works well because it moves risk around to folks that want it and shift it a way from those who don’t want it,” he says.

“External forces,” which among others may include very high-risk loans and poor underwriting that contributed to massive distress in the housing market, “will not return this time around.”

Tobin sees the self-adjusting of the distressed mortgage and loan market is the healthiest market development for the U.S. economy and the world economy. It is sign of financial health when banks can sell loans to the secondary market, the stock market and the bond market. It means the bank has the loans properly marked and can take the hit, understand the value and put that credit into the hands of an investor who is either going to foreclose on the collateral or opt for a restructure with the borrower. “Once you mark that credit down to a market rate,” he says, the borrower is able to manage his debt and ultimately everyone benefits .

“Restructured debt that is sold at a market price allows the bank that owns the debt to be healthy again.” A workout that helps the homeowner to be current on his loan is a good thing for everyone from the largest bank to the owner of a single-family home.

The distressed housing market “is one of the most cathartic and cleansing processes for the economy” vs. cases where banks do not restructure risk, refuse to sell their assets because they are not willing to take a loss, or sell them to investors. “The worst-case scenario is when a bank cannot take a loss it should be taking,” because that would mean severe financial distress.

Tobin sees the all talk about the wave of pending loan maturities as potentially increasing delinquency and being problematic as viewing the glass as half empty.  “We see it completely differently. The wave of loan maturities is being viewed by the smart money as a wave of origination and new issuance opportunity, an opportunity best serviced by the CMBS market…a glass even more than half full.”