Fed's Recommendations Could Benefit RMBS

Recent recommendations of the Federal Reserve provide guidance that may benefit the private-label residential mortgage-backed securities sector, according to Fitch Ratings.

“The U.S. Housing Market: Current Conditions and Policy Considerations,” a much-talked-about white paper published by the central bank in January, makes a handful of suggestions. While the Fed’s chairman Ben Bernanke has noted that the analysis and conclusions are only meant to be suggestions to policymakers, recommended policies have opened up debates across the nation.

Fitch analysts finds these recommendations can help “limit the growth of the inventory of foreclosed homes, make mortgage credit easier to access, and limit the flow of homes into foreclosure.”

The primary recommendation focuses on managing a government-facilitated REO-to-rental program, either through direct rentals or third-party sales, analysts wrote, an idea that in their view “has merit, as it could potentially reduce the number of distressed properties for sale,” even though at the same time there most probably will be “some operational challenges.”

A third-party sales program would present different challenges to REO sellers compared to if they rented properties out directly. A direct-rental program could be costly for an REO holder, analysts note, because it requires specialized services that will have to be provided by additional staffing. Property management demands associated with large-scale property rental programs are challenging to say the least, despite the cost-cutting effect of implementing a third-party sales program that could minimize related, direct costs. The reason, they argue, is that an investor’s ability to secure financing and the lower bids for bulk REO present a different set of challenges.

Foreclosed real estate owners may not be so interested in investor deals, which as a rule involve higher discounts, while individual investors and owner-occupants do not bid as low. The idea that it is more profitable for banks to sell REOs to investors who can then rent them out to former owners or current occupants and clean up the books is a misperception.

The REO holders’ cost to assemble inventory for a bulk sale is significant, says Fitch’s senior director of structured finance, Suzanne Mistretta, because banks would have to “hold the properties off the market until enough were assembled for a bulk sale.” During that time gap the REO holder does not earn rent and incurs costs and losses such as upkeep expenses, taxes, insurance, or depreciation. Thus the recoveries “could be significantly lower” than an REO sale to owner-occupants or individual investors.

The paper stresses these rental programs need “adequate property management and an investor commitment to rehabilitation,” she said, so REO holders have to have the means necessary to ensure the risk of poor property management or maintenance that negatively affects communities is minimized.

It means politics and political correctness could be a challenge.

Analysts suspect a program subsidy “may not be politically well received if it were to lower the recoveries otherwise achieved through sales to owner-occupants.” They find “somewhat less challenging,” however, the expansion of the HARP program to non-GSE and non-FHA loans. If implemented, it would allow GSEs to refinance current underwater borrowers who meet certain criteria, thus reducing significantly, the potential default and loss exposure to the private-label RMBS. But yet again, this recommendation “may be the most politically unpalatable” since it can lead to higher credit risk exposure and larger GSE balance sheets.

A third recommendation calls for the increased use of foreclosure alternatives, such as short sales and deeds-in-lieu, which analysts say may be the easiest to implement, as it is a familiar practice for servicers. Furthermore, “these alternatives have lower loss severities relative to foreclosures as they reduce the need for legal procedures and lower the cost to protect, maintain and broker the property.”

Overall, analysts say these recommendations “could be a net positive for private-label RMBS because they would primarily reduce distressed housing inventory” and maybe help lessen the downward pressure on housing prices.