I was happy to present on the History of Housing Finance as part of the Structured Finance Association’s SF Academy series, hosted by Elen Callahan, the SFA’s Head of Research & Education. You need to sign up to access the SF Academy content (although I have covered similar content in many other venues) for those who do not want to bother). The SFA website states that the
The Structured Finance Industry Group has issued a white paper, Regulatory Reform: Securitization Industry Proposals to Support Growth in the Real Economy. While the paper is a useful summary of the industry’s needs, it would benefit from looking at the issue more broadly. The paper states that
One of the core policy responses to the financial crisis was the adoption of a wide variety of new regulations applicable to the securitization industry, largely in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). While many post-crisis analysts believe that the crisis laid bare the need for meaningful regulatory reform, SFIG members believe that any such regulation must:
In this paper, we will distinguish between the types of regulation we believe to be necessary and productive versus those that are, at the very least, not helpful and, in some cases, harmful. To support this approach, we believe it is helpful to evaluate financial market regulations, specifically those related to securitization, under three distinct categories, those that are:
1. Transactional in nature; i.e., directly impact the securitization market via a focus on underlying deal structures;
2. Banking rules that include securitization reform within their mandate; and
3. Banking rules that simply do not contemplate securitization and, therefore, may result in unintended consequences. (3)
The paper concludes,
The securitization industry serves as a mechanism for allowing institutional investors to deliver funding to the real economy, both to individual consumers of credit and to businesses of all sizes. This segment of credit reduces the real economy’s reliance on the banking system to deliver such funding, thereby reducing systemic risk.
It is important that both issuers of securitization bonds and investors in those bonds align at an appropriate balance in their goals to allow those issuers to maintain a business model that is not unduly penalized for using securitization as a funding tool, while at the same time, ensuring investors have confidence in the market via “skin in the game” and sufficiency of disclosure. (19)
I think the paper is totally right that we should design a regulatory environment that allows for responsible securitization. The paper is, however, silent on the interest of consumers, whose loans make up the collateral of many of the mortgage-backed and asset-backed securities that are at issue in the bond market. The system can’t be designed just to work for issuers and investors, consumers must have a voice too.
SEC Commissioner Piwowar
SEC Commissioner Michael Piwowar’s Remarks at ABS Vegas 2016 are worth a look for all of those interested in the future of the mortgage-backed securities market. I have interspersed selections of his remarks with my comments:
As our country’s capital markets regulator, the SEC’s tripartite mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Securitization can transform illiquid assets like mortgages, auto loans, credit card receivables, and future sales of David Bowie albums into marketable securities. By serving as an efficient means of allocating scarce capital, securitization supports economic growth, business development, and job creation. Securitization further fosters resiliency by diversifying the funding base of our economy.
There are many other benefits associated with securitization, including the potential for reduced costs of, and expanded access to, credit for borrowers, the ability to match risk profiles for specific investor demands, and increased secondary market liquidity. Because banks and other originators can move loans off of their balance sheets into asset-backed securities (ABS), securitization can increase the availability of credit for both businesses and individuals. In many instances, securitization can allow a person to obtain more favorable terms than can be obtained from a bank or other financial institution.
Thus, the ABS market serves as a critical source of capital, providing funding for home and automobile loans, credit cards, and many other purposes. Yet, as shown during the recent financial crisis, investors may abandon the ABS market if they do not believe they possess sufficient information to evaluate the risks associated with a particular asset-backed security and to price it accordingly.
While I generally agree with Piwowar’s assessment of securitization’s value, it is worth noting that he does not acknowledge how important robust consumer protection is to maintaining a healthy securitization market over the long run.
I found his discussion of the Dodd-Frank credit risk retention rules particularly interesting:
For the record, I voted against the credit risk retention rules. These rules require a securitizer to retain a minimum 5% credit risk of any securitization transaction and generally prohibit the sponsor from hedging its retained interest. I was particularly dismayed by the “one-size-fits-all” approach taken by the regulators to create a flat 5% risk retention requirement for all asset classes, except for securitizations involving so-called “qualified residential mortgages” (QRMs) for which the risk retention level is zero. These were arbitrary choices.
Residential mortgages, commercial mortgages, credit card receivables, and automobile loans each have distinct and different attributes associated with their underlying borrowers. Rather than carefully examining these attributes to determine an optimal credit risk retention rate for each asset class, prudential regulators in Washington, D.C., took the easy way out – they simply set it at the maximum statutory rate and ignored the authorization from Congress to create lower risk retention requirements or use alternative methods to align interests.
Perhaps the prudential bureaucrats had their own conflict of interests in setting these requirements. After all, a prudential bureaucrat has a strong interest in self-preservation. Will a prudential bureaucrat get credit if optimally tailored risk retention rates increase economic growth and provide additional opportunities to families and businesses across America? No. Will a prudential bureaucrat take the blame if the next financial crisis – and there will be one eventually – relates at all to securitizations? Probably. Hence, what better way to side step responsibility than to refrain from using reasoned judgment and rely solely on the most risk-averse interpretation of statute instead?
Bureaucratic self-preservation might also explain the decision to adopt as broad of an exemption for QRMs as possible, so as to minimize any political fallout from the real estate and housing industries. Few will disagree that residential mortgage-backed securities played an important role in the 2008 financial crisis. For those in the audience involved in RMBS offerings, you must be quite happy with the broad exemption from the risk retention rules. For those of you in the audience who are involved in other types of securitizations that had little, if any, part in causing the financial crisis, you are probably wondering why you were unfairly targeted. Unfortunately, unlike Las Vegas, what happens in Washington does not stay in Washington. (footnotes omitted)
Piwowar gives short shrift to the benefits of clear and simple rules, but it is still worth paying attention to his critique of the “one size fits all” risk retention rules. If researchers can demonstrate that these rules are not optimally tailored, perhaps that would provide a reason to reconsider them. This is, of course, a long shot, given that the rules have been finalized, but Piwowar is right to shine light on the issue nonetheless.
Candid and thoughtful remarks from regulators are always refreshing. These make the grade.
Jamie Dimon, CEO of JPMorgan Chase
J.P. Morgan’s Securitized Products Weekly has a report, Proposed FRTB Ruling Endangers ABS, CMBS and Non-Agency RMBS Markets. This is one of those technical studies that have a lot of real world relevance to those of us concerned about the housing markets more generally.
The report analyzes proposed capital rules contained in the Fundamental Review of the Trading Book (FRTB). JPMorgan believes that these proposed rules would make the secondary trading in residential mortgage-backed securities unprofitable. It also believes that “there is no sector that escapes unscathed; capital will rise dramatically across all securitized product sectors, except agency MBS.” (1) It concludes that “[u]ltimately, in its current form, the FRTB would damage the availability of credit to consumers, reduce lending activity in the form of commercial mortgage and set back private securitization, entrenching the GSEs as the primary securitization vehicle in the residential mortgage market.” (1)
JPMorgan finds that the the impact of these proposed regulations on non-agency residential-mortgage backed securities (jumbos and otherwise) “is so onerous that we wonder if this was the actual intent of the regulators.” Without getting too technical, the authors thought “that the regulators simply had a mathematical mistake in their calculation (and were off by a factor of 100, but unfortunately this is what was intended.” (4) Because these capital rules “would make it highly unattractive for dealers to hold inventory in non-agency securities,” JPMorgan believes that they threaten the entire non-agency RMBS market. (5)
The report concludes with a policy takeaway:
Policymakers have at various times advocated for GSE reform in which the private sector (and private capital) would play a larger role. However, with such high capital requirements under the proposal — compared with capital advantages for GSE securities and a negligible amount of capital for the GSEs themselves — we believe this proposal would significantly set back private securitization, entrenching the GSEs as the primary securitization vehicle in the mortgage market. (5, emphasis removed)
I am not aware if JPMorgan’s concerns are broadly held, so it would important to hear others weigh in on this topic.
If the proposed rule is adopted, it is likely not to be implemented for a few years. As a result, there is plenty of time to get the right balance between safety and soundness on the one hand and credit availability on the other. While the private-label sector has been a source of trouble in the past, particularly during the subprime boom, it is not in the public interest to put an end to it: it has provided capital to the jumbo sector and provides much needed competition to Fannie, Freddie and Ginnie.
The staff of the U.S. Securities and Exchange Commission has issued its Annual Report on Nationally Recognized Statistical Rating Organizations. The report documents some significant problems with the rating agency industry as it is currently structured. The report highlights competition, transparency and conflicts of interest as three important areas of concern.
Competition. There are some of the interesting insights to be culled from the report. It notes that “some of the smaller NRSROs [Nationally Recognized Statistical Rating Organizations] had built significant market share in the asset-backed securities rating category.” (16) That being said, the report also finds that despite “the notable progress made by smaller NRSROs in gaining market share in some of the ratings classes . . . , economic and regulatory barriers to entry continue to exist in the credit ratings industry, making it difficult for the smaller NRSROs to compete with the larger NRSROs.” (21)
Transparency. The report also notes that “there is a trend of NRSROs issuing unsolicited commentaries on solicited ratings issued by other NRSROs, which has increased the level of transparency within the credit ratings industry. The commentaries highlight differences in opinions and ratings criteria among rating agencies regarding certain structured finance transactions, concerning matters such as the sufficiency of the credit enhancement for the transactions. Such commentaries can serve to enhance investors’ understanding of the ratings criteria and differences in ratings approaches used by the different NRSROs.” (23) The report acknowledges that this is no cure-all for what ails the rating industry, it is a positive development.
Conflicts of Interest.Conflicts of interest have been central to the problems in the ratings industry, and were one of the factors that led to the subprime bubble and then bust of the 2000s. The report notes that the “potential for conflicts of interest involving an NRSRO may continue to be particularly acute in structured finance products, where issuers are created and operated by a relatively concentrated group of sponsors, underwriters and managers, and rating fees are particularly lucrative.” (25) There is no easy solution to this problem and it is important to carefully study it on an ongoing basis.
The staff report is valuable because it offers an annual overview of structural changes in the ratings industry. This year’s report continues to highlight that the structure of the industry is far from ideal. As the business cycle heats up, it is important to keep an eye on this critical component of the financial system to ensure that rating agencies are not being driven by short term profits for themselves at the expense of long-term systemic stability for the rest of us.
Inside MBS and ABS, the trade journal, quoted me in DeMarco Cites ‘Structural Improvements’ in Housing Six Years After GSE Conservatorship, More Needed (behind a paywall). It reads,
Six years after the government takeover of Fannie Mae and Freddie Mac, the former regulator of the government-sponsored enterprises noted that the housing finance system has made “significant progress.” But even as critical structural changes are underway, comprehensive improvement is still several years out.
In a policy paper issued last week, Edward DeMarco–new senior fellow-in-residence for the Milken Institute’s Center for Financial Markets–said that house prices, as measured by the Federal Housing Finance Agency, have recovered more than 50 percent since their decline in 2007.
“While the damage from the housing crisis has been substantial, we are finally seeing a sustained market recovery,” said the former FHFA chief. “The crisis showed that numerous structural improvements were needed in housing–and such improvements have been underway for several years.”
Poor data, misuse of specialty mortgage products, lagging technologies, weak servicing standards and an inadequate securitization infrastructure became evident during the crisis.
“New data standards have emerged…with more on the way,” wrote DeMarco. “These standards should improve risk management while lowering origination costs and barriers to entry.” Development of the new securitization structure, begun more than two years ago, “should be a cornerstone for the future secondary mortgage market,” he added.
DeMarco said the major housing finance reform bills in the House and Senate share key similarities: “winding down Fannie Mae and Freddie Mac, building a common securitization infrastructure and drawing private capital back into the marketplace while reducing taxpayer involvement.”
DeMarco added, “We should build on these similarities, making them the cornerstone features of final legislation.” Prolonging the GSEs’ conservatorship, he warned, “will continue to distort the market and place taxpayers at risk.”
David Reiss, research director of the Center for Urban Business Entrepreneurship at the Brooklyn Law School, lauded the common securitization project. But Reiss worried the former FHFA head is too optimistic about the state of Fannie and Freddie.
“The GSEs have been in a state of limbo for far too long,” said Reiss. “All sorts of operational risks may be cropping up in the entities as employees sit around or walk out the door waiting for Congress to act.”
S&P has posted an Executive Comment, Lifted By Improving Economic Conditions, The U.S. Leads The Global Securitization Rebound–But Headwinds Remain. It concludes,
After surviving its first severe test, the market for securitization is slowly emerging from a sharp downturn, demonstrating its viability to efficiently distribute risk and expand credit availability. In this light, with many regulatory and economic uncertainties still present, we’re forecasting continuing slow growth going into next year.
The question is if, and when, securitization will register large issuance numbers again, contribute to the funding diversity and liquidity positions of banks, and improve the efficient allocation of resources to foster global economic growth.
For the U.S.–far and away the largest and most mature securitization market in the world–it’s clear, given the interconnectivity of the economy, the securitization market, and housing finance, that a continued economic recovery is necessary before the securitization market can fully recover. Economic growth will also encourage regulators, policymakers, and investors to work on the eventual return of private housing finance. But we believe that mortgage financing remains a concern for general credit availability and a continuing housing market recovery. The future of non-agency RMBS will remain in question so long as the GSEs dominate housing finance while enjoying exemptions from the qualified mortgage and risk-retention rules. (7)
I do not think that there is anything particularly new in this analysis, but it does highlight an important issue, one that I have touched on before. The gridlock on housing finance reform in DC has many effects. The GSEs are not on solid footing. The private-label industry does not know what part of the mortgage market it can operate in, whether with Qualified Mortgage (QM) or Non-QM products. And most importantly, homeowners are not getting credit at a price that a stable and mature market would offer.
The conventional wisdom is that housing finance reform is off the table until after the mid-term elections or even until after the next presidential election. That is bad news for American households, the housing industry and the financial markets. And without some strong leadership in DC, it looks like the conventional will be right.
