Tag Archives: Private Label Securitization

Credit Risk Transfer and Financial Crises

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photo by Dean Hochman

Susan Wachter posted Credit Risk Transfer, Informed Markets, and Securitization to SSRN. It opens,

Across countries and over time, credit expansions have led to episodes of real estate booms and busts. Ten years ago, the Global Financial Crisis (GFC), the most recent of these, began with the Panic of 2007. The pricing of MBS had given no indication of rising credit risk. Nor had market indicators such as early payment default or delinquency – higher house prices censored the growing underlying credit risk. Myopic lenders, who believed that house prices would continue to increase, underpriced credit risk.

In the aftermath of the crisis, under the Dodd Frank Act, Congress put into place a new financial regulatory architecture with increased capital requirements and stress tests to limit the banking sector’s role in the amplification of real estate price bubbles. There remains, however, a major piece of unfinished business: the reform of the US housing finance system whose failure was central to the GFC. Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), put into conservatorship under the Housing and Economic Recovery Act (HERA) of 2008, await a mandate for a new securitization structure. The future state of the housing finance system in the US is still not resolved.

Currently, US taxpayers back almost all securitized mortgages through the GSEs and Ginnie Mae. While pre-crisis, private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.

The appropriate pricing of mortgage backed securities can discourage lending if risk rises, and, potentially, can limit housing bubbles that are enabled by excess credit. Securitization markets, including the over the counter market for residential mortgage backed securities (RMBS) and the ABX securitization index, failed to do this in the housing bubble years 2003-2007.

GSEs have recently developed Credit Risk Transfers (CRTs) to trade and price credit risk. The objective is to bring private market discipline to bear on risk taking in securitized lending. For the CRT market to accomplish this, it must avoid the failures of financial assets to price risk. Are prerequisites for this in place? (2, references omitted)

Wachter partially answers this question in her conclusion:

CRT markets, if appropriately structured, can signal a heightened likelihood of systemic risk. Capital markets failed to do this in the run-up to the financial crisis, due to misaligned incentives and shrouded information. With sufficiently informed and appropriately structured markets, CRTs can provide market based discovery of the pricing of risk, and, with appropriate regulatory and guarantor response, can advance the stability of mortgage finance markets. (10)

Credit risk transfer has not yet been tested by a serious financial crisis. Wachter is right to bring a spotlight on it now, before events in the mortgage market overtake us.

Housing Booms and Busts

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photo by Alex Brogan

Patricia McCoy and Susan Wachter have posted Why Cyclicality Matter to Access to Mortgage Credit to SSRN. The paper is now particularly relevant because of President Trump’s plan to roll back Dodd-Frank’s regulation of the financial markets, including the mortgage market. While McCoy and Wachter do not claim that Dodd-Frank solves the problem of cyclicality in the mortgage market, they do highlight how it reduces some of the worst excesses in that market. They make a persuasive case that more work needs to be done to reduce mortgage market cyclicality.

The abstract reads,

Virtually no attention has been paid to the problem of cyclicality in debates over access to mortgage credit, despite its importance as a driver of tight credit. Housing markets are prone to booms accompanied by bubbles in mortgage credit in which lenders cut underwriting standards, leading to elevated loan defaults. During downturns, these cycles artificially impede access to mortgage credit for underserved communities. During upswings, these cycles make homeownership unnecessarily precarious for many who attain it. This volatility exacerbates wealth and income disparities by ethnicity and race.

The boom-bust cycle must be addressed in order to assure healthy and sustainable access to credit for creditworthy borrowers. While the inherent cyclicality of the housing finance market cannot be fully eliminated, it can be mitigated to some extent. Mitigation is possible because housing market cycles are financed by and fueled by debt. Policymakers have begun to develop a suite of countercyclical tools to help iron out the peaks and troughs of the residential mortgage market. In this article, we discuss why access to credit is intrinsically linked to cyclicality and canvass possible techniques to modulate the extremes in those cycles.

McCoy and Wachter’s conclusions are worth heeding:

If homeownership is to attain solid footing, mitigating the cyclicality in the housing finance system will be imperative. That will require rooting out procyclical practices and requirements that fuel booms and busts. In their place, countercyclical measures must be instituted to modulate the highs and lows in the lending cycle. In the process, the goal is not to maximize homeownership per se; rather, it is to ensure that residential mortgages are made on safe and affordable terms.

*     *     *

Taming procyclicality in industry practices in housing finance is much farther behind and will require significantly more work. There is no easy fix for the procyclical effect of mortgage appraisals because appraisals are based on neighboring comparables. Similarly, procyclicality will require serious attention if the private-label securitization market returns. While the Dodd-Frank Act made modest reforms designed at curbing inflation of credit ratings, the issuer-pays system that drives grade inflation remains in place. Similarly, underpricing the risk of MBS and CDS will continue to be a problem in the absence of an effective short-selling mechanism and the effective identification of market-wide leverage. (34-35)

McCoy and Wachter offer a thoughtful overview of the risks that mortgage market cyclicality poses, but I am not optimistic that it will get a hearing in today’s Washington.  Maybe it will after the next bust.

Mortgage Market Overview

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The Urban Institute’s Housing Finance Policy Center issued its May 2016 Housing Finance at a Glance Chartbook. This monthly report is invaluable for those of us who follow the mortgage market closely. The mortgage market changes so quickly and so much that what one thinks is the case is often no longer the case a few months later. This month’s report has new features, including Housing Credit Availability Index and first-time homebuyer share charts. Here are some of the key findings of the May report:

  • The Federal Reserve’s Flow of Funds report has consistently indicated an increasing total value of the housing market driven by growing household equity in each quarter of the past 2 years, and the trend continued according to the latest data, covering Q4 2015. Total debt and mortgages increased slightly to $9.99 trillion, while household equity increased to $13.19 trillion, bringing the total value of the housing market to $23.18 trillion. Agency MBS make up 58.2 percent of the total mortgage market, private-label securities make up 6.1 percent, and unsecuritized first liens at the GSEs, commercial banks, savings institutions, and credit unions make up 29.4 percent. Second liens comprise the remaining 6.4 percent of the total. (6)

It is worth wrapping your head around the size of this market. Total American wealth is about $88 trillion, so household equity of $13 trillion is about 15 percent of the total. With debt and mortgages at $10 trillion, the aggregate debt-to-equity ratio is nearly 45%.

  • As of March 2016, debt in the private-label securitization market totaled $613 billion and was split among prime (19.5 percent), Alt-A (42.2 percent), and subprime (38.3 percent) loans. (7)

This private-label securitization total is a pale shadow of the height of the market in 2007, back to the levels seen in 1999-2000. It is unclear when and how this market will recover — and the extent to which it should recover, given its past excesses

  • First lien originations in 2015 totaled approximately $1,735 billion. The share of portfolio originations was 30 percent, while the GSE share dropped to 46 percent from 47 in 2014, reflecting a small loss of market share to FHA due to the FHA premium cut. FHA/VA originations account for another 23 percent, and the private label originations account for 0.7 percent. (8)

The federal government, through Fannie Mae, Freddie Mac and Ginnie Mae, is insuring 69 percent of originations. Hard for me to think this is good for the mortgage market in the long term. There is no reason that the private sector could not take on a bigger share of the market in a responsible way.

  • Adjustable-rate mortgages (ARMs) accounted for as much as 27 percent of all new originations during the peak of the recent housing bubble in 2004 (top chart). They fell to a historic low of 1 percent in 2009, and then slowly grew to a high of 7.2 percent in May 2014. (9)

It is pretty extraordinary to see the extent to which ARMs change in popularity over time, although it makes a lot of sense. When interest rates are high and prices are high, more people prefer ARMs and when they are low they prefer FRMs.

  • Access to credit has become extremely tight, especially for borrowers with low FICO scores. The mean and median FICO scores on new originations have both drifted up about 40 and 42 points over the last decade. The 10th percentile of FICO scores, which represents the lower bound of creditworthiness needed to qualify for a mortgage, stood at 666 as of February 2016. Prior to the housing crisis, this threshold held steady in the low 600s. LTV levels at origination remain relatively high, averaging 85, which reflects the large number of FHA purchase originations. (14)

It is hard to pinpoint the right level of credit availability, particularly with reports of 1% down payment mortgage programs making the news recently. But it does seem like credit can be loosened some more without veering into bubble territory.

Hard to keep up with all of the changes in the mortgage market, but this chartbook sure does help.

Treasury Gives RMBS a Workout

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The Treasury has undertaken a Credit Rating Agency Exercise. According to Michael Stegman, Treasury

recognized that the PLS market has been dormant since the financial crisis partly because of a “chicken-and-egg” phenomenon between rating agencies and originator-aggregators. Rating agencies will not rate mortgage pools without loan-level data, yet originator-aggregators will not originate pools of mortgage bonds without an idea of what it would take for the bond to receive a AAA rating.

Using our convening authority, Treasury invited six credit rating agencies to participate in an exercise over the last several months intended to provide market participants with greater transparency into their credit rating methodologies for residential mortgage loans.

By increasing clarity around loss expectations and required subordination levels for more diverse pools of collateral, the credit rating agencies can stimulate a constructive market dialogue around post-crisis underwriting and securitization practices and foster greater confidence in the credit rating process for private label mortgage-backed securities (MBS). The information obtained through this exercise may also give mortgage originators and aggregators greater insight into the potential economics of financing mortgage loans in the private label channel and the consequent implications for borrowing costs.

While this exercise is very technical, it contains some interesting nuggets for a broad range of readers. For instance,

The housing market, regulatory environment, and loan performance have evolved significantly from pre-crisis to present day. Credit rating agency models appear to account for these changes in varying ways. All credit rating agency models incorporate the performance of loans originated prior to, during, and after the crisis to the degree they believe best informs the nature of credit and prepayment risk reflected in the market. Credit rating agency model stress scenarios may be influenced by loans originated at the peak of the housing market, given the macroeconomic stress and home price declines they experienced. The credit rating agencies differ, however, in how their models adjust for the post-crisis regime of improved underwriting practices and operational controls. Some credit rating agencies capture these changes directly in their models, while other credit rating agencies rely on qualitative adjustments outside of their models. (10)

It is important for non-specialists to realize how much subjectivity can be built into rating agency models. Every model will make inferences based on past performance. The exercise highlights how different rating agencies address post-crisis loan performance in significantly different ways. Time will tell which ones got it right.

Hockett on NYC Eminent Domain

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Bob Hockett has posted ‘We Don’t Follow, We Lead’: How New York City Will Save Mortgage Loans by Condemning Them to SSRN. The abstract reads,

This brief invited essay lays out in summary form the eminent domain plan for securitized underwater mortgage loans that the author has been advocating and helping to implement for some years now. It does so with particular attention in this case to New York City, which is now actively considering the plan. The essay’s first part addresses the plan’s necessity. Its second part lays out the plan’s basic mechanics. The third part then systematically addresses and dispatches the battery of remarkably weak legal and policy arguments commonly proffered by opponents of the plan.

Hockett has been advocating this plan for some time in the face of concerted opposition from the financial industry. One industry argument that I have found to be over the top is that lenders will refuse to lend in communities that employ eminent domain to address the foreclosure crisis. Hockett writes,

Another policy argument made by some members of the securitization industry is that using eminent domain to purchase loans will dry up the sources of mortgage credit, rendering the American dream of homeownership unattainable. The financial services industry and its legislative supporters have made this kind of claim against regulatory and consumer protection proposals emerging from national, state, or municipal legislatures.

One problem with this argument is that private credit has not flowed to non-wealthy mortgage borrowers since the crash. Federal lenders and guarantors are nearly the only game in town, and they are likely to remain so until the underwater PLS loan logjam is cleared.

Another problem with the credit withdrawal argument is that it characterizes a benefit as a burden. The housing bubble was, like most of the more devastating bubbles through history, the upshot of an over-extension of credit. Lenders extended excess credit through reverse redlining and other predatory lending practices perpetrated or aided and abetted by participants in the securitization industry itself. Hence the securitization industry’s warning that credit might not be overextended in the future is a warning of something that might well be desirable. (142-43, footnotes omitted)

Given that lenders always rush to lend to countries that have recently defaulted on their sovereign debt, I don’t find the credit withdrawal argument to be particularly convincing here. But it may succeed in convincing some local governments not to proceed with their eminent domain strategies. I do hope, however, that at least one locality will follow through during the current foreclosure crisis. That way, we will at least have a proof of concept for the next foreclosure crisis.