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The market for private label residential mortgage backed securitization is back to struggling following a bumper year of deals.Perhaps the most telling harbinger for what the market can expect in terms of RMBS volumes this year is that Redwood Trust, the biggest and at one time the only securitizer in the market, hasn’t issued any jumbo mortgage loan securitizations from its flagship securitization platform Sequoia this year. 

The Mill Valley, California-based real estate investment trust stopped buying Fannie Mae and Freddie Mac loans in the fourth quarter and discontinued its acquisitions of commercial real estate loans in February 2016.

At the time, Redwood Trust said that its conforming loan purchase and sale operations generated a pre-tax loss of $10 to $11 million in 2015 or a loss of $7 to $8 million on an after-tax basis based on the REIT’s preliminary full-year 2015 results.

According to Christopher Abate, Redwood Trust’s chief financial officer at the time, that included interest and fees of approximately $12 million associated with $5.2 billion of loan purchases, and operating expenses of approximately $22 million.

Abate said as a result of the restructuring, the REIT will eliminate this “earnings drag” from its conforming operating activities
going forward and free up $45 million of capital for re-investment during 2016.

Redwood Trust said that instead of acquiring loans to sell to Fannie and Freddie, it will focus on direct conforming-related investments in mortgage servicing rights and risk-sharing transactions.

Redwood Trust said that as a result of this decision, the REIT plans to implement a “workforce reduction,” which will primarily impact the employees engaged in and supporting the REIT’s residential mortgage loan business. 

Redwood Trust said that the cuts will result in a 25% reduction in its workforce.

“One of our goals over the past few months has been to closely evaluate both our residential and commercial business operations and our corporate expense structure to look for ways to increase efficiency and profitability in the face of significant competitive pressures and market dislocations,” Marty Hughes, chief executive officer of Redwood Trust, said last month. 

“Today’s announcement specifically addresses our actions related to our conforming loan activities, which we view as necessary, as we do not see the competitive pressures easing for the foreseeable future.”

Although its jumbo securitization platform remains an open and active option, the economics are currently better on whole-loan sale compared to securitization.  

Redwood, the first issuer to tap the securitization post-financial crisis, emerged as one of the most active securitizers of residential mortgage loan aggregated under its Sequoia structure.  

The REIT stated in its 4Q2015 earning report that it had sold nearly $100 million of the repurchase debt associated with the Sequoia triple-A rated securities as of Feb. 19, 2016, and plans to sells the remaining $47 million over the near term.

“The overall private-label securities market, of which jumbos are a part, still doesn’t even have an upside,” stated Sam Khater, deputy chief economist at CoreLogic, in the April 2016 issue of Market Pulse. “It has been basically a flat line near zero since its calamitous falloff in 2007.”

Although RMBS securitization (including prime jumbo, re-performing/nonperforming, credit risk transfer, single-family rental and servicer advances) has steadily increased since 2012, prime jumbo issuance hasn’t registered strong volumes. 

According to Standard & Poor’s, total RMBS volume was $54 billion in 2015, an increase of $16 billion from the 2014 total.

Prime jumbo securitizations accounted for 38 deals in 2015 or $12.1 billion; that’s less than 9% of 2001’s $142 billion total.

GAME CHANGER 

Redwood has always been a securitization game-changer — even when getting out of the game.

In the years following the housing crash, Redwood always found a way to stay on the forefront. As the private-label market for securitization produced little in securitization volume, Redwood continued to issue.

That all changed beginning in 2014. That was the year Redwood ceased being the game changer, and started becoming the “has been.”

As the first regular issuer of private-label securitizations via its Sequoia platform, the real estate investment trust often stood alone. Others eventually entered into the market, issuing securitization with many similarities. But Redwood always stuck to the plain vanilla narrative of high-quality jumbo loan originations.

Then suddenly the regular issuance stopped, owing to more favorable wholesale market conditions.

At the time, Redwood executives predicted it would start up again in the second half of 2014. Their prophecy remains unfulfilled.

Then, in 2016, the unthinkable happened: Redwood President Brett Nicholas announced he would step down later this year, after 20 years with the company.

Christopher Abate, who currently serves as the REIT’s chief financial officer, will replace Nicholas as president. A replacement for Abate is not yet announced.

Despite the business changes, overall there remains no market for the products Redwood was once known for offering. 

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THE STATE OF THE MARKET

S&P expects total RMBS issuance volume in 2016 to fall $20 billion below its original $70 billion 2016 forecast.  So far, a total of $7 billion in RMBS activity has been issued in 1Q2016—that’s down more than 50% from 1Q2015. Only three deals totaling $1 billion have been prime jumbo originations.  “Prime jumbo securitization never returned to its pre-crash peaks but it did manage to register a pulse until the summer of 2016, when it cratered again,” said Khater.

A Moody’s Investors Service report shows that private-label RMBS funded just 9% ($883 billion) of the $10 trillion of residential mortgages outstanding at year-end 2015 – its lowest percentage since 1996, the report shows.

Moody’s said that the reduction in RMBS funding is mainly because government-sponsored enterprises Fannie Mae and Freddie Mac funded through securitization a significantly larger share of residential mortgages in 2015 (58%, or $5.8 trillion) compared with 2007 (39%) as a result of the private-label RMBS market’s decline.

Behind the retreat in jumbo securitization volume is the combination of high-quality assets that have provided good margins for returns in the current low deposit rate environment. These factors, together with stricter capital requirements for the mortgage servicing rights on loans, mean that whole-loan prices at the supply level are too high for RMBS issuance to be profitable. 

Banks are now acquiring and retaining a portion of their conforming loan production for portfolio investment, which has created what the REIT called “unrelenting competitive pricing pressure” for private label RMBS. 

“It’s not that jumbo mortgages weren’t and aren’t popular. In fact, demand drove jumbo yield below the conventional yield in a highly unusual inversion in 2013. But securities were suffering from formidable competition of the whole loan side. Banks were holding a lot of jumbos in their portfolios, keeping them out of the securitization market,” said Khater. 

Another reason is the interest rate volatility and dislocation in the jumbo securitization market that began impacting the REIT’s jumbo mortgage banking operations during the first half of 2015. The severe volatility and credit spread widening recently observed in the debt markets is signaling an element of potential dislocation that we have not felt since the financial crisis.

A rise in the interest rates could shift the economics in favor of banks securitizing their production (and buying back the RMBS AAAs) rather than owning the whole loans on their balance sheet, but it’s difficult to predict just how much the interest rates need to rise for the economics to shift.

“Interest rates have remained low for a considerable time in the U.S. and it is natural to wonder how much longer we may have such low rates,” said Frank Nothaft, senior vice president and chief economist in CoreLogic’s April 2016 issue of Market Pulse.

Nothaft said that the recent one quarter of a percentage point rate increase the Federal Reserve announced at the end of last year is an indication that rates will continue to rise but likely in those small increments.  In mid-March, the Fed said that if the economy performs as they think it will, rates will increase by another one-half percentage point later this year and may be raised to a full percentage point in both 2017 and 2018.

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NEW TRID RULES TO BLAME?

The shifting regulatory environment is also to blame for why private label RMBS has failed to make a meaningful comeback. The latest regulatory hurdle comes in the form of the “Know Before You Owe” rule, commonly known as TRID.

TRID, implemented six months ago and enforced by the Consumer Financial Protection Bureau, is a rule that ensures consumers are sold mortgages they can pay back. The rules are designed to help borrowers better understand their loan terms and fees. 

Investors and due-diligence firms have reacted cautiously to the TRID rule with regard to securitizations. For securitization, the concern is that the rule expands the amount of potentially erroneous information that the purchaser of a whole loan or loan securitization could be liable for.

Fitch Ratings has estimated that more than half of all home loans originated today have minor errors that are not TRID compliant. Roughly 5% to 10% have major compliance problems, while just 25% to 30% are fully compliant, Fitch said in a March 21 report.

In a March 30 letter to CFPB Director Richard Cordray, the Association of Mortgage Investors said TRID, has “resulted in a climate of legal uncertainty” and is “chilling” private investment in the U.S. mortgage market.

“We seek formal written guidance clarifying the liability for a violation of each individual TRID requirement, as well as the scope and applicability of TRID’s cure mechanisms,” AMI Director Chris Katopis said in the letter. The group is asking the agency to open a new public comment period.

However concerns over the risks of including non-TILA-RESPA compliant loans in securitizations may be overblown.

To begin with, mortgage bond investors are only exposed to maximum statutory damages of $4,000 plus attorney’s fees. “This value is relatively insignificant, especially when considering both default probabilities and our assumption that not all lawsuits will be successful,” according to a Morningstar April 12 report. 

There is also limited incentive on class-action lawsuits, as the potential award is limited to $1 million or 1% of the creditor’s net worth, whichever is smaller.

Kroll Bond Rating Agency said in an April 14 report that it would still rate RMBS pools containing loans with TRID violations. The rating agency also doesn’t expect that transactions involving TRID-eligible loans would be subject to a ratings cap and will still be eligible to receive ‘AAA’ ratings. 

KBRA believes the extent of assignee liability that may ultimately impact RMBS investors in securitizations involving TRID-eligible loans is limited by a number of factors. Chief among those factors is the limited availability of affirmative claims due to the statute of limitations. 

Morningstar has taken a similar position. In a March report, it said that potential errors related to the new residential mortgage disclosure rule are “not a significant source of credit risk to securitizations. We would expect only errors made in good faith to potentially make it into a securitization when a full due-diligence review is completed. “  

Khater said that restarting jumbo issuance depends on the combination of interest rates rising, the industry getting comfortable with TRID and big banks moving away from holding whole loans in their portfolios. 

Until then, he said: “The outlook for prime jumbo securitization is cloudy.” 

WHEN WILL REDWOOD TRUST RISE AGAIN?

In the Redwood first-quarter results for 2016, there is a forward-looking statement that suggests a new Sequoia RMBS in the “next few months.”

 As of press time, they say they’re hearts are in it, as they “continue to believe that over time PLS is very efficient and necessary for mortgage financing, especially for prime jumbo loans.”

In our opinion, the primary obstacle to increasing PLS issuance volume is a lack of market liquidity, as many traditional issuers (i.e., major banks) and many major triple-A investors remain on the sidelines,” the earnings report reads. “This condition has kept credit spreads both wide and volatile, which pressures securitization economics.”

“Despite these headwinds, we currently expect to complete a Sequoia transaction in the next few months and are looking forward to investing in the subordinate tranches,” the statement concludes.