One of the things that has bedeviled mortgage financing post-crisis has been the absence of the private label mortgage backed securities market. The private label MBS market includes loans that are not guaranteed by the government or the agencies, and is a shadow of its former self. During the peak years, private label MBS issuance topped $1 trillion. In 2017, only $70 billion of private label RMBS were issued, although that is a big increase from 2016.

Policy makers are particularly keen to bring back the private label market in order to increase access to credit and shrink the government’s footprint in the mortgage market. What is holding things back?

The issue seems to be spread out between MBS investors, who want added protections, lenders, who have been content to stick to agency and government loans, and borrowers, who are reluctant to set foot in the mortgage market, particularly the first-time homebuyer.

Here’s a little history on how we got here, and some of the concerns of investors.

THE REAL ESTATE BUBBLE

The real estate bubble and bust taught some important lessons to borrowers, lenders and investors. Bubbles are a psychological phenomenon where everyone involved — borrowers, lenders and investors — need to believe that an asset is “special” and will never go down in price, at least not for an extended period of time.

After the real estate bubble burst, borrowers and lenders learned that real estate prices can actually decrease and investors learned that geographic diversification won’t necessarily bail them out when they do. But, the most important lesson for investors in MBS was that liquidity can dry up in an instant, and that when you need to sell, you might not be able to find a buyer. This point is critical in understanding the reticence on the part of investors.

As is typical during bubbles, the use of leverage (borrowed money) enhanced returns to the upside, but also amplified the losses on the downside. Funds that invested in mortgage backed securities and leveraged them 5:1 were able to generate decent returns while the real estate market was rising. Home price appreciation papered over a slew of underwriting errors, and since the value of the collateral was always rising, delinquencies were not much of a problem.

After the real estate market peaked, however, we began to see a wave of strategic defaults, which were largely investors who chose to toss the keys to the bank when home prices stopped rising. As the inventory of underwater homes began to pile up, price depreciation accelerated and the market for MBS froze up.

Funds that use leverage have a problem when they start taking mark-to-market losses. The lender will demand the borrower put up more collateral against the loan. In normal markets, they would raise margin by selling the depreciating securities. However, they couldn’t in this case – there were no buyers. Ultimately the lenders to these funds sold the collateral for whatever they could get, which drove prices down to distressed levels.

Distressed MBS buyers were willing to pay 70 cents on the dollar of the underlying collateral value, not face. So, a security backed by a $130,000 mortgage on a $100,000 house was worth $70,000. The MBS investor ended up taking about a 50% haircut, assuming they had paid over par for the bonds. The investors that made it out alive had no appetite for these securities any longer. In retrospect, many of these securities ended up being “money good.” In fact, Annaly plans an issue with loans from an old 2005 securitization that never happened. Fitch has rated the senior tranches AAA.

Quantitative easing also impacted the demand for private label securities as well. The big mortgage REITs knew the Fed was going to be in the market buying agency and government mortgage backed securities. It made sense for them to piggyback along with that trade, especially since funding costs were being driven down to the floor.

Plus, the big mortgage REITs had been picking up plenty of decent paper trading in the 60s. Why bother buying new issues at par? So, in the years following the financial crisis, many investors were more interested in buying and leveraging agency paper and had little appetite for anything more exotic. Agency and Ginnie MBS were considered “safe” and they were, at least on the credit side. But the interest rate risk turned out to be much higher.

UNRESOLVED ISSUES

Some of the governance issues from the bubble years remain unresolved. Once the causes and effects of the crisis were examined, investors realized that there was no one tasked with looking out for their interests.

In other words, there was no entity which was responsible for examining and dealing with reps and warrants violations, ensuring that the servicer was maximizing the value of the trust and not the value of the servicing (which the issuer usually kept), managing the conflict of interest if the issuer held a second lien, and finally ensuring that the issuer wasn’t soliciting the borrower for a refinancing.

Many investors simply won’t re-enter the marketplace for private label securities until there is a standardized framework to address these issues.

Finally, from the investor’s standpoint, legacy non-agency paper was priced so much better on a risk/ reward basis than new issues that there simply wasn’t that big of an appetite for new paper.

Legacy MBS have been bid up enough that the easy money has been made. However, there still seems to be a bit of a bid/ask spread between what issuers want to get and what investors are willing to pay. New non-agency loans (especially non-QM) don’t have any sort of prepayment history, which makes them tough to value. The risk (from an investor’s standpoint) is that using conventional prepay speeds to value the MBS will overvalue them.

Non-QM paper probably will exhibit higher prepay speeds than conventional loans simply because borrowers will refinance into a conforming loan once they are able to. It may turn out that a lack of investment opportunities will force the buy-side to start buying new issues, but we aren’t there yet.MBS 1

From the lender’s point of view, the immediate post-bubble years were a heyday of refinance activity. As the Fed drove down interest rates, the entire mortgage universe became refinanceable. Originators had their hands full doing the easy stuff – rate/term refinancings on conforming and government loans. The government introduced streamline refinancing products which were easy to do, and often required no appraisal.

Warehouse banks also were reluctant to lend against anything that wasn’t easily saleable. The risk-aversion of warehouse banks is an overlooked but critical factor in this. If a lender can’t get a warehouse bank to accept non-agency loans as collateral, it doesn’t matter how attractive the business may be. Anyone without the ability to hold a loan long term can’t do them.

Another issue for lenders is that the servicing value for jumbo and non-QM loans is much lower than it is for conforming and government. This means the loan is simply not as profitable for an originator as a plain-vanilla conforming or government loan.

Not only that, the risk for a lender is higher because there is invariably only one outlet for the loan. A secondary marketing officer knows that there are dozens of outlets for plain-vanilla conforming and government loans. If one correspondent turns down the loan, it can probably be sold to someone else without too much of a problem. But, if the loan is non-agency, there is usually only one buyer, and if that buyer backs away, the lender is looking at selling it in the scratch-and-dent market, which guarantees a sizeable loss on the loan.

So, from the lender’s standpoint, why bother with loans that are riskier, harder and less profitable, when you can do streamline refinancings all day? It was a no-brainer.

Plus, many of the larger banks were willing to be loss-leaders in jumbo loans as a way to bring in other ancillary services, particularly the lucrative asset management business, where the bank earns a return on someone else’s money. Many independent mortgage bankers had trouble competing with the big banks on price anyway. Banks have largely solved their capital problems and now need to put money to work. Many non-QM and jumbo loans are staying on their lender’s balance sheet, as the economics of holding them are better than securitizing them.

THE ROAD AHEAD

After the real estate market bottomed out, we began to see some interest in non-QM mortgages, however issuance was tiny. Most of the non-QM stuff has been centered on two areas: jumbo loans that have extremely low loan-to-value ratios and stated-income loans, where the borrower is self-employed and lacks W2 income.

Neither of these loans resemble the subprime loans of the bubble years, which were meant to be refinanced, not repaid. FHA is the new subprime and most lenders won’t delve too deep into the lower FICO FHAs, particularly when the borrower is only putting down 3.5%.

Affordable housing advocates are eager to see a return of the private label market, believing that there are many underserved borrowers who need access to credit and are being shut out of the market. The bigger question is whether this is an education issue.

FHA loans are designed precisely to target the underserved and the first-time homebuyer. Prior to the financial crisis, FHA loans were a bit of a backwater of the mortgage market. Once the subprime market fell apart, they picked up the slack. USDA loans are another program designed to target this market.

Ultimately, for whatever reason, the loan demand simply has not been there.

Perhaps borrowers are unaware that they don’t need perfect credit or 20% down to buy a home. Perhaps borrowers with shaky financial foundations are reluctant to take on the risk of owning a home and prefer the flexibility of renting. Many of the alt-A/ subprime products targeted the first-time homebuyer, and this borrower has been missing in action during this housing recovery. In February, the first-time homebuyer accounted for 29% of home sales. Historically, that number has been closer to 40%.

In their latest Profile of Home Buyers and Sellers, the National Association of Realtors had this observation about the state of the first-time homebuyer: “The dreams of many aspiring first-time buyers were unfortunately dimmed over the past year by persistent inventory shortages, which undercut their ability to become homeowners,” said Lawrence Yun, NAR chief economist.

“With the lower end of the market seeing the worst of the supply crunch, house hunters faced mounting odds in finding their first home. Multiple offers were a common occurrence, investors paying in cash had the upper hand, and prices kept climbing, which yanked homeownership out of reach for countless would-be buyers.”

Professional investors, who piled into the “REO-to-rental” trade post-recession have been scooping up properties at the low end of the market, and they have been cash buyers. Since cash buyers don’t need mortgages in the first place, this has been another reason for the low borrower demand.

Despite the lower loan demand, mortgage credit availability is still severely depressed compared to the pre-crisis period, which you can see from the Mortgage Bankers Association Mortgage Credit Availability Index (chart opposite). It is about 20% of what it was during the peak.

Finally, the Millennial first-time homebuyer has preferred to rent in urban areas and has not (at least as of yet) chosen to leave for the suburbs. As the Millennials begin to have kids, that will probably change.

Excessive student loan debt is also an issue for this generation, and soaring home prices have affected affordability. But the punch line remains: low demand from the Millennial generation is a reason why the borrower demand for these loans has been low.

The government is also eager to bring back private capital into the mortgage market, as the taxpayer is bearing the credit risk of the lion’s share of all new origination. Unfortunately, as Redwood Trust put it in their Guide to Reviving the Private Label Securities Market, getting the critical mass needed to revive the market has proved to be difficult: “The most difficult challenge facing the PLS market is a bit of a Catch-22. Investors and issuers are much more inclined to participate in a PLS market that is active and liquid, with ample investment opportunities and tight bid-ask spreads, but the current market has none of these characteristics. The Catch-22 is that we can’t get to a healthy and liquid state while both investors and issuers remain on the sidelines, waiting until the market is healthy and liquid.”

Policy analysts point to a couple of reforms that are probably necessary to bring back the private label market. The first is a “deal agent” which deal would be charged with “protecting the interests of the RMBS trust, maximizing the net present value of its assets and making certain strategic decisions in the limited circumstances that doing so becomes necessary,” according to a recent Urban Institute piece by Laurie Goodman.

Ultimately, the question of a deal agent will come down to how much one costs, and whether it positively affects the rating/pricing of the deal.

The return of the private label market is critical to addressing some of the people who have been shut out of the mortgage market since the crisis. While FHA and conforming loans have picked up much of the slack left over from the death of the private label market, it isn’t really an ideal solution, since the taxpayer is bearing the majority of the credit risk in the mortgage market.

Many borrowers who don’t fit in the conforming/government credit box have been frozen out. In order to bring back private capital, MBS issuers and regulatory agencies need to continue the progress they have been making on fixing the issues that were identified in the financial crisis.

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