There is a perfectly fine article up at the Wall Street Journal on the current, probably weakening, state of the housing market, save that it fails to discuss the elephant in the room, that of the continuing moribund conditions in the so-called private label securitization market.
The piece, “Housing Shaky as Lenders Tighten,” gives a straightforward recitation: housing sales have fallen markedly in the second half of 2010 as housing tax credits expired, even with record low interest rates. (And that tailwind may no longer be behind housing as mortgage rates moved up last week).
The piece also gives macro implications: that housing has normally provided a significant boost in all past postwar expansions (yes, Virginia, this is not a normal “recovery”). And it does acknowledge the way that lending is now dominated by government entities, which are not being terribly generous with credit now. And the article suggests that the government should do more:
“Right now, we’re in that vicious cycle where we tighten, which makes things worse, so we tighten, which makes things worse,” says Bob Walters, chief economist at Quicken Loans. “How do you get out of that cycle? Folks in government are going to have to stand in and make some calls.”
Banks have become more restrictive in part because Fannie and Freddie are stepping up demands for banks to buy back defaulted loans when they can prove that the mortgage didn’t meet underwriting guidelines, an expensive proposition for banks.
This picture is woefully incomplete. Before the crisis, Fannie and Freddie provided roughly 40% of residential lending. Their outsized role now is in large measure due to the collapse of the so-callled private label securitization market.
Now some of that lending was reckless and should not come back. But the utter failure of the private label securitization market to revive gets nary a mention in this story. The closest we see is an allusion: “But that isn’t happening now because private lenders have ceded the market to government entities.” That fails to explain what is really at play. The “lenders” mentioned in the piece for the most part are banks acting as originators. They don’t have much capacity to hold loans to maturity, and if they did, it would be at much richer interest rates than those offered by Fannie and Freddie.
The reason the lenders have pretty much only the GSEs to go to is that investors, who were badly burned on private label MBS, are simply not coming back in a meaningful way until they see real reforms. Yet the securitization industry has fought them tooth and nail, as if this were a negotiation. Wake up and smell the coffee. It isn’t. The customer is always right, and in this case, the customers have made it abundantly clear that they have no interest in buying what you used to sell.
It’s been surprising and frustrating to see the securitization industry weigh in against investor-friendly proposals, like one put forward by the FDIC earlier this year. Those proposals included:
1. Mortgages must be seasoned 12 months before they can be securitized
2. The originator must retain at least a 5% interest in the credit risk of the assets sold
3. The interest of all parties to a transaction must clearly be disclosed, along with their fees
4. Re-securitizations (meaning CDOs) are severely restricted (note a disconnect here; the e-mailed and verbal reports suggested they were banned entirely; the language at the FDIC website seems to indicate that they are allowed in limited circumstances, but any use of synthetic assets, meaning credit default swaps, in a asset-backed CDO is verboten)
5. Compensation to servicers will include incentives for loss mitigation
This plan, which is pretty consistent with the level of change investors want to see to be enticed back into the pool, was forcefully opposed by securitization industry incumbents early in 2010.
The Wall Street Journal story reminds us that the securitization market is still on Federal life support. Admittedly, a securitization market with sound standards would be a much smaller than the one we saw in 2004 to 2007. But that would be a feature, not a bug.
Perversely, the securitization industry seems to be holding out for its fantasy of a return to status quo ante, when even a mini-revival of the private securitization market would reduce the dependence on government support and might even provide some economic lift.
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“Right now, we’re in that vicious cycle where we tighten, which makes things worse, so we tighten, which makes things worse,” says Bob Walters, chief economist at Quicken Loans. “How do you get out of that cycle? Folks in government are going to have to stand in and make some calls.”
My Randian hero.
(This, of course, is exactly what Rand and the “libertarians” really mean. Their actions prove it, every time.)
Now some of that lending was reckless and should not come back.
I’d say securitization itself is reckless and pointless and should not come back. We already know it serves no constructive purpose. We already know its effects are purely destructive. We already know the kind of people who do it or would want to do it are nothing but parasites and criminals, in action and thought.
Is there anything else we need to know?
So isn’t this state of affairs exactly the kind of step down in a gradual unwind that reformers say is best? (I.e., the whole thing didn’t go down all at once, but it’s unwinding.) But then those same people turn around and lament any such step down. It casts serious doubt on the sincerity of “reformists”. (I don’t mean this post, but we see that all the time in the MSM.)
Better that securitization be gone than continue the fraud. Investors are leery of these and for good reason. Once TRUST is gone, it can not be immediately recreated, it must be built up over time.
There have been rumors that the creators of these securities substituted mortgages in and out of packages already sold to the investment trusts. That seemed impossible to do without leaving a trail of any malfeasance. Now we know that it was indeed possible to do that without leaving a trail, since the Notes were not immediately endorsed over to investment trust!
Yves… thought I’d chime in on this one.
I wouldn’t place all the blame on the failure of investors to be interested in PLS. What I think is the more important and intractable hurdle is the Rating Agencies.
No one is going to originate a loan (a process that costs at least $101-16) only to turn around and monetize it for $80-00 at best. The reason the math doesn’t work at this point is because the Rating Agencies simply won’t sign off on the enhancement levels they were once okay with.
For the most part, investors in private credit residential mortgages will only think about paying $100-00 for a security that is senior pay — i.e., absent structural leverage. In the old days, if the rating agencies were looking at a pool of prime, super jumbo loans, they’d likely been okay with ~5% enhancement to AAA. If issuers could get similar levels of enhancement now, there’d be a chance a PLS market could gain some traction. Monetize $95-00 through the sale of the AAA bond, strip out some IO worth a few points thereafter, and be comfortable enough in the credit of the pool to own the residual at whatever their remaining basis was in the pool.
The problem? The Rating Agencies just won;t play ball. Fitch has stopped rating private label mortgages altogether, and S&P and Moody’s new ratings methodology is absolutely draconian. Only DBRS (traditionally an also ran) is actively rating deals… and in most cases the subordination levels they provide just don’t work to make the process of securitization economically attractive.
The only deal I’ve seen recently was a pool of seasoned loans rated by DBRS. It was a ~$100mm pool of +24 month seasoned loans, all of which were current. The enhancement? 30% to DBRS only “A”.
The only reason why I expect the deal worked economically for the issuer was because they bought the loans at a discount long ago and specially serviced the heck out of them to boost their collective performance.
Investors at this point are making all kinds of stupid investment decisions. We live in bizarro world again and in the all out chase for yield investors are acting much the same way they did in the run up to the debacle. In this case, its the RAs that are being the governor on bad behavior in PLS… not the collective wisdom of the sheep.
Investors are not behaving irrationally. The flaw with the current securitization model is that it does not provide investors with the current loan-level information that they need upfront and on an ongoing basis to be able to analyze and value the securities.
The industry keeps pushing out a product that relies on trust. As in, trust the underwriter, issuer and the Rating Agencies that there is value in the brown paper bag containing the mortgages (see The Brown Paper Bag Challenge at http://www.tyillc.com).
That trust based model is dead. Not surprising when losses on these securities are several hundred billion dollars.
Investors learned at the start of the credit crisis that if they cannot monitor the performance of the underlying loans on an observable event basis (see each payment, delinquency, default, bankruptcy filing), they could not value the securities. If the securities cannot be valued, there is no secondary market.
If there is no secondary market, then the premium they have to charge for illiquidity in the primary market makes these deals economically unattractive to the issuer.
“Investors learned at the start of the credit crisis that if they cannot monitor the performance of the underlying loans on an observable event basis (see each payment, delinquency, default, bankruptcy filing), they could not value the securities. If the securities cannot be valued, there is no secondary market. ” This seems about right. The bizarro factor in the world is that the ratings agencies continue to exist. Seems like they would have been completely discredited.
Ding!
Attempter says the model is broken and should be trashed, and then Entirely comes in right after and says the problem is the rating agencies won’t give high enough ratings. Amazing.
Obviously, Entirely works in the securitization business. His nut comes from passing the peas on to someone else. He needs a higher rating so he can pass it on. He doesn’t care who gets stuck with it.
Hard to fathom which is more incredible: That Entirely would think that we would fall for the Higher Ratings lie again, or that he would post his thoughts here among the Yves-educated.
You are WAY off base in your criticism of Entirely. He’s been very generous over time, and provided some invaluable information. Being in the industry does not mean being of the industry (you also incorrectly assume he’s on the sell side, in origination….another huge leap).
He is pointing out that the rating agencies are not longer playing ball, and arguably (and he’s pretty conservative in his assessments re risk) going overboard in the other direction.
However, the implicit issue is up in the air: would a not-overreactive ratings scheme work? I suspect not, beyond a very thin slice of oddball credits, but I’m not familiar enough with the models and risk levels to opine either way.
Thank you very much Yves… and you’re right. My input was meant to be coonstructive… not an attempt to advocate a return to the idiocy of 2006. Actually, it makes me quite happy that the RAs have been so conservative. Investors are acting like sheep again and I have no doubt that if the RAs weren’t around acting as a governor that investors would run headlong over the cliff again. How else can you explain the return of a *VERY* healthy new issue CLO and CMBS markets.
Our system (via the 8% compounding returns necessary for the pension and insurance industries) is required to blindly chase that 8% target. In a world where the 30yr UST is at 4.5% these investors have no other choice but to do dumb things with the money they’re trusted to invest.
I actually applaud the RAs on this point. If not for them, the next iteration of New Century would undoubtedly be setting up shop in Orange County just this very minute.
Not the first time that I’ve heard this, but in all honesty, I think that many Americans (and certainly a lot of reporters) don’t seem to follow this simple set of relationships.
Yes, the buyers’ strike remains in effect. The G30 report of January 2009 makes that clear in its Core Recommendation IV.
The recommendations were not followed, so it is not surprising that the strike continues.
Your last paragraph seems to indicate that the sell side wishes for “collective amnesia” on the part of the buyers. In years past, that was not an unreasonable belief as “animal spirits” would often takeover along with performance pressures.
However, this time too much has been written regarding misbehavior and the staggering losses that resulted. Buyers still have not forgotten.
It cheers me up a bit to know that “Buyer Beware” is still the regulation of last resort.
The thing I haven’t heard much about is how current F&F&FHA MBS sales are going, other than they are the entire market for funds and rates are creeping up lately. Underwriting is a bit better, maybe, but there is that 3% down FHA loan which is a fay cry from 20% in the old days. Putbacks are stronger. At least liar loans aren’t allowed, but the credit scoring level is not that impressive. So I don’t really see why investors see these “as good as treasuries”. There is that implicit-explicit government guarantee, but personally I haven’t been able to find the fine print on how that works exactly. But maybe I just missed it.
The only good part is we probably won’t have to worry about “prepays” that much in future years. Course that doesn’t bode well for volatility in the asset value. Then again, that’s why investors are supposed to buy this stuff because we can afford it but banks can’t afford to just make loans and keep them on the books.
Step up everyone.
Course the other way is for banks to raise capital and make loans and hold them on the books. But they would have to attract capital by paying dividends, and interest on bank savings accounts, bonds and CDs. But that would be soooo ’70s, and I’m sure the industry would fight that idea.
The point about the rating agencies is correct. As long as home prices are still falling they have to incorporate a level of conservatism that makes securitization less economical. Also, a blizzard of regulation has made securitization less attractive to issuers, who will obtain less regulatory capital relief and incur much more expense. There is no buyers strike. The only private-label securitization brought in 2010, SEMT 2010-H1, was wildly oversubscribed.
“2. The originator must retain at least a 5% interest in the credit risk of the assets sold”
5%, would that really be helpful ? Shouldn’t it be higher ?
I agree and have argued that point elsewhere. But higher risk retention levels kill the business completely (which I think is where this comes out, that the securitization industry if we ever get back to normalcy, is much smaller than before, and no one wants to face that outcome, hence the massive increase in socialization of housing credit).
The implicit if not explicit assurance by servicers of cash flow, despite non-payment by borrowers, helps the servicers hide defaults and delinquent payments, and creates conflicts of interests.
This feature allows the servicers – with their sponsor masters – to swap mortgages in and out of the pool, with the investors having no idea what is going on, since the cash flows remain stable.
In addition, it seems to me that servicers become a quasi-guarantor and should be considered co-issuers of the securities.
The servicers then do everything they can to manipulate this assurance of payment so as to increase their revenue, I am told, by charging profitable interest on the advances.
And, as far as the “collateral”, it seems that the credit rating of borrowers has little predictability of payment once a home is 20% under water and the borrower is on week 99 – especially in non-recourse states.
This post is pretty funny. An analogy would be complaints in 1720s France and England concerning the difficulty of floating new schemes and bubble companies. Today, even institutions desperately chasing yield understand that there is no secondary market in MBS. You buy this shit and you get out only at a dealer’s phony price. Actually, there never was a secondary market but the traders kept the customers so bamboozled they never noticed. Big surprise that the customers are now scared away.
Makes you wonder what the institutions are buying these days to create the illusion of generating returns.
The two other reforms that prospective buyers of mortgage securities should also insist on:
1) No conflicts between the servicer’s duty to the securitization trust and its own economic interest in second lien home equity lines;
2) Full books and records inspection rights so that a mortgage security holder could see the full loan file (all the paperwork on every mortgate) whenever they want, as opposed to just the “loan tape” summary information currently offered.
The originators will just hedge it away with CDS unless the protection is too exepnsive which it will be if the originators must retain the first loss piece.
You need another side to the trade to hedge it. The only time we saw large scale shorting was when 1. lending standards were awful on riskier credits AND 2. CDS on asset backed securities were grossly underpriced because BBB risk was disguised as AAA risk via CDOs. The FDIC proposal nixes that, plus buyers generally are more wary of synthetic/heavily synthetic CDOs.
The competing business interests did not battle one another when we had the world to expand into for profits. Now, when the whole world plays the capitalist game, national interests prevent American business from reaping the bounty and we are stuck with one another here in America. Globalization has us cannibalizing the domestic market for business and we are now bumping into all of the people who aspire to billionaire status, who achieve, who don’t take no for an answer and never take any prisoners. The investors want nothing but upside from the financiers who want no one behind the corporate veil but their body guards. The people with the pile of money don’t want to give it to the people who process the piles of money, because they can’t be trusted. No one can be trusted, so there is no room for compromise, like equitable regulations to protect all parties. No, that would be wrong, everyone needs to fight harder, and use game theory to get an advantage. Giving in to reasonable negotiationss would make you look weak like Obama, the Quisling of Democracy.
Paul,
I agree that when ” the whole world plays the capitalist game” the game radically changes.
As for ” the financiers who want no one behind the corporate veil but their body guards” I agree that financial sector will not voluntarily give up any ground it gained.
At the same time the pie is shrinking as GDP is stagnant and population is growing. That’s creates an interesting dilemma for the political establishment, not unlike the situation of the 30-th. As for “everyone needs to fight harder, and use game theory to get an advantage” I an afraid that it’s not only game theory that is used ;-).
Two previous similar situations (in 30th and 80th) were resolved via technological breakthroughs and collapse of opposite alliances (Germany-Italy-Japan and USSR + Warsaw Pact countries, respectively) which provided a huge new markets when you need them most.
What if there will be no technological breakthrough this time for another ten-twenty years. And what if China fail to collapse?
As for “Obama, the Quisling of Democracy” what if his actions are actions of “Lord-protector” of the current political establishment, not the product of betrayal, cowardice, weakness, incompetence, or bad timing.
Another great post, Yves. Keep up the good work to keep us up to date on this important subject – the greater mortgagegate scandal – parts of which could so easily slip out of interest and therefore out of notice.
Here’s a little numerical anecdote. As you pointed out – Inability to come to realistic terms is an impediment is resolving this. Actual offer by buyer on MBS: I’ll give you 80% of market value. Counter-offer by seller: No, give me 40% of face value. One may think ‘40% is less than 80%, do the deal’. But market- and face- value are radically different. In this case 40% is greater than 80%
Resolution: Too far a gap between those numbers, both sides stubborn, deal dissolves, MBS prices sink even further. It’s a bit like the stubborn home seller delusionally hoping/waiting for the 2006 price, while the actual price falls.
Thanks again, to Yves and her steadies.
I say stay focused on the breadth of the SECURITIZATION industry. This process(securitzation) allowed a global criminal mindset to evolve; hence, there are now hundreds of thousands of financial criminals sniffing in any possible direction. My fear is that if securitization,itself, were declared illegal, we now must contend with a subterranian financial criminal class which is way too cozy with the political elite, corp. board members, and the Washington “revolving door syndrome.”
STAY STRONG Y’ALL!
Okay, I agree with your general thesis and most of the comments. MORE TRANSPARENCY is needed. RF hit the nail on the head. Investors need to be able to “monitor the performance of the underlying loans on an observable event basis (see each payment, delinquency, default, bankruptcy filing).” Servicers need to be compensated adequately for loss mitigation activities. (the 25-50bp strip does not cover their cost of loss mitigation and advancing on serious delinquent loans).
However, the risk retention rule is a COMPLETE RED HERRING—Banks and Investment Banks (yes even those originating loans) lost BILLIONS on the risk they were retaining. Risk retention did not prevent loose lending criteria or sloppy underwriting. Merrill lost so much from the risk it retained when issuing CDOs that it had to be rescued by a FED engineered takeover by BofA. And 90% of the firms that had a pure “originate to distribute” business model went out of business due to repurchase risk. They were effectively retaining risk via the put back option. (even if they didn’t realize it at the time). There are much better solutions–regulating mortgage brokers in the same way stock brokers are regulated, requiring compensation for those originating risk (loan officer) or trading risk to be aligned with the performance of that risk overtime (instead of fully loading the compensation upfront in year one). The risk retention option is popular because on the surface it seems logical and is easy for regulators and politicians to explain to the general public. The risk retention proposals also cause a whole host of accounting issues that defeat one of the main benefits of securitization–a capital efficient source of off balance sheet funding so that the capital can be re-invested or re-lent to others. (The accounting regs should be changed to align with the new risk retention rules). I’m not saying I disagree with the risk retention proposals. I’m just saying it is not the panacea that some people believe it is and provides a false sense of comfort that we have truly addressed the underlying causes of the credit bubble.