At a June conference on the future of mortgage finance sponsored by Moody's Investors Service at its corporate headquarters in New York, the audience was polled with this question: When do you see the private-label residential mortgage-backed securities (RMBS) market making a comeback?
An overwhelming 74 percent of the 150 attendees at a panel on RMBS said the market will come back no sooner than 2012, mirroring the views of the panel. A distinct minority--6 percent-said it would come back in 2011. However, a skeptical 20 percent voted in the poll that a comeback will happen "when hell freezes over," according to a source who attended the event.
The number of people who identify with that hell-freezing-over option may have grown since June, given the policy and market issues that have already emerged in the wake of unintended consequences from the passage of the 2,319-page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The new law creates a number of barriers to the resurgence of RMBS, many of which were anticipated by the financial markets prior to passage.
"The general consensus for the future is that there is doubt that [private-label RMBS] will come back and that it will come back in any way like it was before," says Guy Cecala, publisher of Inside Mortgage Finance. "The basic problem is that the market has been dead for two years, and it's really showing no signs of coming back whatsoever," he adds.
The cautiously hopeful see the prospects for RMBS as a glass with a splash of water in it rather than a glass virtually empty.
"The market is very, very slowly coming back to life. It's a very, very slow process," says David Spector, chief investment officer at Calabasas, California-based Private National Mortgage Acceptance Co. LLC--or PennyMac, as it is better known--which completed a private-placement securitization of $372.8 million of non-performing alternative-A loans on Sept. 14.
All but one of eight recent deals (see sidebar) have involved the private-placement securitization of non-performing loans. The coupon in the PennyMac deal priced at an unexpectedly low 4.25 percent, which made the deal attractive for the sponsors. "If you think about the environment that existed from two years ago until now, I would consider that significant progress," says Spector.
"Investors are getting more comfortable with these kinds of transactions and the collateral backing them," says Spector. This improved investor appetite, combined with the ability to buy non-performing loans at very attractive prices, has made it economically feasible for the securitization market in non-performing loans to take hold, he explains.
There are six other private-placement RMBS securitization deals--all but two of them took place earlier this year (see sidebar for summary). The Federal Deposit Insurance Corporation (FDIC) sponsored securitization of performing loans from 12 failed banks in a pilot program in July and backed the securities with a guarantee.
There is also American General Finance Inc., Evansville, Indiana, which has done at least two securitizations and, before it was sold Aug. 11, had been planning many more. Eighty percent of American General's shares, held by parent American International Group Inc. (AIG), were sold to the Fortress Investment Group LLC, New York. The sale closes in the first quarter of 2011. The list of securitizers on non-performing loans also includes Lone Star Funds, Dallas, a private equity group; and Waterfall Asset Management LLC, New York.
Sequoia Mortgage Trust
The only public securitization of recently originated mortgages this year was the Sequoia Mortgage Trust 2010-H1 deal that closed on April 28. The $237.8 million transaction was sponsored by Redwood Trust Inc., a Mill Valley, California-based real estate investment trust (REIT) that for more than a decade has been a major investor in jumbo residential mortgages. The collateral for the deal is 255 adjustable-rate jumbo mortgages originated mostly in the fall of 2009 by CitiMortgage Inc., O'Fallon, Missouri.
The Sequoia deal is the first public deal of recently originated mortgages since Oct. 30, 2008, when Green Tree Financial Corporation, St. Paul, Minnesota, did a small $62.63 million subprime home-equity loan securitization, according to Inside Mortgage Finance. Prior to that, there was a $146.97 million prime jumbo deal on Aug. 8, 2008, with the loans purchased from third-party originators through New York-based Lehman Brothers' conduit program, according to Inside Mortgage Finance.
Redwood is also in the process of putting together a second public deal expected to include $300 million in recently originated jumbo mortgages, according to the company's Aug. 4 form 8-K filing with the Securities and Exchange Commission (SEC).
Redwood's business model is based on buying mortgages to securitize them and retaining the subordinate tranches. Mike McMahon, Redwood's managing director, explains, "The way we prefer to invest in mortgage credit risk is to buy prime jumbo mortgages, securitize them, sell the seniors and keep the subs. We like to be the cook. We like to eat our own cooking."
While Redwood has at times bought the subordinated tranches put together by other parties, this is not its preferred way of doing business, "because we have less control over collateral quality and loss mitigation," McMahon explains.
Redwood has invested in prime jumbo mortgage securitizations since 1997. The REIT has done roughly 50 securitization deals totaling $35 billion in prime jumbo mortgages, according to McMahon. So far, total cumulative losses have been 32 basis points, he notes. "So, we have a very good track record," he says.
Redwood structured its Sequoia deal to address many of the concerns about the originate-to-distribute model of mortgage securitization that critics, including Federal Reserve Chairman Ben Bernanke, have said contributed to the financial crisis of 2007-2008. The primary concern has been that the originators had little incentive to care about the credit quality of the mortgages they originated and sold to Wall Street investment banks, because they did not expect to share in the credit loss exposure.
Similarly, Wall Street securitizers were faulted for having too little "skin in the game," because the risk was being transferred to investors. Since the crisis, the Dodd-Frank law requires at least 5 percent retained credit risk on certain mortgages. The Redwood deal retains 6.5 percent of the subordinate risk and also retains 5 percent of the AAA, representing both vertical and horizontal risk.
Even with 6.5 percent subordination, Redwood was criticized for not doing enough. New York-based Standard & Poor's (S&P), which had not rated the deal, issued a statement saying that the deal should have had 7.5 percent subordination. In its RMBS ratings criteria issued in September 2009, S&P set 7.5 percent credit enhancement as the level it would require for a typical pool of prime mortgages for a rating of AAA.
In a public statement at the time of the Sequoia deal closing, S&P said that the average loan balance at $932,699 poses a "concentration risk," meaning that the portfolio lacks diversity in the size of the loans. S&P pointed out that a default of the 19 largest loans or 33 average-size loans with a 50 percent recovery would wipe out the entire subordinated classes in the deal.
A source familiar with the Sequoia deal says there had been considerable delay in obtaining a rating from S&P and that Redwood was worried that market conditions could change and make the deal less attractive if it were further delayed. Redwood decided to go to market without a rating from S&P, the source says.
S&P's assessment, in turn, was questioned in an analysis of the deal by Richard Ellson and William Searle using the LoanDynamics[TM]computer model at Andrew Davidson & Co. Inc., New York, a firm that specializes in risk analytics in mortgage-backed securities (MBS). In their report, Ellson and Searle simulated the expected losses from the collateral in the Sequoia deal and found that the credit risk in the deal was lower than "S&P's archetypical pool" that would require 7.5 percent subordination and that "the credit support level is conservative." The authors did concur with S&P in its view that the deal had concentration risk, and advised that the pool of collateral "be closely monitored."
One of the reasons Redwood did the deal in April, according to McMahon, was "to demonstrate to policy makers that a well-structured securitization would be favorably received by institutional investors." The Sequoia transaction was five times oversubscribed and the prospective coupon rate of 4 percent was pushed down to 3.75 percent. The buyers were about 20 different institutional investors, according to McMahon. "Clearly, there was big institutional demand," he says.
Redwood's president and co-chief operating officer, Martin S. Hughes, explained the company's missionary zeal for restarting the RMBS market at a presentation to JMP Securities LLP, San Francisco, on May 11. "We have been on this soap box for a while," he told the investors and advisers. "We believe there's a screaming need for private securitization to help support the $11 trillion mortgage market. Although the government is doing it all right now, it can't do it all for an extended period of time."
Hughes believes that the 96.5 percent government share of the mortgage market is unsustainable. "It still isn't clear today exactly how and when the government backs out. Our recent securitization on the prime side does demonstrate that private investors are ready, willing and able to resume their role of providing liquidity to the mortgage market. Hopefully, the deal that got done prods regulators to get on with the chore of downsizing Fannie Mae and Freddie Mac," he said in his May 11 presentation.
The appeal of the Sequoia deal