The Dim Future of Non-Agency MBSs

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Originally published in the April 2012 issue of Asset Securitization Report (www.sourcemedia.com)

A recent story in ASR's sister publication, National Mortgage News, reported that a number of conduits formed to securitize jumbo-balance loans using private-label securitizations have recently been closed.  This is not surprising, considering the continued difficulties the non-agency MBS market faces.  Lenders' inability to securitize loans has profound implications for the mortgage and housing markets, and will make the GSEs increasingly indispensible to housing finance.

A cursory examination suggests that the jumbo mortgage market is reasonably healthy.  The Bankrate.com national average Jumbo rate is around 4.60%, roughly 55-60 basis points over the average conforming rate.  However, this masks deep problems in Jumbo lending.  These rates are only available to very high quality borrowers with, for example, a combination of 70% LTVs and 760 FICO scores.  The relatively low level of jumbo rates reflects demand for strong-credit jumbo mortgages from depositories looking to add yield to their investment portfolios.  More disturbing is the lack of availability of loans to less iron-clad borrowers.  They are either forced to pay significantly higher rates or are shut out of the mortgage market entirely, denying financing to a large and important segment of the housing market.

This reality reflects the continued inability of lenders to fund their operations through securitization; only one issuer (Redwood Trust) has been able to issue private-label transactions in the last three years.  This in turn reflects the profound changes undergone by the financial markets since 2007.  Uncertainty from regulatory changes such as the Dodd-Frank Act and its implementation continues to trouble the market.  Even more profound changes have resulted from the practices of the rating agencies.  Their subordination levels (or "splits") were certainly too low in the run-up to the financial crisis; their lack of diligence was certainly a factor in the creation of multitudes of flawed securities and the resulting near-collapse of the financial system in 2007 and 2008.

As part of the backlash from the mortgage meltdown, however, the rating agencies now model subordination levels using extremely onerous default and loss assumptions.  (Dodd-Frank's removal of their "expert exemption" is probably also a factor.)  In addition to very high base subordination levels, significant additional subordination is required for even modestly weaker credit (e.g., a 730 FICO score), as well as other nebulous factors (such as a "lack of geographic diversity.")  The cumulative effect is to require subordination levels so onerous that the interest rates implied by deal execution would be high enough to be considered predatory.

The unworkable economics associated with non-agency execution for both conforming- and jumbo-balance loans explains why so few issues of non-agency MBS have been brought to market over the last few years, as well as why conduits have been abandoning the market.  In turn, the inability of lenders to economically securitize their production has deprived many qualified homebuyers access to mortgage funding.  The spotty availability of reasonably-priced Jumbo mortgages has inhibited trade-up home buying, and is a key factor weighing on home prices in high-cost areas.  The inert state of the non-agency MBS market also makes the idea that private-label issuance can replace the GSEs increasingly dubious.

Unfortunately, I don't anticipate that the situation will improve in the near future.  Dodd-Frank is almost certainly here to stay, and I expect the rating agencies to remain extremely cautious in how they evaluate prospective MBS deals.  I think that issuers and policy makers need to come to terms with the fact that the private-label MBS market as it previously existed is dead.  At best, it will serve as a niche market for REITs and other investors looking to finance their assets, rather than sell them into the market.

Bill Berliner is Executive Vice President of Manhattan Capital Markets.  He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of Mortgage-Backed Securities:  Products, Structuring, and Analytical Techniques (J Wiley & Sons, 2011).

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