The Costs and Benefits of A Dodd-Frank Mortgage Provision

Craig Furfine has posted The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages to SSRN. The abstract reads,

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 imposed requirements on securitization sponsors to retain not less than a 5% share of the aggregate credit risk of the assets they securitize. This paper examines whether loans securitized in deals sold after the implementation of risk-retention requirements look different from those sold before. Using a difference-in-difference empirical framework, I find that risk retention implementation is associated with mortgages being issued with markedly higher interest rates, yet notably lower loan-to-value ratios and higher income to debt-service ratios. Combined, these findings suggest that the implementation of risk retention rules has achieved a policy goal of making securitized loans safer, yet at a significant cost to borrowers.

While the paper primarily addressed the securitization of commercial mortgages, I was particularly interested in the paper’s conclusion that

the results suggest that risk retention rules will become an increasingly important factor for the underwriting of residential mortgages, too. Non-prime residential lending has continued to rapidly increase and if exemptions given to the GSEs expire in 2021 as currently scheduled, then a much greater fraction of residential lending will also be subject to these same rules. (not paginated)

As always, policymakers will need to evaluate whether we have the right balance between conservative underwriting and affordable credit. Let’s hope that they can address this issue with some objectivity given today’s polarized political climate.

The End of Private-Label Securities?

Steve Jurvetson

Jamie Dimon, CEO of JPMorgan Chase

J.P. Morgan’s Securitized Products Weekly has a report, Proposed FRTB Ruling Endangers ABS, CMBS and Non-Agency RMBS Markets. This is one of those technical studies that have a lot of real world relevance to those of us concerned about the housing markets more generally.

The report analyzes proposed capital rules contained in the Fundamental Review of the Trading Book (FRTB). JPMorgan believes that these proposed rules would make the secondary trading in residential mortgage-backed securities unprofitable. It also believes that “there is no sector that escapes unscathed; capital will rise dramatically across all securitized product sectors, except agency MBS.” (1) It concludes that “[u]ltimately, in its current form, the FRTB would damage the availability of credit to consumers, reduce lending activity in the form of commercial mortgage and set back private securitization, entrenching the GSEs as the primary securitization vehicle in the residential mortgage market.” (1)

JPMorgan finds that the the impact of these proposed regulations on non-agency residential-mortgage backed securities (jumbos and otherwise) “is so onerous that we wonder if this was the actual intent of the regulators.” Without getting too technical, the authors thought “that the regulators simply had a mathematical mistake in their calculation (and were off by a factor of 100, but unfortunately this is what was intended.” (4) Because these capital rules “would make it highly unattractive for dealers to hold inventory in non-agency securities,” JPMorgan believes that they threaten the entire non-agency RMBS market. (5)

The report concludes with a policy takeaway:

Policymakers have at various times advocated for GSE reform in which the private sector (and private capital) would play a larger role. However, with such high capital requirements under the proposal — compared with capital advantages for GSE securities and a negligible amount of capital for the GSEs themselves — we believe this proposal would significantly set back private securitization, entrenching the GSEs as the primary securitization vehicle in the mortgage market. (5, emphasis removed)

I am not aware if JPMorgan’s concerns are broadly held, so it would important to hear others weigh in on this topic.

If the proposed rule is adopted, it is likely not to be implemented for a few years.  As a result, there is plenty of time to get the right balance between safety and soundness on the one hand and credit availability on the other. While the private-label sector has been a source of trouble in the past, particularly during the subprime boom, it is not in the public interest to put an end to it:  it has provided capital to the jumbo sector and provides much needed competition to Fannie, Freddie and Ginnie.

Monday’s Adjudication Roundup

SEC Update on Rating Agency Industry

The staff of the U.S. Securities and Exchange Commission has issued its Annual Report on Nationally Recognized Statistical Rating Organizations. The report documents some significant problems with the rating agency industry as it is currently structured. The report highlights competition, transparency and conflicts of interest as three important areas of concern.

Competition. There are some of the interesting insights to be culled from the report. It notes that “some of the smaller NRSROs [Nationally Recognized Statistical Rating Organizations] had built significant market share in the asset-backed securities rating category.” (16) That being said, the report also finds that despite “the notable progress made by smaller NRSROs in gaining market share in some of the ratings classes . . . , economic and regulatory barriers to entry continue to exist in the credit ratings industry, making it difficult for the smaller NRSROs to compete with the larger NRSROs.” (21)

Transparency. The report also notes that “there is a trend of NRSROs issuing unsolicited commentaries on solicited ratings issued by other NRSROs, which has increased the level of transparency within the credit ratings industry. The commentaries highlight differences in opinions and ratings criteria among rating agencies regarding certain structured finance transactions, concerning matters such as the sufficiency of the credit enhancement for the transactions. Such commentaries can serve to enhance investors’ understanding of the ratings criteria and differences in ratings approaches used by the different NRSROs.” (23) The report acknowledges that this is no cure-all for what ails the rating industry, it is a positive development.

Conflicts of Interest.Conflicts of interest have been central to the problems in the ratings industry, and were one of the factors that led to the subprime bubble and then bust of the 2000s.  The report notes that the “potential for conflicts of interest involving an NRSRO may continue to be particularly acute in structured finance products, where issuers are created and operated by a relatively concentrated group of sponsors, underwriters and managers, and rating fees are particularly lucrative.” (25) There is no easy solution to this problem and it is important to carefully study it on an ongoing basis.

The staff report is valuable because it offers an annual overview of structural changes in the ratings industry. This year’s report continues to highlight that the structure of the industry is far from ideal. As the business cycle heats up, it is important to keep an eye on this critical component of the financial system to ensure that rating agencies are not being driven by short term profits for themselves at the expense of long-term systemic stability for the rest of us.

Reiss on Investing In Real Estate Versus REITs

Investopedia quoted me in Investing In Real Estate Versus REITs. It reads in part,

The U.S. real estate market is finally starting to fire on most, if not all, cylinders, with investors’ enthusiasm gathering steam seemingly each passing month.

According to a study from the Urban Land Institute and PwC,expectations on profitability from the U.S. real estate sector are on the upside going forward. “In 2010, only 18% of respondents felt the prospects for profitability were at a good or better level,” the ULI reports. “This has improved steadily each year, with 68% of respondents now feeling that profitability will be at least good in 2014.”

The study reports that myriad investment demographics are pouring into the market, including foreign investors, institutional investors and private equity funds, as well as leveraged debt from insurance companies, mezzanine lenders, and issuers of commercial mortgage-backed securities.

“The anticipated interest in secondary markets is indicative of how the U.S. real estate recovery is expanding beyond the traditional investment hubs,” says Patrick L. Phillips, chief executive officer at the ULI. “Access to greater amounts of both debt and equity financing, combined with a sustained improvement in the underlying economic fundamentals, means that the opportunities and returns offered in smaller markets are potentially very appealing.”

A burgeoning profit avenue for investors is the real estate investment trust market, a market that is truly growing by leaps and bounds. Ernst & Young reports the REIT (Real Estate Investment Trust) market has grown from $300 billion in 2003 to $1 trillion by 2013, with growth expected to accelerate going forward.

By definition, an REIT is a corporation, trust or association that owns and, in most cases, operates income-producing real estate and/or real estate-related assets. Modeled after mutual funds, REITs pool the capital of numerous investors. This allows individual investors to earn a share of the income produced through commercial real estate ownership, without having to go out and buy or finance property or assets.

REITs differ from traditional real estate investing, primarily due to the fund-heavy strategic asset flow from REITs, versus the traditional free, more direct access flow from real estate investing (like becoming a landlord or buying stocks from homebuilding companies.) But both investments offer distinct advantages

*    *     *

some industry experts say the advantages of both investment classes cut much deeper than the descriptions above.

One big difference is that the market for REIT shares is much closer to the efficient market described by Nobel Prize winner Eugene Fama than the market for individual real estate parcels is, says David Reiss, a professor of law at Brooklyn Law School, and an expert on REITs.

“That means that the price of a REIT’s shares is more likely to contain all available information about the REIT,” he says.

“Because individual real estate parcels are sold in much smaller markets and because the cost of due diligence on a single property is not as cost-effective as it is on REIT shares, an investor has a better opportunity, at least in theory, to get a better return on his or her investment if he or she does the diligence him or herself.”

S&P: Future of Private-Label RMBS Uncertain

S&P has posted an Executive Comment, Lifted By Improving Economic Conditions, The U.S. Leads The Global Securitization Rebound–But Headwinds Remain. It concludes,

After surviving its first severe test, the market for securitization is slowly emerging from a sharp downturn, demonstrating its viability to efficiently distribute risk and expand credit availability. In this light, with many regulatory and economic uncertainties still present, we’re forecasting continuing slow growth going into next year.

The question is if, and when, securitization will register large issuance numbers again, contribute to the funding diversity and liquidity positions of banks, and improve the efficient allocation of resources to foster global economic growth.

For the U.S.–far and away the largest and most mature securitization market in the world–it’s clear, given the interconnectivity of the economy, the securitization market, and housing finance, that a continued economic recovery is necessary before the securitization market can fully recover. Economic growth will also encourage regulators, policymakers, and investors to work on the eventual return of private housing finance. But we believe that mortgage financing remains a concern for general credit availability and a continuing housing market recovery. The future of non-agency RMBS will remain in question so long as the GSEs dominate housing finance while enjoying exemptions from the qualified mortgage and risk-retention rules. (7)

I do not think that there is anything particularly new in this analysis, but it does highlight an important issue, one that I have touched on before. The gridlock on housing finance reform in DC has many effects. The GSEs are not on solid footing. The private-label industry does not know what part of the mortgage market it can operate in, whether with Qualified Mortgage (QM) or Non-QM products. And most importantly, homeowners are  not getting credit at a price that a stable and mature market would offer.

The conventional wisdom is that housing finance reform is off the table until after the mid-term elections or even until after the next presidential election. That is bad news for American households, the housing industry and the financial markets. And without some strong leadership in DC, it looks like the conventional will be right.

Cherryland, Very Strange

I looked at the Cherryland decision yesterday. Law360 ran a story (behind a paywall) about it today, quoting me and others.  To recap, the original Cherryland case appeared to unexpectedly open up many commercial borrowers in Michigan to personal liability. The most recent Cherryland opinion reversed this result as a result of Michigan’s newly passed Nonrecourse Mortgage Loan Act.

The story reads in part:

Cherryland and Schostak reaped the benefits of the NMLA. But many CMBS loan documents are similarly written, and other borrowers and guarantors “may not have the saving grace of a politically connected developer getting a law passed very rapidly,” said Brooklyn Law School professor David Reiss.

“If I was an existing borrower [or borrower’s counsel], I would look at this very carefully,” Reiss told Law360. “And new borrowers should try to negotiate new language that protects for this, saying that becoming insolvent is not something that is going to trigger the bad boy guarantee.”

After the initial decision was handed down last year, attorneys say they and their colleagues all took a hard look at the language in their clients’ nonrecourse loan documents to be sure that if they found themselves in a similar situation they would be protected without the cover of a law like Michigan’s NMLA or Ohio’s Legacy Trust Act, which followed shortly thereafter.

In fact, experts say they don’t believe many other states will likely follow suit with their own guarantor-protecting statutes. So even though Wells Fargo lost out in the Cherryland row, lenders will likely keep the case in mind when considering deals.

Although “most people believe that the [pre-NMLA] decision in Cherryland was not what was intended by virtue of the documents,” said Schulte Roth & Zabel LLP real estate partner Jeff Lenobel, the solvency covenant was drafted in a way that allowed it to be read as a bad boy trigger.

This has led many who represent borrowers and guarantors to seek more due diligence and spend more time making sure loan language is just right.

More than $1 trillion in CMBS loans are coming due over the next several years, and Lenobel said he wouldn’t be surprised to see the issue come up again in a different court.

While the Cherryland case is all but over, another similar suit — Gratiot Avenue Holdings LLC v. Chesterfield Development Co. LLC — is making its way through Michigan’s federal courts. And attorneys aren’t ruling out the possibility of an appeal to the U.S. Supreme Court to ultimately determine the responsibilities of a guarantor in a nonrecourse loan.

“It may be a very smart move by the lending industry to appeal to the Supreme Court,” Reiss said.