Many people are looking to the far horizon, hoping to see the return of the private-label market. They may be waiting for some time. This week, MortgageOrb speaks with Richard Zahm, portfolio manager with Darien, Conn.-based Second Angel Fund I, regarding the state of securitization and residential mortgage-backed securities (RMBS).
Q: How would you categorize the state of the RMBS sector?
Zahm: The term ‘moribund’ has been used a lot to describe RMBS, but it's actually not near death. It's just taken a giant step back in time, gearing down to volumes it saw around 1995. It's not on the verge of extinction.
RMBS is in the early stages of correction and improvement – analysis and policy creation. We're recognizing where it was strong, what it provided and also where it failed. These lessons are being applied to create a more secure, robust system that will better meet the needs of investors, borrowers and the market as a whole.
Reinvigorating securitization is central to getting credit growth again, but it's going to look enormously different than it did a few years ago.
Q: What will it take for the private-label market to return? Is federal intervention needed, or can it rise on its own?
Zahm: In agriculture, vineyards and orchards are periodically ‘pushed.’ In response to market conditions like oversupply – too much wine being produced – or overwhelming competition or blight, growers simply rip out the vines and tear up the trees they've carefully nurtured over years. They then plant again, with new combinations of grapes and fruit, using the same land and irrigation systems – production elements that still apply to what they're doing.
Factors leading up to a decision to push can be brutal, and recovery to previous levels can take years. But it's a natural process – one that's spanned the ages.
This is what's happening across RMBS – and it will likely be the same with commercial mortgage-backed securities. The fundamental flaws of the system are being discovered and rooted out, and the new fruit will, it's hoped, be free of the elements that have caused such severe pain and indigestion.
These include varying origination standards, limited recourse, risk transfer, prepayment risk and subordinated tranches that can't absorb the entire credit risk exposure, rating agency failures to accurately project or describe risk, a complex securitization structure, and the lack of transparency and weak disclosure requirements.
So the secondary markets will have to fulfill lender needs, without ramping up leverage of increasing product complexity. It's not going to be like the jet-fuel years of 2005-2007. Instead, it's going to be a time of regaining the solid footing that has been the foundation of home finance. We're likely to see increased capital requirements, tighter accounting standards, bigger and longer originator retention requirements, and greater disclosure.
Q: So what will ‘RMBS 2.0’ look like?
Zahm: RMBS 2.0 will not likely generate the same level of fees. And, in retrospect, a good amount of structured credit products could be seen as having existed largely to generate fee income. Products like collateralized debt obligations squared are not likely to return.
We've also got a long way to go. Although subprime loans have largely cleared through foreclosures, vulnerable option adjustable-rate mortgages made in 2004-2007 are scheduled to re-adjust over the coming two years, peaking in late 2011. As many as 20% of these loans are already be behind on payments. This would delay the clearing function.
Q: When the private-label market is re-established, how it will look in comparison to the pre-crisis period?
Zahm: The market will likely look a lot like it did in the late 1990s, with a European-overlay. By this I mean that homeowners will adopt the view Europeans have traditionally held when it comes to real estate: A house is a home, only marginally an investment, and definitely not an ATM or a retirement account. This more conservative, or traditional, viewpoint will be mirrored by the way homes are financed, and European-style covered bonds will play a role. Home loans will look like they have in the past, and alternative loan products will carry increased scrutiny.
Securitization, in some form will remain a central underpinning of finance, but it will carry a new emphasis on originators' retaining skin in the game. The trouble here is that requirements have to be effective while, at the same time, not so onerous as to slow market recovery – a difficult balancing act.
Q: Covered bonds were talked up prior to the recession. Do you believe this market can finally take root after the crisis is behind us?
Zahm: I believe that covered bonds are a nearly perfect solution to our situation. They'll be a key component of RMBS 2.0. They've weathered the storm fairly well and contain a key element securitization lacks: a double layer of protection for investors, with the asset being backstopped by the issuer.
They're not a securitization product in the purest sense, because lenders retain the default risk, but they provide what looks like gentle medicine that works. In addition to accountability, they provide excellent mechanisms for transparency. The biggest stumbling blocks at the moment are legislative issues and a lack of understanding in the U.S. – but both of these can change quickly.
One example: Last summer's Federal Deposit Insurance Corp. oversight and policy statement provides greater certainty for holders of covered bonds as to damages and rights. The trouble is, covered bonds don't provide a good option for private label because they require a capital base to retain loans on balance sheets. This works against smaller market participants. They also don't provide the leverage seen in the past. But in light of the new age of deleveraging, this isn't altogether a bad thing.
Q: In a post-crisis environment, where will the government-sponsored enterprises (GSEs) fit in?
Zahm: I don't see a huge impetus to push away from GSEs in the future. The transfer of risk from the private sector to public balance sheets has created a tectonic shift, ranging from allegiances within the industry to the way we view the role of government.
Virtually all mortgage originators work indirectly for GSEs now in some form, and increased capital and reporting requirements being required will further raise barriers to entry, while closely aligning the interests of both. There's unlikely to be a movement to bite the hand that feeds the business and keeps the doors open from that end. Banks are in no position to complain about inefficiencies or to claim that they could handle issues any better.
Plus, it's going to take a long time for them to wean themselves off of government funding support, especially as they're still under deleveraging pressure. Government seldom motivates itself to cede control once obtained. And in the larger context, there also seems to be a growing acceptance of the role of government across different industries.
Banking, healthcare and insurance, energy, mortgages – the sense of the moment is that private regulation and controls haven't provided the results or the answers that we need, and in fact, they created the mess that we're now in.
Deleveraging will continue for some time, and it's going to take time to get new policies in place and engaged. The policies will have to grapple with conflicting needs: ensuring sufficient credit growth, maintaining exit strategies, all while maintaining a balance between regulation and market forces.
The challenge is going to be how to foster, and not suffocate innovation and growth – and this is rarely government's strength.
But as long as the GSEs are able to at least show some marginal advantages over the older system – not difficult under the circumstances – and their inefficiencies and inequities are not shown to be too egregious, we're likely to see them continue to dominate for some time to come.