Never has a housing boom ended with such a spectacular implosion. Fuelled by low interest rates, an absence of due diligence and zany mortgage products that in retrospect beggar belief, the bursting of the US and UK housing bubbles crippled the mortgage markets and destabilized the global economy. Now politicians and industry representatives are working together to rebuild these vital markets.
There is a lot to be done and the overarching theme emerging from early discussions is: back to basics. Gone are the days of 125% loans, tempting customers with free cars and accepting fake income documentation from unscrupulous websites such as fakepaystubs.com. At least it is hoped that this kind of excess and fraud will be curbed and the business of making housing loans to those truly able to afford them will return.
It will take time. The US and the UK take different approaches to mortgage financing. The most important difference is that the former used government-sponsored entities (GSEs) such as Fannie Mae and Freddie Mac to handle the prepayment risk long-term fixed-rate mortgage products generate. Thanks to the sub-prime crisis, both countries now face the same fundamental problems that have dramatically curtailed mortgage lending and damaged the wider economy.
The cores of the two countries’ financial systems are barely functioning and bank bail-outs have so far done little to unfreeze the credit markets. Investor confidence has been shattered, making the public sale of mortgage-backed bonds impossible. The outlook for primary market issuance, apart from those bonds structured and sold to central banks for repo, is also weighed down by the amount of paper sloshing around in the secondary market. Until this overhang is dealt with, the prospects for the primary market are bleak.
The postmortem on the sub-prime crisis is well under way. Although no firm plans have been established to reform the mortgage markets, experts are focused on a back-to-basics approach. Broadly it will include more transparency and a better alignment of risks throughout a mortgage’s lifecycle, from origination through to financing. A bolstering of the fundamentals of mortgage finance should gradually restore investor confidence to the point that a healthy and sustainable mortgage finance sector will function once again in the important US and UK markets.
The bigger they come...
At $12 trillion, the US mortgage market is far and away the world’s largest. Built on the GSE concept, as of 2008 half the market was either owned or guaranteed by such institutions as Fannie Mae, Freddie Mac or a Federal Home Loan Bank (FHLB). In 2003, a record $4 trillion in mortgages were originated, most of which were refinancings. That kind of volume wasn’t sustainable but demand from investment banks’ structured credit desks kept the party going until early 2007.
"The US housing boom would have petered out in 2004 without the substantial increase in sub-prime lending," says Michael Lea at Cardiff Consulting in San Diego, California, a former chief economist for Countrywide Financial. "It extended the bubble for three years and accelerated the pace. Most of the problems are in loans made in 2004 through 2007 where 100% loans were made to non-creditworthy borrowers on the assumption that prices would continue to go up. Now we are suffering the consequences."
It didn’t take long for sub-prime loans to come under pressure and the domino effect to kick in. By late 2008, Fannie and Freddie were both placed into conservatorship and many of the largest players in sub-prime mortgages such as Lehman Brothers, Countrywide and IndyMac were out of business. While the US government continues to prop up ailing Fannie and Freddie, policymakers and industry representatives such as the Mortgage Bankers Association (MBA) are studying ways of reinvigorating the barely functioning mortgage markets.
At the forefront of concern is what to do with the GSEs and how to go about jump-starting the private-label securitization market. In the immediate aftermath of Fannie and Freddie’s collapse in September MBA leapt into action and started to draft a framework for recovery.
"We wanted to expand the debate beyond just fixing Fannie and Freddie into a more global consideration of how the markets should look," says John Courson, president and chief executive of Washington, DC-based MBA.
MBA convened a secondary market summit, which included its membership, representatives from the Bush and incoming Obama administrations as well as Congress and think-tanks focused on the mortgage market. The outcome has been the establishment of a council of industry leaders and the publication of a white paper entitled Key Considerations for the Future of the Secondary Mortgage Market and the Government-Sponsored Entities (see mbaa.org). This paper is meant to be a foundation for discussion that will take place and lays out the ideas that should be considered. It includes the summaries of various funding options available as well as suggestions for dealing with GSEs.
The future of the GSEs is coming up for much discussion and the early thinking is that there will be a role for them but it probably won’t be as a bulk purchaser of mortgage loans.
"As long as we have these 30-year fixed-rate mortgages as a prominent feature of housing finance, we’re going to have a Fannie Mae or Freddie Mac in some form," says Cardiff’s Lea.
The new GSE or GSEs will likely play the role of a government guarantor or a risk insurer of securities rather than a buyer and holder of securities. It would also provide a liquidity backstop for the broader mortgage market.
"GSEs will still have an important role," says MBA’s Courson. "One is to provide funding and hold securities or loans for products that do not have a viable secondary market, like affordable housing products. Second will be as a liquidity backstop when the private market is not working properly."
"[The GSEs] will be either competing with or superseded by Ginnie Mae," says Lea. "You put a guarantee on a pool of mortgages and then sell it into the market. You won’t have the big portfolio build-ups that were the source of systemic risk for Fannie Mae and Freddie Mac. They’ll have this guarantee function and then the question is, do you need Fannie Mae and Freddie Mac if you have Ginnie?"
Since their founding in 1938 and 1970, respectively, Fannie and Freddie have played a pivotal role in the US mortgage markets. As the sub-prime boom blossomed, the GSEs’ market shares decreased as private-label securitization began to dominate. In 2003/04, Fannie and Freddie had a 55% to 60% market share. By 2006 that had dropped to mid-30% levels as private market securitization, bolstered by toxic mortgages, flourished.
The originate-to-distribute model of mortgage finance has been blamed for inflating the housing bubble. It was simple. Demand for mortgage bonds meant issuers were willing to buy up mortgages, no matter the quality, to securitize and sell on to the investors clamouring for paper. Mortgage brokers and non-bank lenders were happy to supply more loans to meet this demand. All they had to do was throw their lending criteria out the window and write more loans.
It’s easy to see why the originate-to-distribute model and private label securitization has come under fire from politicians and regulators. Still, no one believes private label securitization is dead. It will be back and playing a role in mortgage finance, but not on the scale seen in 2006/07.
"Structured finance will return," says Lea. "It will separate out the benefits of structured finance from some of the excesses of the originate-to-distribute model. There is a valid economic function being performed by structured finance, not only from the standpoint of financing non-bank competitors but also from the sufficient allocation of risk. It should be allowed to come back in a modest, transparent and regulated way."
| Non-agency volumes spiked until mid-2007... |
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| ...And across product categories |
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| Source: Barclays Capital |
Crucial to luring investors back to the private securitization market will be the better alignment of risk throughout the mortgage finance process. Those financial institutions originating mortgages must become more transparent, consistent and prudent in their underwriting policies. And those at the other end of the chain, selling bonds backed by mortgages, must be seen to share some of the risk this paper contains instead of passing it all on to investors. "We need something in the private market to force originators to be more cautious," says Priya Shah, a mortgage analyst at Barclays Capital in New York. "That could be requiring the retention of the equity piece of a transaction. That could also run the risk of choking off the private lender market. We need to strike a balance."
Whether risk sharing and the better alignment of interests – from mortgage originator, to MBS issuer, to investor – is something that will come through regulation or through industry agreement is unclear. The American Securitization Forum has already started a few initiatives aimed at bringing more transparency to the market as well as improving deal disclosure and documentation.
Tom Deutsch, ASF’s deputy executive director, is leading Project Restart, which is coordinating these initiatives to get the US securitization market back on track. "I don’t think any of us believe or even want the level of origination we saw in 2006 or 2005," he says. "The ABS/MBS markets won’t return to those levels. They might return to 2001 or 2002 levels where you have significant issuance in the trillions of dollars but much lower than 05/06."
At present, Project Restart’s work is focused on improving and enlarging the data disclosure package an investor gets before buying a security. It is also working on a reporting package, which is all the data a servicer would give an investor on a monthly basis on outstanding loans. A lot of this work revolves around expanding the amount of data investors receive and standardizing definitions for data so that investors receive consistent information.
The move to standardize disclosure is a direct result of the sub-prime crisis. Mortgage originators’ definitions relating to the documentation of income varied greatly. Until this ASF initiative got under way there was no standard definition of what a full documentation loan was, for example. What one considered to be full documentation would be a low- or no-doc loan to another. Project Restart is seeking to get all originators on the same page with standard definitions.
"By creating the standardization you would eliminate the ability for an issuer to arbitrage those definitions," says Deutsch. "Some of the issuers that are no longer with us originated loans they said were full doc but were really a partial doc or a no doc to other type of issuers. We can eliminate those and create transparency of what they did. Ultimately investors will price based on that transparency."
Deutsch fully expects the ASF’s new standards for documentation and disclosure to be accepted and implemented by the market. It aims to launch the standards by the end of the year, by which time the international securitization markets might be coming out of suspended animation.
"I’d be very surprised if any of the ratings agencies wouldn’t require this information on an ongoing basis," he says. "If an issuer doesn’t present certain data on new issuance the ratings agencies wouldn’t rate the transactions or would impair the rating on the transaction because of the availability of the data."
The UK mortgage market, although much smaller than that in the US, is among the world’s largest and has been crippled by the credit crunch. Worth approximately £1.2 trillion ($1.7 trillion), the UK market has witnessed a steep drop-off in new mortgage approvals. According to the Council for Mortgage Lenders (CML), a modest 516,000 house purchase loans were made in 2008, down 49% on 2007 and the lowest level of activity since 1974.
The reckoning for the UK came in September 2007 when Northern Rock, a top-five mortgage player, failed to raise money in the public markets and turned to the Bank of England as a lender of last resort. The bank was taken into public ownership early in 2008 but the damage had been done. Since Northern Rock’s failure to raise funds, the UK securitization market has been shut and mortgage funding, as demonstrated by the CML data, has declined every month since. In the process, many of the non-bank lenders stopped lending and put their portfolios into run-off and the largest mortgage players, such as HBOS, Lloyds (now Lloyds Banking Group) and Royal Bank of Scotland, are on government-funded life support. At the end of February, though, Northern Rock was authorized to begin lending again, with £14 billion allocated for the next two years.
The UK mortgage bubble was financed in part by the same investor demand witnessed in the US and the growth of the originate-to-distribute model. It was helped along by Britons’ new found enthusiasm for credit as well as the government’s desire to democratize credit and get people into their own homes.
The response to the credit crisis has been led largely by HM Treasury and the Bank of England. The focus has been on providing liquidity to the markets and coaxing banks into lending again. Thanks to the extent of UK banks’ deep liquidity and capital problems, the billions of pounds the government has pumped into the market have served to keep the banks afloat but failed to get them lending. There are simply too many problems at the banks for mortgage finance to be a priority.
| "Securitization in general still has a place" Rob Thomas |
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"The interesting question is where we go from this de facto nationalization of wholesale funding where investors have disappeared, to a world where you can get back to private wholesale funding," says Rob Thomas, senior policy adviser at CML in London. Banks used the Bank of England’s Special Lending Scheme (SLS) and are now poised to use the Asset Purchase Facility whereby the central bank will buy commercial paper. Specific to the mortgage market, plans outlined in the Crosby report for the government to guarantee mortgage bonds might yet come to fruition.
The UK government has always resisted the idea of creating a treasury function similar to the US GSEs, and the MBS guarantee scheme could lead to the creation of a UK version of Fannie or Freddie. Banks could get used to the drip-feed of government funding or guarantees reducing the incentive to go out to investors with public issuance.
"If we get temporary government guarantees of mortgage-backed securities, it is quite possible lenders would come to see the benefits of making these a permanent part of the market," says Thomas. "You could even imagine a GSE coming about by accident. Once these structures are in place they could become the default option that no one wants to unwind."
CML has its own ideas on how to restart the UK MBS market. Its scheme wasn’t taken up but Thomas believes it might still be worth revisiting. Last year, CML proposed a repo facility with a twist. There would be public issuance where securities were sold to a real investor and then that investor has the right to repo that security to the Bank of England at a favourable repo rate.
"It is a way of creating that extra liquidity and extra gearing among investors which should translate into higher private-sector demand for RMBS," explains Thomas. "They wouldn’t offer it to institutions that were already leveraged. It would be an exercise to promote the entry into the market of cash-rich investors like pension funds."
Even though the government has been reluctant to step into the business of mortgage finance previously, regulators’ despair over the originate-to-distribute model and its use of securitization could mean that the MBS guarantee scheme becomes a permanent feature. The government doesn’t want to curtail mortgage lending but without securitization available as a funding tool it will be difficult to get people into their own homes. Old-fashioned deposit-based funding just won’t be enough to meet demand.
"Securitization will return at some point because there isn’t enough capacity," says Ron Thompson, head of securitization research at RBS. "Securitization came about because there wasn’t enough capacity in deposit growth. If we go back to the model where banks can only grow as fast as deposits then the banking industry winds up unable to grow faster than GDP."
Thompson points out that for the worst-performing UK prime RMBS master trust Mound from Bank of Scotland annualized losses are around 12 basis points. Mound throws off 93bp in excess spread so the loss coverage is about eight times. In other words, losses have to go up eight times for the transaction to be impaired.
Even though UK regulators seek to blame securitization for the credit crunch, the Bank of England’s SLS may have shown them the benefits of structured finance. The Bank has been responsible for the biggest ever UK boom in MBS. They have, through their own facilities, recognized the benefits of creating higher-rated securities.
"It demonstrates that securitization in general still has a place," says Thomas.