How to bring private investors back into mortgage market

April 23, 2014

The Senate Banking Committee is scheduled next week to debate a bill to reform Fannie Mae and Freddie Mac, the government-sponsored enterprises that have single-handedly propped up the market for residential mortgages since the housing crash of 2008. The bill, known as Johnson-Crapo for the lead senators on the banking committee, faces an uncertain future. But even if it manages to emerge from the committee and ultimately become law, Johnson-Crapo won’t, on its own, guarantee the continuation of the U.S. housing recovery because the bill doesn’t address private investment in mortgage-backed securities.

The housing market needs private capital to share risk and keep interest rates affordable, as Pimco CEO Douglas Hodge wrote in an April 11 op-ed in Barrons. Yet as we all know from years of MBS litigation, investors in pre-crash MBS trusts believe they were badly deceived by issuers, originators and trustees, who then compounded their sins by refusing to make good on buy-back provisions in MBS contracts.

Even worse, in the eyes of MBS investors, banks that issued the securities and serviced the underlying mortgage loans shifted some of the burden of their own $25 billion settlement with the U.S. government onto investors. A report earlier this month from the Housing Finance Policy Center concluded that 24 percent of the mortgages that banks modified as part of the $25 billion settlement were owned by investors in MBS trusts, not by the banks themselves. Those modifications could be to investors’ benefit, if they result in revenue to MBS trusts from homeowners who might otherwise default, but as the Housing Finance report notes, there’s no transparency for investors, so they don’t know whether the banks acted reasonably or not.

Mistrust of the sell side, in other words, runs deep among MBS investors. So how can the securitization industry – the mortgage originators, issuers, rating agencies, lawyers and accountants who are counting on the revival of the mortgage finance market – woo back private capital?

I’ve got some ideas, based on interviews with several folks in the MBS business who are thinking about that question, especially as Congress considers legislation to reform government-backed securitizations. Pimco’s Hodge laid out one big proposal in his Barrons piece, urging Congress to enact legislation to tag MBS trustees and mortgage servicers with fiduciary duties to investors in private-label MBS trusts. (The Trust Indenture Act of 1939 did just that for bond investors after the bond market collapsed in the Great Depression.) Hodge argued that such a “simple – but powerful – reform …. would go a long way in bringing back investors, such as Pimco clients, to a marketplace that is (or may soon be) desperately in need of private capital.” (You may recall that Georgetown law professor Adam Levitin has made similar arguments about the role of MBS trustees, including in the litigation over Bank of America’s $8.5 billion breach-of-contract settlement with Pimco and other Countrywide MBS investors.)

I’d certainly agree that going forward, the duties and responsibilities of MBS trustees have to be clearer. In the early days of the MBS post-crash put-back wars, trustees were at worst obstructionist and at best apologists for issuers. If investors are to begin once again to risk capital in mortgage-backed securities, they’ll need assurances that trustees will act in their interests, and not in the interests of the issuers who (at least in the old model) hire them and pay their bills.

Like Hodge, the Association of Mortgage Investors – a trade group for funds that invested in mortgage-backed securities – has been arguing for years, including in testimony last April before the House Financial Services Committee, that Congress must impose fiduciary duties on MBS trustees. I’m still not convinced that’s the best way to reassure investors; tagging trustees with liability as fiduciaries puts them on the hook for damages if a trust implodes, but it doesn’t prevent an issuer from stuffing an MBS trust with deficient loans to begin with. And will banks take on MBS trusteeships – a low-margin business – if they face the risk of fiduciary duties? For sure, they’d charge more, which would probably eat into investor returns.

Besides, obstructionist MBS trustees were only one of the problems with the old securitization model, which was as rotten as a worm-eaten apple. Investors need confidence that issuers are bundling mortage loans that meet contractual representations and warranties – and that if the underlying loans turn out to be materially deficient, originators will repurchase them. Assuring the quality of the securitized mortgages is a matter of loan-level transparency and due diligence, both of which were lacking in pre-crash deals. The MBS industry has to figure out a way to reassure investors about the quality of underlying loans. Perhaps those checks will be conducted by firms that developed an expertise in re-underwriting mortgages through MBS litigation. Perhaps banks in the trustee business will develop separate due diligence divisions. The extra time and cost will hit either MBS buyers or sellers, but they’ll have to find a workable balance between risks and returns.

The contracts that govern MBS deals, usually known as pooling and servicing agreements, will also have to be rewritten to bring private investors back. Specifically, contract language on representations and warranties about the underlying loans and the procedures for investors to obtain relief for deficient loans have to be revised to eliminate some of the obstacles for investors. MBS noteholders lost untold billions of dollars in the housing collapse because they couldn’t meet threshold procedural requirements to sue issuers for breaching pooling and servicing agreements before the statute of limitations ran out. They’re not going to let that happen again.

There’s division in the securitization industry about the most effective way to recalibrate due diligence, PSAs and communications between investors, trustees and mortgage servicers. A year-old organization called the Structured Finance Industry Group (born out of a 2013 corporate governance crisis at the American Securitization Forum ) believes that discussions between stakeholders will produce reforms with a broad base of support. Last fall, SFIG started RMBS 3.0, an initiative to find consensus among MBS players with varying interests. (Its 244 members include representatives from all sectors of the securitization industry.) According to SFIG’s website, RMBS 3.0 subcommittees are looking at loan-level disclosures; representations, warranties and put-back provisions; and reform of Fannie Mae and Freddie Mac. The group has specifically said in Senate testimony that it does not want Congress to prescribe contract language for private-label MBS.

The investor-only AMI, meanwhile, is pushing for legislation rather than negotiation. SFIG’s RMBS 3.0 and its predecessor project at the American Securitization Forum, Project Restart, “have not been fruitful so far,” said AMI executive director Chris Katopis. “We think there needs to be a mandate from Washington to restart private label securities.”

So far, Congress hasn’t been at all eager to take on the burden of reviving the private market. Here’s hoping the Senate Banking Committee at least reconsiders that reluctance next week when it takes up Johnson-Crapo.

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