Seven years after the financial crisis the private label securities (PLS) market is "barely clinging to life", a Treasury official said on Wednesday. Michael Stegman, counselor to the Treasury secretary for housing finance said the earlier structural deficiencies in that market shattered the trust of market participants. Concrete reforms are clearly needed to rebuild confidence so private capital will return to the housing markets.
Stegman, speaking to attendees at the 1st Annual Private Label RMBS Reform Symposium sponsored by Information Management Network and the Structured Finance Industry Group (SFIG), said the Obama Administration has a deep policy interest such a return and his department is well positioned to assist in that regard.
In June, Treasury Secretary Jack Lew requested public comment on an initiative to facilitate development of market standards and practices and the comments from the mix of industry groups that responded highlighted many if the key impediments - like conflicts of interest and inadequate enforcement mechanisms -and proposed a range of solutions. A series of roundtables and focused conversations with institutional investors, issuers, trustees, due diligence firms, and service providers has aided Treasury in looking more deeply as these issues.
While stakeholders recognized the need for reforms, there was little consensus about the form they should take or how they should be implemented or enforced but there was a strong conviction that the market based problems of PLS should have a market-based solution. One proposal is for a benchmark transaction; one which would reflect an agreement on terms between issuers and a subset of highly influential institutional investors who have been sitting on the sidelines since the market collapsed.
There are at least three reasons advancing a benchmark transaction. First, both issuers and investors appear reluctant to allocate resources to a thinly traded market. The benchmark transaction would involve collateral from a number of sponsors and would be much larger, ideally over a billion dollars of unpaid principal balance, than what is coming to market today. This would result in more favorable allocations at issuance, improved liquidity in secondary trading, and ultimately helping to make a case for infrastructure investment by issuers and investors.
Second, such a collaborative effort would demonstrate the structural reforms necessary to attract those senior bond investors who said they would never return to the market without sufficient protections, setting a de facto industry standard and giving subsequent transactions a pattern to follow.
Third, unlike regulation or legislation, a benchmark transaction would leave room for innovation and evolution while grounding the market in a simple, transparent standard. This could catalyze issuance and liquidity in the here and now.
Stegman sees such a transaction establishing a model set of documents and terms, providing issuers with reduced operational and legal costs while retaining the ability to deviate from the standard by blacklining term differences. Investors would be able to conduct due diligence more efficiently.
The risk-reward profiles of sectors such as agency mortgage-backed securities (MBS) are more attractive to investors today than AAA PLS even though the latter offers wider spreads. Without needed reforms investors simply do not feel adequately compensated for the risk. A benchmark transaction with improved investor protections, Stegman said, would reverse this perception even though those protections come with costs and such a transaction will not happen unless the economics work.
Even if investors and issuers agree to sit down and work together to develop a market standard it might now be easy to reconcile their often conflicting interests. The small deals that currently come to market differ markedly despite the homogeneity and singular quality of the collateral largely because of a lack of willingness on the part of some issuers to concede to a common standard. They are "structuring deals to the current size of the market rather than adopting the reforms required to expand the investor base," Stegman said.
He reminded stakeholders that market conditions will not always favor the retention of whole loans on balance sheet. The curve has flattened by over 80 basis points since the beginning of the year, and if this continues banks will find it increasingly unattractive to grow their portfolio investments in mortgage loans.
Regulators and policymakers have little direct control over the shape of the yield curve but they do continue to play a significant role in housing finance and thus the scope of the PLS market. It is often suggested by stakeholders that government lower conforming loan limits, thus reducing the market share of the government sponsored enterprises which would catalyze the PLS market by increasing supply and improving liquidity. .
But Stegman said this is contrary to the Administration's other goal of providing access to mortgage credit to all qualified borrowers. Prematurely reducing loan limits without first putting reforms in place to attract private capital could unbalance the market leading to lower credit access and higher borrower costs. This would hurt the health of the housing market
Reducing the loan limits makes sense from a liquidity standpoint Steadman said. But his discussions with institutional investors have convinced him that liquidity alone is not a sufficient condition for their broad-scale return to the non-agency market. A benchmark transaction would offer concrete evidence of the private sectors ability to provide mortgage credit at competitive rates and would support the argument that reducing the government's footprint can be achieved without undesirable results for consumers.
The significant structural flaws brought to light by the financial crisis included misaligned incentives, ineffective enforcement mechanisms, weak or no oversight of transaction parties, and lack of transparency and without remedies to these the PLS market will not return at scale. A "Green Paper" published earlier this week by SFIG sets out a second set of emerging consensus industry standards, a so-called RMBS 3.0.
RMBS 3.0 focuses on best practices for representations and warranties, repurchase governance, and other enforcement mechanisms; due diligence, disclosure and data issues; and roles and responsibilities of transaction parties and their communications with investors.
Stegman said standards cannot work in isolation but a benchmark transaction could serve as a "road test" for the consensus terms achieved to date. "While a benchmark transaction would help catalyze the market today, the ongoing RMBS 3.0 effort can form the basis for future oversight to ensure that its still-evolving standards are not watered down over time."
Stegman used the Securities and Exchange Commission's (SEC's) revisions to Regulation AB as another example of the utility of a benchmark transaction. First, it could help expand the Regulation, which only applies to publicly registered offerings by making the rule's critical reforms a best practice for 144A private placement offerings which is where most PLS transactions are occurring today.
Regulation AB II also seeks to address repurchase obligations by requiring for shelf registration an independent third party review of loans for compliance with representations and warranties upon the occurrence of a two-pronged trigger, including a pool-level delinquency threshold and an investor vote. Stegman said he agrees with RMBS 3.0 which sets out loan-level in addition to pool-level delinquency triggers. He also suggests the reviewer recommend to the trustee if the repurchase obligation should be enforced based on the review and that deal documents direct the trustee to enforce the repurchase obligation on the reviewer's recommendation - without need for an investor vote.
The benchmark transaction can also establish a market-wide standard for investor communication, not just as a requirement for shelf registration. There should be a more seamless ways of facilitating investor communication as part of the investment process, perhaps leveraging market-standard data platforms or online bulletin boards like those that have become customary in CMBS.
Stegman said the common theme among these structural enhancements is the need to empower transaction parties through prescription rather than the imposition of ambiguous mandates. This should come through clarity of terms and contracts.
Prominent investors have been insisting that a trustee fiduciary duty is the only way of accounting for all of the failures of the legacy model. Stegman says he does not necessarily believe in imposing such a duty but that the Trustee is the wrong party in which to vest it. An independent reviewer could be the cornerstone of a reformed set of investor protections - tasked with reviewing loans for breaches of representations and warranties, recommending appropriate remedies, and performing servicer oversight and cash flow reconciliation. The Trustee's core competence is administrative and strong contracts clearly defining these functions should insure investor satisfaction.
The role and compensation of a reviewer should be a serious consideration in order to properly align incentives. Well-defined responsibilities can protect investors from exposure to soaring expenses, ensure consistency across reviews, and assure reviewers they are protected by bounded obligations. Again a benchmark transaction could define the details such as the triggers that would activate a breach or a servicer review. Well-defined duties coupled with an obligation to perform those duties in the interest of the trust would likely be more effective in protecting investor interests than a vague mandate alone.
The agency market is recent years provides ample evidence of what happens when responsibilities and obligations are not clearly defined. Because the obligations to purchase defective loans have lacked certainty originators have restricted lending to the safest borrowers. When the rules are not clear market participants respond by exercising extreme caution or withdrawing completely, both of which would have negative implications for the private label RMBS market.
Stegman said the next step is to bring together issuers, institutional investors, and service providers to begin work on an actual term sheet for a benchmark transaction. This can put into action the industry consensus that is being reached as part of RMBS 3.0. He encouraged his audience to remain actively engaged and to communicate with Treasury how a benchmark transaction could be best structured to meet their needs.
