Reviving Private Label MBS: How and Why?

In an earlier article we summarized the first part of a report by Urban Institute's Housing Finance Policy Center, Senior Fellow Jim Parrott about the failure of private label securitization (PLS) to recover after the housing crisis.  He cites the lack of certainty in the system on the part of investors and a standardized structure that would ally the lack of trust as well as several economic conditions that weigh against a PLS return, including the lack of incentives and capital to repair the system. He says we are left with a Catch-22: "only with a strong market is it worth spending the time and money to take the steps necessary to create a strong market.

Having set out the problem, Parrott suggests three steps to gradually build infrastructure needed for the PLS market to take off again.   

First would be establishing what he calls a "self-regulatory organization" (SRO), a baseline foundation providing enough investor confidence to do plain vanilla deals initially and on which to build more complex structures over time. While it is not in any one company's interest to solve all the existing problems alone, contributing, along with all key market participants, the resources needed, would be.

A baseline structure providing the certainty for simple securitizations will help end the Catch-22, creating a market worth the expenditure of resources and making it easier to move to move gradually across the differences between simple and complex deals.

Parrott points to work already underway by the Structured Finance Industry Group's (SFIG's) RMBS Task Force.  It has notified the Treasury it hopes to:

• Promote standardization where possible, building on best practices and procedures,
• Clarify differences in alternative standards to improve transparency across RMBS transactions
• Develop solutions to the challenges impeding the emergence of a strong post-crisis RMBS market.
• Draft or endorse model contractual provisions where appropriate to reflect the foregoing.

This effort is exactly what is needed now, he says, but it must move from a good concept to market adoption.

Treasury recently attempted a benchmark deal along with some of the market's most important investors.  This was helpful, Parrott says, but not enough without a broad buy-in and that is unlikely for the reasons he mentioned.  In contrast, an SRO would bring the industry together more broadly with the resources and collective authority needed to become an industry standard. 

A baseline PLS deal would have to align the incentives of the key parties.  If it does, it will reduce the risk that misaligned incentives and conflicting interests will drive some parties to take on excessive credit risk, a repeat of the run-up to the crisis.  If it doesn't it won't get the market off the ground.

Regulatory relief is also needed for a successful SRO structure. This is not only in the interest of the investor and the broader market, for if done right, it should also benefit regulators.  Capital relief or exemptions from Dodd-Frank risk retention would improve the economics enough to attract more capital, helping get the market off the ground more quickly, and in a way that's both more standardized and more sustainable.

Parrott's third and final step would be to include these standards in the common securitization platform (CSP) that's being built out by Fannie Mae and Freddie Mac, expanding its back-office infrastructure for the securitization of PLS as well as agency loans.  This would embed the terms of pooling and servicing and the standardization offered by the SRO market wide, improving the long-term liquidity of the PLS market and making the securitization system more efficient. The only meaningful differences between agency and non-agency securitization would be the government guarantee and whatever more detailed provisions PLS investors want to take on specific kinds of credit risk. In addition, by allowing a wide range of originators to securitize their production through either the PLS channel or the agency channel, it would increase its liquidity and benefits still further. 

Parrott says these steps should be thought of along a continuum.  By replacing a system that is so heterogeneous it couldn't work in any scalable way with one bringing some initial uniformity, investors and issuers would gain enough confidence in a single system to begin building a broad PLS market once again. 

However, how far should one take the effort?  It is enough to get a sufficient baseline structure in place to get the PLS market back on its feet, then allowing it to develop in whatever ways a purely private market will, or should there be a push for still greater standardization to be more liquid, stable, and accessible to a wider range of lenders? These questions cut to the heart of housing finance reform, raising issues of how the secondary market is managed and by whom.  Where should there be competition and what are the market's objectives?

Parrott believes the effort should push all of the core secondary market infrastructure into a single utility, maximizing liquidity, efficiency, and systemic stability, and making it easier to serve the policy ends competing in the housing finance system. It says however, that is a discussion for another day.  No there is merely a need to agree that some standardization is necessary to get the PLS market moving again.  

One cannot avoid thinking, however, about how the new political landscape will play into this.  He sees the new Republican control of Washington as presenting both some risk and some opportunity.

On the risk side, while President-elect Trump and Republican leadership's intent to unwind much of Dodd Frank is clear, we don't know what it might mean in practice.  Its structure has come to define the rules of the road on lending, risk management, and any number of core components of the housing finance system. Upending it dramatically could lead to the very sort of uncertainty that virtually paralyzed the PLS market affecting a much broader segment of the housing finance system.  This would greatly postpone the time before there is a steady enough housing finance system to build out a vibrant PLS market. 

As to opportunity, most Republican lawmakers believe more private capital must be brought back into the system, particularly what is needed to revive the PLS market.  Some believe that government must be pulled out of the market, which Parrott views as a dangerous mistake.  Be he sees enough members of Congress will move to revive the market if provided some clear direction about a subject "that is utterly confounding to most lawmakers."

So where to begin?  

• The Structured Finance Industry Group (SFIG) must continue to develop industry standards and, along with other industry organizations to push for adoption of an SRO with the authority to adopt, implement, and enforce these standards.
• Stakeholders need to make the case to policymakers that some form of regulatory relief is warranted for deals that comply with the SRO's standards.
• Similarly, stakeholders must help Congress understand that these standards should be part of a platform that is finally open to the broader market.

Would the result be worth the effort?  There is already a market for buying and selling credit risk through the GSEs' risk transfers and a relatively clear structure in which investors have confidence.  Even if it doesn't offer a sustainable mechanism for sharing credit risk through the economic cycle, surely it would be a good deal easier to build on this rather than to revive the PLS market. Do we even need one?

Parrott says there is a real difference between a market where private actors take almost all the risk, as they would in the agency market, and one in which they take all of it, as they do in the PLS market. In the former some risk remains with the taxpayer and we see neither competition nor any of the benefits that flow from it. 

A significant segment of the market needs a government backstop to ensure broad access to long-term, fixed-rate lending.  But putting the taxpayer on the hook means measures to constrain risk in that channel and an obligation to strike a conservative balance between flexibility, dynamism, and innovation on the one hand, and protecting the taxpayer on the other.  This leads, or should lead, to a more cautious lending environment within the agency channel. 

The market would be well served with a supplement in which the taxpayer is largely removed from the equation, thus allowing more creative ways to connect investors and borrower.  That in turn should lead to more liquidity and more lending. And, if that that segment of the market is well-regulated, it should do all of this without increasing risk to the taxpayer.

In Parrott 's view, a healthy and vital housing finance system must have a secondary market outside the government's footprint and that is why life must be breathed back into the PLS market.  He acknowledges that his view may be falling out of favor, that many increasingly view the PLS market as less important than once thought.  He cautions that the longer the PLS market sleeps however, the less help policymakers and other stakeholders may provide toward waking it. There is still a window of opportunity to pull off the rescue he has suggested, but it won't be open forever.