Pondering the future of private-label mortgage-backed securities

The market for Securities and Exchange Commission registered mortgage-backed securities has been moribund since 2008. In an effort to revive this market, SEC Chairman Jay Clayton has asked for public comment on ways to bring this back to life.

"In light of the absence of SEC-registered RMBS offerings, I have asked SEC staff to review our RMBS asset-level disclosure requirements with an eye toward facilitating SEC-registered offerings," said Clayton.

In 2014 the SEC adopted significant revisions to its regulations for registered offerings of certain asset classes, including RMBS. These new RMBS rules require issuers to disclose a wide array of data on each and every residential mortgage loan in the underlying pool, both at the time of an offering and on an ongoing basis.

Since then, the market for registered RMBS deals has died. No SEC registered offerings have taken place. Fannie Mae and Freddie Mac, on the other hand, have issued an aggregate of approximately $4.5 trillion in face amount of RMBS under their statutory exemption from SEC registration. As a result, a big focus on the request for input by the SEC is the scope of data disclosure required for a registered RMBS deal.

"The financial industry has done a great deal of work regarding best practices in RMBS deals without a government guarantee," notes Eric Kaplan, the director of the housing finance program within the Center for Financial Markets at the Milken Institute. "Organizations like the Mortgage Industry Standards Maintenance Organization have been working to define the data investors really need in order to manage their investments. We've been improving on a template that’s already shown commercial viability for private-label RMBS, but how much weight will the SEC give industry stakeholders?"

One key group involved in the SEC process will be investors (aka "the victims"), everyone from funds to banks to insurance companies and corporate and pension funds. The ratings agencies that must assess and rate RMBS deals are intimately involved in the conversation in that their financial and operational risk criteria ultimately govern the formulation of ratings. Assets, as we all learned in 2008, move for ratings. Prudential regulators must also take a view of how to weight private RMBS in terms of capital. And finally, the issuers of private RMBS from JPMorgan Chase to Redwood Trust must be heard as well.

While the question of data disclosure in private mortgage deals sound imminently solvable, the related and more problematic issue inherent in the SEC's efforts is the question of managing the loan collateral that backs any RMBS deal. The loans are typically sold to a special purpose vehicle that is set up in Delaware and governed by New York trust law. The SPV is, in fact, the owner of the mortgage notes in the deal and the trustee, who typically works for a national bank, exerts fiduciary control over the assets. The investors own securities issued by the SPV, but have no control over the SPV or its assets.

These technical attributes are important because a major bone of contention by investors coming out of the 2008 financial crisis was the role of the trustee in the management of the assets. Many investors sought to get trustees to take a position helpful to one set of investors or another, creating what was called "tranche warfare" for the next decade thereafter. Many trustees, despite their fiduciary duty, refused to get actively involved in the management of subprime mortgage notes or the resolution of defaulted mortgages, for example.

Even if the SEC and the industry are able to reconcile on the issue of data disclosure in public RMBS deals, the role of the trustee in managing the assets of the SPV is a crucial issue and impacts the rating for a given RMBS deal. For example, you might argue that an RMBS issue with enhanced powers given to the trustee might be better for investors and thereby warrant less credit enhancement — and cost — for the bond issuer. But the role of the trustee also becomes a ratings negative, this because operational risk of a trustee not performing their duties in a deal is difficult to assess and quantify.

The importance of the revival of private-label mortgages extends far beyond this small market. If, for example, the Federal Housing Finance Agency decides to rip off the "GSE patch" that presently affords all agency loans with a legal safe harbor, then a good 10%-20% of conventional loan production will need to be financed via private-label securities instead. With collateral that has relatively low credit score borrowers and relatively high loan-to-value ratios, the investor reception for that paper is likely to be weak, notes the head of RMBS at a major credit ratings agency in New York.

"To make the economics of a private RMBS deal work so the trustee has an incentive and the legal indemnification to act to maximize the value of the mortgages in the deal will be a challenge," the executive said. "And creating the infrastructure among the issuers and ratings firms to do more volume of lower credit quality RMBS deals will take time as well. There is no instant private-label fix for RMBS if the FHFA simply rips off the GSE patch."

The bottom line is that the SEC's consideration of ways to encourage the public issuance of residential mortgage-backed securities is a positive development, but it's not just about data disclosure. More, the question of how to oversee the management of the mortgage loans that stand behind these securities is at least as important as the disclosure mandated by the 2010 Dodd-Frank law. But most important, the assumption that the private-label market will take up the slack as and when millions of conventional loans suddenly cannot be purchased by the GSEs may be very suspect indeed.

When investors are asked to take direct credit risk, the role of the trustee in an RMBS goes from being ministerial to crucial. The noteholders of a private-label RMBS need to know that the SPV is being actively managed on their behalf so that expenses related to default servicing are minimized and the net present value of the mortgage notes is maximized. To make the vision of a larger market for private mortgages a reality, the industry needs to address the issue of trustee duties in the context of private RMBS.