Private Label Mortgage Backed Securities: Is the market really reopening? Chris Ames, Senior Fixed Income Portfolio Manager October 2013 Recent sell-side research showing a year-on-year increase in Private Label (i.e. not government guaranteed) Mortgage Backed Securities (MBS) issuance has been touted as another indicator of a healing housing market in the US. In this article, we argue that the Private Label MBS market is still fundamentally broken and that it will remain so until meaningful regulatory and operational changes are made.

Chris Ames Senior Fixed Income Portfolio Manager

The housing press recently got excited by a Deutsche Bank research report that showed Private Label MBS issuance increasing from $14.6 billion in 2012 to $19.2 billion year-to-date in 2013 (see Figure 1).

Figure 1: Gross Private Label MBS issuance ($bn) 25 20 15 2012 10

2013 YTD

5 0 Private Label Source: Deutsche Bank

A 32% increase in Private Label MBS issuance sounds positive for sure. However, this level of new origination needs to be put into context. The reality is that Private Label MBS issuance these days hardly even shows up on a graph that also shows Agency (i.e. government guaranteed) MBS origination (see Figure 2 overleaf).

Talking Point Private Label Mortgage Backed Securities: Is the market really re-opening?

Figure 2: Gross MBS issuance ($bn) 2,000 1,800 1,600 1,400 1,200 2012

1,000

2013 YTD

800 600 400 200 0 Private Label

Agency

Source: Deutsche Bank, Bloomberg (as of 9/25/13)

Figure 3 shows the historical relationship between net mortgage origination (new loans less repaid/defaulted loans) that goes into Agency MBS and those that are either retained on a lender’s balance sheet or are securitized as Private Label MBS. The historical (and likely most healthy) ratio between the two channels is about 1:1. In the mid-2000s this relationship broke down as the subprime boom led to Private Label domination. Following the crash, however, net Private Label and balance sheet-retained originations have been negative each year.

Figure 3: Net mortgage origination ($bn) 1,400 1,200 1,000

800 600 400

Agency

200

Other

-200 -400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Q1

0

-600 -800 Source: Federal Reserve, SIFMA, Bloomberg

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Talking Point Private Label Mortgage Backed Securities: Is the market really re-opening?

With so much political focus on reforming the Mortgage Agencies, one would think that regulators and legislators would be keen to see Private Label issuance resume its former market share, taking the pressure off government mortgage programs. Unfortunately, they have actually passed laws that make this outcome less likely. We will now lay out the four key issues which are hurting the Private Label MBS market and offer our proposed fixes. Qualifying Mortgages The Dodd-Frank Act defines mortgages with certain features as Qualifying Mortgages (QMs). QMs are treated favorably over loans that don’t meet the criteria. Amongst other things, banks that securitize non-QM loans must retain economic risk in that transaction. This retained risk attracts a significant capital charge. Likewise, a non-QM loan originated and retained by a lender also attracts a significant capital charge. However, mortgages that go into Agency MBS are exempt from QM rules. Banks therefore have an incentive to originate loans that can be securitized via the Agencies or, in the case of loans that exceed the Agencies’ size limits, to only make qualifying loans. Furthermore, they are likely to retain these ‘jumbo’ qualifying loans on their balance sheets, as fixed origination costs and economies of scale make these loans attractive. As a result of the negative incentives listed above, very few non-qualifying jumbo loans are being originated today (hence the result in Figure 3 above). Non-qualifying jumbo loans have traditionally been the main collateral for Private Label MBS so new transaction volumes are minimal. We understand Congress’ desire to use legislation to curb irresponsible mortgage lending in the future. However, the unintended consequence of over-reach has been a severe reduction in mortgage lending. While we think the QM concept is flawed (i.e. Congress should not be in the risk management business), we do not expect it to go away. There has recently been progress made in regards to raising or removing maximum loan-to-value requirements, and we applaud this step. However, the issue remains that with such binary and significant differences in capital treatment between QMs and non-QMs, banks will stay well clear of any lending which even comes close to the line. In our view, in order to facilitate the re-emergence of a robust Private Label MBS market, the scope of QM criteria should be limited to documentation requirements. Regulators and the capital markets, cognizant of the lessons learned during the crisis, should be able to manage the risk of a broader and more dynamic range of mortgage products than will be possible under current QM rules. Assignee liability Another aspect of the QM rule is the concept of assignee liability. Under Dodd-Frank, if a bank makes a loan that is non-qualifying, a defaulting borrower is able to sue the lender for irresponsible lending. The rules include scope for significant additional damages - enough to attract lawyers willing to work on contingency. Up to this point we have no problem with the law because it is good to hold banks accountable for predatory lending. However, the rules also provide for assignee liability; if the bank sells the loan, the buyer of the loan becomes the lawsuit target, not the lender that made the bad loan in the first place. In the case of a Private Label MBS, the Trustee for the transaction would be the lawsuit target, and any legal, settlement and damage costs would come out of collateral cashflows. First of all, this is patently unfair. If a bank makes a predatory loan, misrepresents it and then sells it via a securitization, the investors in the MBS are victims, not culprits. By assigning the liability away from the lenders, the lenders get a free pass. Secondly, this will have a chilling effect on Private Label MBS issuance. Investors in MBS are not close enough to the origination process to determine for themselves if all loans are exactly as advertised at the time of purchase. Historically, delinquent or defaulted loans were examined to ensure they met the initial criteria for inclusion in a pool. If they did not meet the criteria, the lender had to buy them back at full price. That may still be the case under QM, but the lawsuit costs and damages will, at least at first, come out of the MBS cashflows and the large damage formulas are likely to lead to higher-than-normal default and lawsuit activity. This will be a problem for subordinated bond investors and likely even senior bond investors and rating agencies, as it will be difficult or impossible to quantify these outcomes.

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Talking Point Private Label Mortgage Backed Securities: Is the market really re-opening?

From our perspective, assignee liability is a flawed concept in this context and should be removed from the law. Servicer/Trustee fiduciary duty Ever since the crisis began, it has been apparent that a glaring failure in the structure of Private Label MBS is the fact that neither Trustee nor Servicer has a regulated fiduciary duty to bondholders. As a result, Trustees have routinely ignored investor demands that certain actions be taken on their behalf, and Servicers have forgiven principal vastly in excess of what would be necessary to cure a delinquent loan. It is very difficult, if not impossible, for investors to ensure that Servicers transact at arms-length when they are repairing or selling foreclosed properties. Today, investors in pre-crisis bonds comfort themselves that they can assume the worst in these transactions and still earn relatively attractive yields. However, for meaningful new mortgage origination and Private Label MBS issuance to occur, yield spreads have to be low enough to produce a competitive mortgage loan rate. So we are at an impasse; until Servicers and/or Trustees have a legal fiduciary duty to investors, the sector will remain suspect and yields will remain elevated, thus limiting growth prospects for this important market segment. Ideally, we would like to see Servicers and Trustees have a regulated, legal fiduciary duty to investors. But if we had to settle for one group we would recommend Trustees. Although Servicers are in a position to injure investors through their actions, Trustees already have a contractual relationship with them that we do not have. Therefore, if Trustees had a fiduciary duty to investors, they would be obligated to police the Servicers to an extent that they do not today. Eminent domain Finally, we have the threat of municipalities using their powers of eminent domain to steal mortgages from Private Label MBS trusts. The logic behind the plan is that borrowers have negative equity (i.e. the loan amount is higher than the house value) and Private Label MBS trusts will not or cannot modify loans (i.e. change the loan terms to reduce the loan’s interest rate or principal amount). Therefore, the municipalities “take” the loans from the trust at a discount (what they consider fair value) and then refinance the old loan with a new one (at a higher value, in complete contradiction to the idea that the first, lower, value was “fair”). The municipalities are exclusively targeting loans in Private Label MBS. The logic of this plan is flawed. First, most of the targeted loans are not delinquent and therefore big discounts in valuation are not justified. Second, many of these “underwater” borrowers are underwater because they’ve taken one or more chunks of cash equity out of their home via cash-out refinancings. Third, Private Label MBS Servicers are able to modify loans to ensure the best expected outcome, and they do so all the time. Finally, it is quite clear that any jurisdiction that goes through with this will destroy their constituents’ chances to obtain competitive financing in the future by proving that they are willing to break mortgage contracts. The investment community has been very active in fighting this plan. However, it is an inefficient process as individual municipalities across the country contemplate going down this path. A Federal response is necessary via the Justice Department, Congress, or the Federal Housing Association (FHA); FHA loans are expected to be the replacement loans in this plan, providing the profit for the plan’s sponsor. Richmond, California, is furthest along the eminent domain path. They are poised to proceed and without a Federal response there could be a domino effect across the country. This is another area where losses are unquantifiable and therefore would be impossible to address via price or structure. We believe that the use of eminent domain in this manner would have an immediate negative impact on Private Label MBS with assets in eminent domain jurisdictions. And the domino effect could spread the damage quickly. Longer term, it would be very difficult to see new Private Label MBS thriving, as there would be no way to convince investors that new contracts could not be broken just like old ones were. Likewise, banks could pull back further from lending for their own balance sheet – just because the initial target was Private Label MBS does not mean this will always be the case. We need a ban on the use of any Agency program to refinance these “taken” loans. This could be handled by the Agencies themselves, the FHA in particular, or by legislation. This important issue cannot be left to fester until it reaches the Supreme Court.

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Talking Point Private Label Mortgage Backed Securities: Is the market really re-opening?

The above items represent significant hurdles to bank lending and investor acceptance of Private Label MBS. This is a shame, because we want to invest in the sector. The credit quality of newly originated mortgages will be excellent, at least for a while, and post-crash property values should have limited further downside. The Association of Institutional Investors, a buy-side trade group to which we belong, is actively lobbying to fix these problems (as are other industry groups). Last month we met with the Consumer Financial Protection Bureau, House and Senate aides, and the FHA to discuss the issues. We will continue to fight for changes, but in the meantime we will protect our investors from the current shortcomings in the Private Label MBS market.

Important Information: The views and opinions contained herein are those of the Chris Ames, Senior Fixed Income Portfolio Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This newsletter is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. Past performance is no guarantee of future results. Sectors/regions/companies mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties. Schroders has expressed its own views and opinions in this document and these may change. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroder Investment Management North America Inc. (“SIMNA Inc.”) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the “Schroder Funds”.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. Further information about Schroders can be found at www.schroders.com/us. Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution. Further information on FINRA can be found at www.finra.org Further information on SIPC can be found at www.sipc.org Schroder Fund Advisors LLC, Member FINRA, SIPC 875 Third Avenue, New York, NY 10022-6225

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