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From Securities Regulation Daily, April 24, 2013

Hearing Reveals Consensus on Restarting Private Mortgage-Backed Securitization Market

By Jim Hamilton, J.D., LL.M.

A House Financial Services Committee hearing on removing impediments to private capital in the securitized mortgage market revealed a growing bipartisan consensus to replace the current system, in which the federal government backstops 90 percent of the securitized mortgage market, with a privately funded regime. Committee Chairman Jeb Hensarling (R-Tex) said that the goal is to gradually reduce and eliminate Fannie Mae and Freddie Mac and get private capital into the market. Barriers to entry of private capital must be removed so that a secondary securitized private market can be created. He noted that the Obama Administration generally is committed to a primarily private market for mortgage credit. Thus, Chairman Hensarling believes that there can be bipartisan agreement on legislation to ensure that private capital is the primary source of funds for the secondary mortgage market.

SEC-CFTC regulations. A Financial Services Committee staff memo noted that the SEC and the CTFC have issued many regulations affecting issuance of, disclosure regarding, and trading and investment in mortgage related financial instruments. For example, SEC rules for disclosures relating to asset-backed securities may affect the ability of private issuers to build a market similar to the one that exists for the GSEs. The staff also observed that the Dodd-Frank Act is not the only source of regulatory change that will affect the securitization of mortgages. The most recent iteration of the Basel Accords will change the risk weighting for mortgages and mortgage-backed securities, which will affect the amount of capital that financial institutions hold against these kinds of assets.

Ranking Member comments. Representative Maxine Waters (D-Cal), the Committee’s Ranking Member, said that the current system in which the taxpayers backstop 90 percent of housing finance is not sustainable. At the same time, investors must have confidence when they purchase private mortgage-backed securities. One purpose of the Dodd-Frank Act is to restore confidence in the private secondary securitization market, she noted, referencing the risk-retention provisions. The Dodd-Frank Act improves disclosures around underlying assets and raises the possibility of liability on credit rating agencies when analyzing those securities. The Ranking Member said that she supports aspects of Rep. Scott Garrett’s (R-NJ) securitization legislation. She emphasized that Congress must enact comprehensive housing finance legislation to bring about real reform.

Private securitization market. Representative Randy Neugebauer (R-Tex), Chairman of the Housing Subcommittee, noted that the mortgage securitization market has essentially been nationalized. He said that it has become critical to restart private securitization. Chairman Neugebauer also noted that there is currently regulatory uncertainty in this market, which is an impediment to the return of private capital.

Noting that 90 percent of residential mortgages are currently securitized into government backed securities, Rep. David Scott (D-Ga) queried whether the private sector has the capacity to handle that kind of risk and perform the role that the GSEs are now performing. That said, he added that the present GSE duopoly over securitization needs to be reformed.

James Millstein, former Chief Restructuring Officer for the U.S. Treasury, a role in which role he had primary responsibility for the oversight of the government’s capital commitments to AIG, testified that the conservatorships of the GSEs are the greatest impediments to the return of private investors to the mortgage market. Private investors need to understand what the future of the GSEs looks like before committing capital to this market. Mr. Milstein advised policymakers to avoid wishful thinking as they consider whether the sale of new private label securities truly signals the return of private risk-taking in the mortgage market that is capable of displacing the government. First, while growing, the total volumes might represent 1 to 2 percent of aggregate demand. In addition, the securities being sold are backed by mortgages that represent the cream of the crop.

Moreover, the issuers of these new private label securities have had to retain the subordinated tranches in their new issues to get investors to buy the senior tranches at all. Regardless of how the risk-retention rules come out, private investors are not only demanding that issuers have "skin in the game" but also that the issuer’s "skin" be in the "first loss" tranche in the new structures and that there be a mountain of homeowner equity ahead of them as well.

Regulations also affect the availability of private capital in the mortgage market, noted the former Treasury official. Banks face a new capital regime that makes it more expensive to hold mortgage assets, in particular non-conforming mortgages. The final Qualified Mortgage (QM) rule reinforces this bias, he said. While lenders have a safe harbor for conforming mortgages for up to seven years, lenders are exposed to potential liability from violations for other mortgages. Further, although it has not been finalized, it is likely that the Qualified Residential Mortgage (QRM) rule will have a similar impact.

However, Mr. Millstein strongly cautioned against concluding that these regulations should not be implemented. On the contrary, the United States just experienced the worst financial crisis and recession in four generations, he stated, which was in no small part because of weak capital requirements and loose regulation of providers of mortgage credit.

While they may not be perfect, he continued, Basel III and the Dodd-Frank Act represent significant positive steps toward a better-capitalized and less "fast and loose" financial system. He did urge federal regulators to finalize the QRM rule as soon as possible and to provide certainty to the market over how the QM and QRM rules will be implemented. This is easier said than done, in part because regulators have no clearer picture of the future role of Fannie Mae, Freddie Mac, and other government providers of mortgage credit than private investors do.

Trust Indenture Act analog. In his testimony, Chris Katopis, Executive Director of the Association of Mortgage Investors, urged Congress to enact a new Trust Indenture Act for mortgage-backed securities that would include, among other things, real-time public loan-level information available to all investors, not just ratings agencies, both at the time of underwriting and as loan performance emerges and cooling off periods when mortgage-backed securities are offered so investors have a real opportunity to analyze what they are being offered. The Act should also include public deal documents for all mortgage-backed securities for investors, other market participants, and regulators.

The landmark Trust Indenture Act enabled the corporate bond market with the standards and structures necessary for its efficient operation, noted Mr. Katopis. In the same way, he continued, the enactment of a new and explicit parallel to the Trust Indenture Act for the residential mortgage-backed securities industry would have dramatic, positive effects for the return of private capital to the U.S. mortgage market.

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