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From The CEO: Securitization Relabeled by Ed Fay

Returning private-label securitization to the housing market will require more than rebranding

Securitization Relabeled

Many people who earn their living in the residential mortgage industry are eager to see the private-label securitization(PLS) market come back to life in a responsible way. Recent deals such as the first few rated reperforming loan transactions are encouraging signs that rating agencies will become more comfortable moving across the credit spectrum over time.

There is a long way to go to establish a truly vibrant market for new origination PLS — or for term-finance legacy PLS for that matter. It’s not just a case of simply rebranding an old package and shipping it out. Bringing PLS back to the market will require real change, because risk-based pricing and a wider credit box can only return if they are nurtured by a sensible and healthy private-label securitization market.

Some believe that the growth in the PLS market is more of a matter of when than if. To accelerate and guide the process, the following three themes must occur. First, the supply of underlying assets must be sufficiently large and viable to support PLS. If lenders adjust their perspective they will embrace an attractive market just waiting for them. Second, the structures of PLS deals must be specifically tailored to today’s environment to bring trust back into the market. Third, all counterparties must fully leverage each other’s strengths to maximize performance, which will ultimately drive more volume.

Going to market

To establish a strong PLS market you need a lot of loans. Currently many creditworthy loans that fall outside of the government-backed programs just aren’t being booked. One reason that volumes of non-agency loans have been so light is that many lenders and investors are trying to model what they think will perform well and then finding borrowers who fit their programs. A lot of people want access to credit, but in reality there just is not much demand for loans with well-above market interest rates accompanied by low LTVs.

To reverse this process the PLS industry must first identify a larger market of borrowers who deserve and want credit and then tailor lending programs to them with complementary servicing solutions in mind. By applying nonstandard but reasonable and proven credit metrics such as residual income to these potential borrower populations, the supply of securitizable loans can increase dramatically.

There just is not much demand for loans with well-above
market interest rates accompanied by low LTVs.

More attention and regulatory coordination should be focused on developing tightly underwritten products for non-agency borrowers in a disciplined manner. This will have a positive impact on the PLS market, the housing industry and, ultimately, the nation’s economy.

Structuring deals

Structuring PLS deals going forward is a broad topic made up of many complex elements, so let’s focus on alignment of interests and transparency — two PLS issues greatly affected by the role of the servicer. Many precrisis PLS deals did not effectively designate authority to manage servicing decisions.

Numerous conflict-of-interest issues arose when loans went delinquent and that led to nasty legal battles between servicers, bankers, originators, investors — including tranche warfare between multiple investors in the same securities — and other players.

Naturally, in the wake of those battles, alignment of interest has been a top priority for all counterparties involved in new securitizations. No one claims to have a silver-bullet answer that successfully addresses everyone’s concerns, but simply putting a 25 basis point servicing fee strip on all performing deals is definitely not the answer. Each security deserves a customized servicer compensation solution based on the specific collateral and the goals of the counterparties.

In addition, a consistent waterfall of loss-mitigation procedures must be agreed upon in advance of the security and maintained. Odd situations happen more often than many investors believe, and servicers should be able to retain some degree of flexibility within the structure to use proprietary strategies without fear of being sued at a later date. Various success-based fees can be added to deals that benefit each party, but they must be customized to match the security and the collateral.

In terms of deal transparency, the growth of nonperforming and reperforming whole-loan markets has demonstrated just how much of a positive effect increased transparency could have on the PLS market. Whole-loan investors own each borrower’s loan completely, so they have access to a tremendous amount of information. They can view the borrower’s bank statements, taxes and even personal budget analyses — down to determining the type of car a borrower owns and how far that borrower drives to work.

That amount of detailed data allows servicers to more accurately estimate a borrowers’ actual monthly expenses. As whole-loan investors absorbed this level of information they gained a deeper understanding of the quality of their assets, as well as how effective relationship-based servicers can be with distressed borrowers, their appetites for this asset class grew. At the same time their financing partners were becoming more comfortable with these portfolios and the associated cash flows, so lending terms gradually eased, making the market much more fluid. Although privacy concerns will keep the PLS market from ever reaching the granular transparency in the whole-loan market — and rightfully so — the trend of higher-quality, loan-level data is a powerful one and should draw more investor interest.

Leveraging strengths

If rated legacy and near-prime PLS deals are going to grow quickly, performance needs to be excellent relative to expectations straight out of the starting gate. Effort must be spent to ensure that the strengths of the servicer chosen for a security match up with the nature of the collateral and the goals of the investors. Every servicer is different, and as more credit-sensitive deals are designed it is worth understanding why certain servicers could be a better fit for the security than others. This will help ensure deals meet investor objectives and focus on the right assets for the bond.

To help determine where this edge lies, ask the following questions:

  • Can the servicing strategy be tailored to a specific asset type?
  • To what degree can the servicer build relationships with borrowers to maximize loan value?
  • What kind of cash flows and redefaults should be expected if your servicer has to modify loans?

Issuers of new origination products also must be sensitive to meeting the needs of origination partners. For example, making sure the servicer is highly responsive to issues that may arise during loan transfers could be the key to maintaining valuable relationships with lenders.

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The supply and demand for distressed-legacy whole loans has lasted longer than many expected — and still has some legs — while the anemic volumes of the private-label securitization market this long after the crisis have been a great disappointment. Some have argued that the extended period of opportunity in legacy business has given players the chance to hone “best practices” from the whole-loan market, which can be leveraged to develop the PLS market in an intelligent and sustainable way.

If the industry can increasingly align interests, add more transparency into deal structures and leverage core competencies of key securitization counterparties, a sturdy foundation will be set that should lead to a robust and healthy PLS market that was well worth the wait.