Cleaning Up the Private-Label RMBS Market: Not Dead, Just Imperiled

By the end of 2009, there were signs that issuance could resume, at least modestly, in the non-agency MBS market this year. The re-REMIC market, for example, was springing into life: Amherst Securities reported in a December 9 research note that over $43bn of outstanding non-agency MBS, 95% backed by prime and Alt-A collateral, were re-securitized in the first 11 months of 2009, with November the biggest month at almost $10bn. Revived by re-REMIC demand, prices on prime private securitizations improved dramatically. According to J.P. Morgan analysts writing in their Securitization Outlook late last year, AAA paper has bounced from prices as low as 60 points near the start of 2009 to the high 80s currently. (Furthermore, JPM points out that those prices reflect existing deals with weaker underwriting and less subordination than would be attempted today). Extrapolating, JPM estimates a hypothetical prime deal could be executed at 99 10/32s. In other words, still below the price on the loans (around 100), but vastly improved. Assuming prices could even be put on subs, new deals were more than 10 points out of the money a year ago. (For the curious, a hypothetical deal in the current rate environment might be a AAA 4.75% prime pass-through trading at par, with 50bps of IO at a 3 multiple and subordinates at 12-14% yield. A 3 multiple means that the price is 3 times the interest strip; in this case, then,150bp or 1.5 points. That pass-through would then be “time tranched,” or sliced sequentially to create a series of bonds with short, intermediate and long average lives to match common maturity requirements of institutional investors.) Unfortunately, this math does not reflect the higher capital costs that would be incurred if bank regulators and/or Congress succeed in imposing risk retention requirements. Under FAS 166/167 accounting rules, that risk retention requirement could force the bank to consolidate the underlying loans; in turn, regulators would require risk-based capital be held against the all those loans – 8% times the 0.5 risk weighting of residential loans equates to a 4% capital charge under Basel I (under Basel II standardized approach, this drops to 3.5%). Before the crisis, a bank issuer might retain IOs and residuals and hold capital against them. JPM analysts calculated that, under Basel I, this course resulted in just 6 basis points of capital costs to issue a transaction. Higher capital charges will worm their way into interest rates charged borrowers. JPM analysts framed this problem in terms of bank return-on-equity (ROE): “In the ‘new world’ of SFAS 166/167, Basel II, and risk retentions, however, capital requirements rise dramatically while ROE’s plunge.” By their estimate ROE plunges to “a meager” 4%. To bring ROEs back to the normal target levels, say 20% (a common threshold, says JPM for entering a new business), mortgage rates would need to rise by more than 300 bp relative to other rates, all else equal. Lowering the ROE target is possible of course, but an appreciable impact on mortgage rates remains. There’s a message here for regulators and Congress: Prevent the abuses that wounded the economy and shut off capital market funding for many essential consumer lending activities — but use a scalpel, not a sledge hammer. NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine.