Fed’s Krozner: Mortgage Markets Need Greater Standardization

Federal Reserve Board Governor Randall Kroszner said on Monday that “a lack of information and insufficient due diligence” were at the root of the U.S. subprime mortgage-backed securities debacle, and suggested that greater standardization would likely be the key to reviving a secondary market that have been stuck in the deep freeze since late last year. “When market participants realize that they do not have the information necessary for proper valuation of risks, market liquidity can become impaired, such as in the CMO market in the 1990s and in the subprime market recently,” Krozner said in remarks to the Community Reinvestment Fund First Annual Forum in Minneapolis. Krozner likened the current secondary market crisis to a collapse of the collateralized mortgage obligation (CMO) market in the early 1990s, and said that restoring market confidence in subprime RMBS and asset-backed CDOs would “likely take time.” “As in the case of today’s market for residential mortgage-backed securities, the general market reaction was a flight away from these instruments [CMOs],” he said. “Increased information and standardized pricing conventions, such as the use of option-adjusted spreads, moved these instruments from the experimentation and learning phase to broad market acceptance.” It’s an interesting argument, and one that contrasts with the notion that large parts of the MBS and derivative markets are dead and not coming back. “More-detailed data will need to be collected in a more systematic manner” and “investments will need to be made to warehouse and model data” related to RMBS, Krozner suggested, noting that “the payoff from these activities will be a greater understanding of risks and greater ability to value the instruments.” More than a few sources that have spoken with Housing Wire over the past few months have suggested a similar sentiment, saying that the secondary market for mortgages is simply too large and — over the long term — too profitable for investors to simply bypass altogether. To be sure, it isn’t exactly a sentiment that is shared equally by all market participants. Some have suggested that CDOs will never come back after the current financial debacle, and that subprime mortgages will once again be relegated to so-called hard-money lending. But if history is any indicator, the truth — as with most things — will likely lie somewhere in the middle. That process of learning that Krozner referred to is what now has hundreds of billions of dollars worth of private capital waiting in the wings and ready to pounce on now-devalued mortgage-backed securities, the indexes they make, or even whole loan pools themselves. This new breed of distressed asset purchasers is uniquely focused on mortgages, for one thing — because the market has learned that even the most basic assumptions don’t carry across asset classes — and has commissioned much of its own research, rather than relying on a rating agency’s particular work in the area. Will it work? Time will tell, but the back half of this year should be instructive, even as the housing mess seems likely to roll onward.