Could New Rules Spell Doom For Securitization Market?

WASHINGTON — While a religious group is predicting the imminent Apocalypse this week, a set of financial services industry representatives are warning of the possible end to their own world — the collapse of the securitization market.

They worry that a deluge of new rules coming down the pike — including risk-retention requirements, proposed Basel III restrictions, Volcker Rule limitations and enhanced derivatives regulation — will make it virtually impossible for the private market to return.

"It is in effect the securitization markets' greatest fear is not to be damaged by one slice of the sword but in fact to be destroyed by death of a thousand cuts," Tom Deutsch, executive director of the American Securitization Forum, told a Senate Banking Committee hearing last week.

Many of their claims remain controversial, with some observers skeptical the new rules will turn out to have so dire an impact. But at least one policymaker, Acting Comptroller of the Currency John Walsh, was voicing similar worries last week about the pending rules and enforcement actions that will impact mortgage servicing.

"There are 15 to 20 new mortgage lending requirements in the regulatory pipeline, and their impact on the mortgage and servicing businesses will be more tsunami than simple wave," Walsh said in remarks to the Financial Services Roundtable's Housing Policy Council.

The chief worry for many industry representatives remains how the risk-retention proposal will affect the securitization market. Under a proposal released by the federal banking regulators, lenders would have to retain 5% of the credit risk of loans they securitize in order to offset the problems seen during the financial crisis where incentives emphasized volume over quality and easy fees over long-term viability.

Some lawmakers said that such a change was needed to fix the system.

"We only need to look at the residential mortgage markets to see how badly things will go if securitization is not executed carefully," said Sen. Jack Reed, D-R.I., who chaired the hearing last week on the state of the securitization market. "The mad rush to cut corners led to an eventual freezing of the securitization markets as investors lost confidence and drastic government intervention was necessary to prevent the evaporation of liquidity and allow access to credit to continue for many consumers and businesses."

While those in the industry acknowledged past failures, however, they argue the proposed solutions go too far, and may not ultimately prevent financial risk to the system. They claim that many lenders will only make "qualifying residential mortgages," which require at least a 20% down payment from borrowers and compliance with certain debt-to-income ratios.

Some industry representatives argued the criteria was too strict and would result in reduced availability of mortgage credit.

"These prohibitions are all meant to redirect, or eliminate, or severely reduce risk," Richard Dorfman, managing director and head of the SIFMA Securitization Group, said in an interview. "A noble thought provided that there is balance, provided that there is remembrance that what we are trying to do here is fix the system, not freeze the system."

But the fears go beyond risk retention. Industry representatives are also raising worries about the impact of proposed Basel III capital rules, which would let mortgage servicing assets be counted as 10% of Tier 1 capital at most — and even less if the bank has large holdings of deferred tax assets or other intangible assets.

Such a cap is far more stringent than the current 50% cap, and if implemented, could hurt the capital ratios of mortgage-heavy institutions — making a return of the private-label securitization market even more unlikely.

In the case of the Volcker Rule, which attempts to restrict investment in hedge funds and private-equity firms, it could also be detrimental to securitization. A regulatory rule implementing the Volcker limitation restricts banks from engaging in any securitization transaction with an issuer fund in which the banks have any equity interest or sponsorship role if the fund relies on private placement exemptions. Many securitization issuers, according to Deutsch, rely on such exemptions, a result Congress never intended.

"Congress made clear that even though some securitization issuers would otherwise fall within the definition of 'hedge fund and private-equity fund,' those issuers and their sponsors were not meant to be included in the prohibited activities," Deutsch said.

Overall, many observers said there won't be enough profit for the private market to return. They fear securities dealers, originators and others will refrain from putting capital into a business that is unlikely to provide a return that would satisfy shareholders and bondholders.

"Capital craves yield, but unfortunately the current legal and regulatory environment is not conducive to those yields," said Chris Katopis, executive director of the Association of Mortgage Investors.

Lisa Pendergast, president of the Commercial Real Estate Financial Council, agreed, saying an inability to sell an investment or the lack of liquidity could be "extremely troublesome."

"Ultimately what that does is that it causes the cost of capital to rise for those commercial real estate borrowers that are out in the market," Pendergast said.

Industry members say they already see evidence of a withdrawal in the market.

"Today securitization is shut down," Katopis said. "Mortgage investors are on strike. This is not our choice. We have private capital to invest in the markets."

But the market still may recover, some industry executives said.

Redwood Trust officials, who have completed two issuance of fully private mortgage-backed securities of newly originated mortgage loans, said the speed of the return of the private market will depend on several factors.

Through the government-sponsored enterprises Fannie Mae and Freddie Mac and the Federal Housing Administration, the government currently supports the credit risk of 90% of the mortgages in the U.S., Martin Hughes, Redwood's president and chief executive, said at the hearing.

"We believe private capital is ready to step back in and invest in safe, well-structured prime securitizations, backed by good mortgages," Hughes said. "Government subsidies must be scaled back on a safe and measure basis to permit the private market to flourish."

Since the crisis, the private-label MBS market has been dormant as a result of below-market government financing which has crowded out the traditional private market.

"It's easy to love and get used to, because it gives you the safety that you crave," Dorfman said.

Hughes said Redwood is waiting on the government to act to give the private market room to return.

"We can only securitize the small volume of prime quality loans outside the government's reach," he said. "We're ready to purchase and securitize any prime loan and to do it at an affordable rate once the government creates a level playing field."

If the administration follows its plan to reduce conforming limits and increase guarantee fees to market rates to facilitate a withdrawal from the market within five years that will be enough to allow private-label market an opportunity to gain standardized practices in procedures, Hughes said.

Deutsch agreed GSE reform would play the biggest role in shaping the future of securitization.

"The future of the residential mortgage funding hangs in the balance as the administration and members of Congress seek to wind down the GSEs and wean Americans' addiction of cheap or government subsidized mortgage credit," he said.

Some lawmakers agreed they were worried about the delicate balance between ensuring that the problems of the past don't occur again without stifling the growth of the securitization market.

"The implications of how we resolve this issue are going to have huge consequences for our economy and we've got to get it right," said Sen. Mike Crapo, R-Idaho. "If we're going to encourage private money that's still sitting on the sidelines to return to security markets, we need to provide the appropriate balance between the strong standards that will align with the interest of lenders, issuers and investors with the ability of the securitization process to work."

Industry representatives are now pressing regulators to halt the process and take more time or risk unintended consequences.

"The statutorily imposed Dodd-Frank rulemaking schedule creates needless time pressure on regulators, especially, given that the rules will not go into effect until some time in 2013," Pendergast said.