Securitised US subprime mortgages understandably take a large share of the blame for triggering the global financial chaos that has unfolded over the past 18 months. But it would be a grave mistake if market abuses obscured the importance of capital market routes for financing residential and commercial real estate.
“People have to recognise that securitisation is a necessary product, it is funding about $8500bn in mortgages around the world. Without that, economies would just continue to shrink,” says Darrell Wheeler, head of securitised products strategy at Citi in New York. He has worked in almost every part of the industry, establishing his own commercial real estate mortgage brokerage earlier in his career.
As investors face redemptions and more banks take defensive positions by stepping back from market-making in residential and commercial mortgage-backed securities (RMBS and CMBS), illiquidity intensifies, and spreads in the secondary market have widened to levels that make new primary issuance prohibitively expensive.
“You can go into the RMBS market and buy bonds that, even assuming US house prices decrease another 30% to 40%, are still going to yield 20%. These are AAA bonds that have been downgraded to AA. And on the super-senior class of CMBS that have 75% credit support, yields have reached 12%. You would need three-quarters of the mortgage pool to default before you lost any money,” says Mr Wheeler.
Given such depressed valuations, returning confidence to the MBS market is clearly part of the answer in the short term. In November 2008, James Crosby, the deputy head of the UK Financial Services Authority (FSA), released a report that suggested auctioning government guarantees on AAA tranches of RMBS.
Many countries have already started providing guarantees on banks’ issuance of plain vanilla unsecured senior debt, so a similar concept for the MBS market would seem “a simple and effective solution to restore investor confidence”, says Angela Clist, a partner in the international capital markets practice at law firm Allen & Overy in London. But she emphasises that the Crosby report details would need to be carefully thought through.
“As proposed, the guarantee would have to apply to new stand-alone issuances or new programmes – it would not be palatable to investors to have two tiers of bonds from one covered bond programme or master trust programme, some guaranteed and some not,” she says. “Furthermore, the proposal is to guarantee mortgages originated after a specified date, but of course existing programmes would contain assets from many different dates. The cost of setting up new ‘guaranteed’ programmes would put a lot of issuers off, and this aspect should be reconsidered.”
The more fundamental challenge, however, is to wean markets off their dependence on government guarantees and central bank liquidity. Asset-backed security (ABS) issuance in 2008 has actually been at record levels – but almost all of this paper has been structured for the sole purpose of qualifying as collateral for repo financing with the central banks.
“What issuers want is for the market to be able to stand on its own two feet, for investors to focus on the underlying mortgages and become comfortable with the product again, and the sooner that process starts, the better. The concern is that government guarantees on mortgage-backed securities would delay that process, by distracting the focus away from underlying asset quality,” says Conor Downey, partner at law firm Cadwalader, Wickersham & Taft in London.
Helping the homeowners
In western Europe, the damage to underlying mortgage pools has so far been manageable – even in the UK, one of the fastest-declining real estate markets, there have been no defaults at the AAA level on RMBS to date. But the US presents an altogether more severe problem. Delinquencies on subprime mortgages reached 17.85% in the second quarter of 2008, and although the overall mortgage default rate was only 4.5%, the vast majority of problems are occurring on a small vintage of mortgages – from 2005 to 2007, when underwriting standards were lowest, and loan-to-value (LTV) ratios were highest.
As house prices fall, recovery rates are also deteriorating rapidly. About one in six mortgages in the US have 100% LTV ratios. According to data provider First American CoreLogic, 18.3% of all mortgaged homeowners in the US were in negative equity by October 2008. In California and Florida, the rate is closer to 30%, and in Nevada, that figure rises to almost 50%.
In this context, Tonko Gast, co-founder of structured credit investor and adviser Dynamic Credit Partners in New York, warns that the downward spiral for RMBS may not be over yet, as the impairment spills over from subprime into Alt-A (often self-certified mortgages) and prime assets originated in 2005-2007. “We calculate that there could be another $700bn in RMBS to be downgraded from investment grade to speculative grade. The attachment point for credit enhancement on an Alt-A AAA tranche is typically 14%, but for 2005-07 vintage, delinquencies could go to 20% or higher, so the value will break into the AAA,” he warns.
With so many properties in negative equity, it makes more economic sense for lenders to renegotiate mortgage terms and keep borrowers current, rather than foreclosing and being left holding a depreciating asset. However, where mortgages have been securitised, that may not be possible, as some RMBS contracts expressly forbid mortgage modification, or allow the servicer some authority to seek to mitigate losses, but without clear instructions as to how.
From TARP to TALF
Even where mortgage modifications are technically possible, the incentive is unclear in securitised transactions. “A direct lender such as Citi or Bank of America has a reputation in the market, and they want to keep their customers. But a servicer does not have a retail brand to protect in the same way,” says Glenn Snyder, a real estate lawyer in the California office of Pillsbury. He believes this could have been an advantage of the Troubled Asset Relief Program (TARP) as originally conceived, before US Treasury secretary Henry Paulson announced in November 2008 that it would not be directly buying RMBS after all. “If the government had become the single owner of a transaction, they could have chosen to unravel the underlying mortgages to modify them. It is much harder to do that if the RMBS remain held by a wide group of investors,” says Mr Snyder.
Furthermore, some plan is still needed to fulfil the original purpose of TARP, says Mr Wheeler, namely to begin purging the system of existing depressed assets so that healthy financial institutions can begin lending again. “Given the size of the discount in the market, each time a bank books a new mortgage, the equity analysts value it at 70 or 80 cents on the dollar – that prevents financial institutions from lending. Only the government-supported entities (GSEs) are doing new lending. We need to ring-fence the legacy assets so that people can understand that banks will do new lending, and not every new loan in this environment is going to be worth only 70 cents on the dollar,” he explains.
In November 2008, the US Federal Reserve announced that it would purchase up to $600bn in mortgage-backed securities from the GSEs, including Fannie Mae and Freddie Mac that were effectively nationalised in August 2008. But many of the most troubled assets, including securities built from mortgages that had initial teaser rates with a sharp step-up (adjustable-rate mortgages, or ARMs), were not originated through the GSEs. The government also proposed using TARP to indemnify the Fed against losses on its $200bn term asset-backed lending facility (TALF) – but this does not yet accept mortgage-backed securities as collateral. This suggests that the US government may still need to expand TALF in 2009. “For MBS we still need another market-maker that can step in and play a stabilisation role. This would eventually restore confidence enough for private investors to take over from government assistance,” says Mr Wheeler.
Clearly, the commercial property sector will also suffer rising default rates in the economic downturn, as retailers shut their stores and companies vacate office space. But there is a consensus that in the future RMBS transactions may draw on CMBS as a structural template to tackle some of the problems thrown up over the past two years.
Mr Downey at Cadwalader says CMBS servicers have more flexibility to manage financial stress, including an enforcement period of at least two years to sell or refinance assets as required. However, when real estate values fall, the servicers still face the challenge in deciding whether the market will have recovered far enough in that time to pay off all classes of investors – and this has the potential to trigger disputes between the different creditor classes. “The more junior investors may be prepared to wait, particularly if they bought at a discount. But those holding senior tranches may prefer early repayment, so that they can reinvest in the secondary market at higher yields,” he explains.
Another vital lesson for RMBS that could be learnt from the CMBS market is the importance of greater transparency on loan-level data. “CMBS products start with three years of financial history for every loan in the pool, appraisal on every loan and updates every month on the performance of the pool. That sort of loan seasoning and flow-through of information is key to restoring confidence in RMBS,” says Mr Wheeler at Citi.
Jordan Schwartz, a lawyer at Cadwalader in the US and member of the board at the American Securitization Forum (ASF), is part of a team drawn from across the industry who have drafted a proposed RMBS disclosure package to deliver that kind of transparency. “This has 135 fields of loan level data, including documentation and verification, property valuation methodology, whether brokers were involved in the origination, whether the borrower is a speculator or a resident, and we have 30 fields on loan modifications,” he says.
Rebuilding servicing capacity
Changing RMBS documentation and pool surveillance cannot happen overnight, however. Alan Cleary, the CEO of UK mortgage asset quality assessment and servicing company Exact, notes the scale of institutional adjustment needed to provide extra information at the origination end of the system. “For example, there is a significant shortage of experience in managing mortgage arrears, because we have not had a sustained housing market downturn in the UK for 15 years or so,” he says.
After leading mortgage sales and intermediary teams at the Halifax Bank of Scotland group, Mr Cleary left to found his own company, Edeus, in 2006. Edeus originated non-conforming mortgages (buy-to-let, self-certification or to those with adverse credit histories) for selling on to investors. It had completed seven whole-loan sales and was on the brink of its first securitisation when the market shut down altogether in March 2008.
Mr Cleary was forced to put the company into administration in November 2008, returning the mortgage portfolio to the banks that had provided his funding lines, but he realised there was value in the servicing operations themselves. “We still retain all the technology to originate loans, but we don’t expect to return to that market for another two to three years, until we find funding that is cost-effective. In the meantime, we can generate positive cash-flow from the operational business alone,” he says.
To extend the work currently undertaken by the international credit ratings agencies, Exact offers 100% loan-level analysis of RMBS pools to investors on an ongoing basis. In the past, investors would be provided with analysis of a 10% to 15% sample, only at the time of origination. Exact has also introduced much more thorough fraud investigation, as well as cross-checking credit histories with other products such as credit card debt.
Distressed debt investors are already beginning due diligence on RMBS transactions in the secondary market to see if the current large discounts imply default rates on the underlying mortgages that exceed the actual rate of delinquencies. Indeed, Exact’s leading investor, the US-based distressed debt hedge fund Elliott Management, could be an early customer in this category.
Unsurprisingly, the banks are Mr Cleary’s first customers, as anxiety grows about the quality of their portfolios. Besides delinquencies, cases of fraud also rise in an economic downturn. Exact’s work exposed a lawyer in London who had single-handedly submitted fraudulent mortgage applications totalling £20m ($30.8m). “Almost every major bank had some of these loans on their books, but they did not know about them. Just one case of fraud exposed in the mortgage pool repays the cost of a full investigation, if the investor can find and exclude that mortgage before buying the pool,” says Mr Cleary.
Covered bonds diversify funding
As banks and RMBS servicers race to build the capacity to analyse mortgage pool behaviour more accurately, the covered bond structure could provide a route to diversify scarce funding sources in the meantime. “The principal difference between them is that with RMBS, it tends to be a static mortgage pool or available mortgage portfolio, whereas with covered bonds there is a requirement to keep on topping up the pool to maintain AAA ratings,” says Ms Clist at Allen & Overy. This shields investors to some extent from a general deterioration in mortgage asset quality, so she expects confidence in the covered bond market to recover ahead of RMBS.
At present, however, even covered bonds are struggling to find liquidity, as investors focus on the supply of bank debt that carries government guarantees. “We need to see some senior unsecured deals so the market can take a view on what the pricing is, then we can see what scope there is for tighter pricing using covered bond collateral,” says Derry Hubbard, head of covered bond marketing and execution at BNP Paribas. The French bank reopened the market for non-guaranteed bank debt in December 2008. “We will also need to increase the number of individual investors in covered bond deals, bringing order books back up to triple digits,” he adds.
In any case, says Tauhid Ijaz, partner in the capital markets practice of law firm Lovells in London, covered bonds do not fulfil the same function as MBS from the bank balance sheet viewpoint, as the mortgages in the cover pool remain on the bank’s own books. “On covered bonds, the banks do not have the regulatory capital relief under Basel II that they would have with a securitisation,” he says.
New buyers, new sellers
Consequently, MBS will still be essential to provide banks with a balance sheet exit for mortgage origination. And while covered bonds typically have three to 10-year maturities, MBS transactions usually last the length of the underlying mortgage, about 20 to 40 years. They therefore play a specific role on the buy-side as well. Real money investors such as pension and insurance funds have similarly long-term liabilities, and are seeking higher returns to meet the challenge of ageing populations in the Western hemisphere.
As originators now have to work so much harder to find liquidity, Mr Downey at Cadwalader suggests they will look at new structures designed specifically to appeal to the needs of pension and insurance funds that are increasingly pursuing liability-driven investment (LDI) strategies. “LDI investors like inflation-linked assets, so we could see more loans backed by real estate revenues that rise with inflation, sale and lease-back structures, or whole-business securitisations,” he explains.
However, these tailored deals are more labour-intensive than large-volume standardised transactions, at a time when investment banks are staging a wholesale retreat from the MBS industry. One market participant estimates that, of the 40 or so banks that had European CMBS programmes at the peak, only 10 still retain origination capability. Given this loss of investment bank capacity, together with investors’ desire for a deeper knowledge and valuation of the underlying assets, Mr Downey believes there may be a growing role in the market for specialist real estate advisory firms, such as CB Richard Ellis, Jones Lang Lasalle and DTZ.
Barry Osilaja, the director of European structured debt and equity solutions at Jones Lang LaSalle Corporate Finance, says the pension and insurance funds themselves will need to become better co-ordinated internally if they want to arrange deals directly with commercial real estate originators, rather than using investment bank intermediaries.
Historically, institutional investors’ real estate desks would only take direct investment positions, while bond desks have bought only MBS transactions, based on pricing relative to other asset-backed securities such as credit-card receivables. These bond investors often did not have in-depth knowledge of the underlying real estate assets – other than through credit ratings agency presale reports.
“The more sophisticated institutional investors such as some life insurers are now looking at how to buy into hybrid transactions, where the real estate desk takes the direct asset, and the annuity division takes the securitised cash flow to meet their liabilities,” explains Mr Osilaja.
The simple things
Alongside this increased investor sophistication, however, Mr Osilaja emphasises that other aspects of deal structure will need to become simpler. “The pricing will be more attractive, and you will not have so many tranches of notes, it will just be senior and subordinated, so that people can see more quickly what they are buying,” he says.
Once those conditions are met, he sounds a rare note of optimism, suggesting that volumes in the CMBS market could arguably become larger even than before the crisis. “If you make the deal simpler, more transparent and easier to understand, it creates better liquidity. Once you are creating bonds that are liquid and listed, there should be no ‘black box’ that excludes some investors,” he says.
But as with all other market participants, he notes that there is still plenty of deleveraging and repricing to come before appetite for new deals will return. This means that 2009 will be a year to begin re-engineering the mortgage securitisation market from the bottom up, and only afterward will it be ready for any kind of revival. Even then, investors are sceptical about whether some parts of the RMBS market should ever recover.
“Teaser-rate ARMs, low documentation, high LTV, those assets cannot be securitised again,” says Mr Gast of Dynamic Credit Partners.