United States: Selected Issues

The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

Abstract

The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

IV. Strengthening Private Mortgage Securitization1

The issuance of private-label mortgage-backed securities (MBS) has fallen sharply following the financial crisis. Reviving its issuance on a robust and sustainable footing is crucial to meeting credit demand as the economy recovers. Hurdles to private securitization span both demand and supply factors. The decline in private-label issuance, along with agency mortgage-backed securities, is in part due to reduced demand for home mortgage credit. The decline is also attributable to reduced investor demand, whose appetite for structured products was badly shaken by losses suffered in the financial crisis. But the sharp decline in private-label MBS, in stark contrast to the relatively resilience of agency MBS, underscores the funding advantage of the government-sponsored enterprises (GSEs), which, with explicit government support, have been able to structure securities at costs below those faced by private entities. Reviving private MBS supply, then, must address these supply and demand barriers. Such efforts rest in large part on rebuilding investor confidence in securitized products and leveling the playing field between the GSEs and private entities.

A. The Mortgage-Backed Securities Market After the Financial Crisis

1. Issuance of private-label residential mortgage-backed securities (RMBS)—the largest of the asset-backed securities (ABS) classes—has declined sharply. While agency RMBS issuance has remained strong on the back of government sponsorship and the funding advantage of the GSEs, private-label RMBS markets are effectively shut down.2 Of the private-label RMBS issued in 2010, roughly two third—about $1.2 billion—was new mortgage supply, while the rest comprised of loans that were either repurchased or bought out of an existing mortgage pool due to non-compliance with investor terms, such as early payment or default.

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Issuance of Residential Mortgage-Backed Securities

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A004

Sources: Board of Governors of the Federal Reserve System, IMF, J.P. Morgan, and SIFMA.

2. The decline in RMBS supply is a result, in part, of reduced demand for housing finance, a logical turn of events following the financial crisis. On net, demand for new mortgages has declined consecutively since 2008. In 2010, home mortgage loans totaled $10 trillion, compared to $10.5 trillion in 2007. As a result of the decline in mortgage lending, the supply of RMBS collateral has fallen as well.

3. Ample liquidity and historically-low funding rates have also reduced banks’ incentives to securitize loans. One of securitization’s traditional roles is to serve as a funding tool. However, the Federal Reserve’s long period of policy accommodation has provided funding to banks at historically-low rates, reducing the attractiveness of securitization. Instead, banks have been holding mortgages on their balance sheets to realize the difference between their low funding costs and the relatively high rates on mortgage loans.

4. In addition, the decline in private-label RMBS supply reflects the funding advantage of the GSEs and their yet-to-be-resolved future landscape. Low capital requirements and government guarantees to the GSEs, made explicit since the financial crisis, reduce these institutions’ effective financing costs, thus crowding out the private sector. This government support was all the more valuable at a time when investor risk aversion to structured products reached a historically-high level. Currently, the GSEs structure roughly 65 percent of residential mortgage-backed securities.3 Although a policy discussion on reducing the GSEs’ presence in housing finance has started, the structure of the GSEs going forward—public, private or a hybrid of both—remains uncertain; this uncertainty has muddied incentives for private-sector involvement.

5. Meanwhile, investor appetite for structured securities was badly shaken by the financial crisis, which laid bare the information asymmetry, opacity and incentive misalignment along the securitization chain in some market sectors. Legislations that seek to address these inefficiencies could boost investor confidence and revive securitization, but they have also made the securitization process more expensive.

B. The Magnitude of Mortgage Credit Shortfall as the GSEs Shrink

6. Reviving private sector involvement in MBS issuance—and ensuring that the new issuance model is robust and sustainable—is needed to meet credit demand. Bank supply alone may not be sufficient to meet mortgage credit demand should the economy returns to its long-run trend growth. 4 If the GSEs’ presence in housing finance were to be trimmed, their role in new home mortgage securitization will likely be much smaller relative to their traditional share of 55 percent, requiring banks and private securitization to shoulder a greater share of the new home mortgage credit provision. An illustrative example outlines the possible gap private securitization would need to fill. Rough estimates suggest that by 2018, net new private sector mortgage credit supply—from banks and private-label securitization—would need to reach around $525 billion (Table below). Relative to a total supply of less than $2 billion in 2010, private-label RMBS supply would need to rebound to around $65 billion in 2018 to meet the expected demand. Based on historical levels of private-label mortgage credit provision, such a contribution is well within the realm of possibility.

Table 1.

Potential Scenario for Financing New Home Mortgage in 2018 1/

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Source: Staff estimate, based on OCC Working Paper 2009–6, The US Financial System in 2011: How Will Sufficient Credit Be Provided?

In 2018, the GSEs’ retained portfolios are expected to fall to a “lower, less risky size” as suggested by Treasury Secretary Paulson.

Nominal GDP is calculated from IMF WEO forecasts and based on 4.5 percent growth rate per year.

Impact of New Incentive Structure on Securitization

7. In response to mortgage securitization incentive misalignments between originators and investors, authorities are putting in place new regulations that will force securitizers to retain economic exposure to the assets that they securitize.1 The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) imposes a five percent minimum credit risk retention rate (“skin in the game”) on securitizers (Box 1). By mandating “skin in the game”, the Dodd-Frank Act—the regulations for which are yet to be finalized—is supposed to reduce a sponsor’s incentive to securitize poor-quality assets, and in turn, boost investor confidence in structured products.

8. The impact of the five percent risk retention requirement on mortgage rates is generally expected to be modest. In addition to the expected loss on the underlying loans, risk retention can be considered as an additional cost, reflecting the expected higher capital costs imposed on the risk retainer. Together, these costs can affect the price of loans. By one estimate, if one were to assume the same 25 percent loss rate on foreclosed properties once the housing market normalizes, and given the five percent risk retention, the implied loss on the mortgage value would be 1¼ percent. If one further assumes that one in ten mortgages were to go into foreclosure, then the expected loss on loans would be 0.125 percent. Were these losses to be fully passed on to borrowers, they would be the equivalent of raising the mortgage rate by 13 basis points (Baker, 2011). Most of other estimates converge around 20 basis points, with a few noting that new rates could be 50 basis points higher. In general, the new interest rates, while higher, are not expected to materially affect the cost of mortgages. By contrast, market participants see the proposed “premium capture cash reserve account” as a bigger hurdle to securitization as many believe it would reduce or eliminate up-front profit realization and cost recovery. That said, these accounts are meant to prevent deal sponsors from circumventing the risk retention rules, effectively preventing them from structuring deals in ways that negate or reduce the economic exposure to the securitized assets. In effect, the premium capture regulations, stipulate that if securitizers sell the unretained securities at a premium (i.e., for an amount greater than par), they must place some of this premium into the cash reserve accounts.2 These accounts would be used to absorb potential losses and be subordinate to all other tranches; it is in effect, the first loss tranche on a deal.3 Additionally, the captured amounts would not be released to the deal sponsor until all the interests are paid and the entity is resolved, usually upon the loan’s maturity. As a result, they could reduce potential upfront profitability. Additionally, the recovery of the costs of origination and hedging of risks would be prohibited.

9. MBS backed by the government and its agencies, or by “qualified residential mortgages” (QRM), are proposed to be exempted from risk-retention requirements. All MBS backed by the housing GSEs would be exempt while they are operating under the conservatorship of the Federal Housing Finance Authority. In any case, the GSEs already retain 100 percent of the credit risk of their securitization activity because they fully guarantee the securities. Hence, the near-term impact of the retention requirement on housing finance is expected to be limited, because over 90 percent of current residential mortgage origination is being done under the umbrella of the GSEs and the fully government-guaranteed Federal Housing Administration. In any case, the QRM underwriting criteria are very strict, so that few private-label RMBS will be exempt from the retention requirements. In fact, only about 30 percent of mortgages securitized by the GSEs in 2010 would have qualified.

C. The Impact of Winding Down the GSEs

10. The GSEs’ funding advantage has allowed them to structure securities at costs below those faced by private entities, enabling them to dominate mortgage securitization. Such advantage mainly takes the form of lower funding costs to finance their debt issuance. This advantage, relative to other financial firms’ costs of corporate debt issuance, averages around 40 basis points (Passmore, 2005). To reduce the systemic risks posed by the GSEs and to ensure that securitization will be on a robust and sustainable footing, authorities have introduced proposals to level the playing field between the GSEs and private entities. Uncertainties over the future of the GSEs are muddying the outlook for private-label housing finance. In the meantime, efforts to bolster private securitization, including reducing the GSEs’ conforming loan limits and raising their guarantee fees could have a moderate impact on raising private entity participation.

The Impact of Reducing Conforming Loan Limits on Mortgage Volume

11. Although reducing the conforming loan limits will expand the volume of quality loans for private securitization, the expansion will only be marginal. The maximum loan amount that qualifies for Fannie Mae and Freddie Mac purchase is scheduled to fall from $729,750 to $625,500 after September. By some estimates, this scheduled reduction will shave roughly 3 percent off the mortgage loans eligible for GSE purchase, or roughly $33 billion, based on the total amount of mortgages purchased by the GSEs in 2010 and the portfolios’ growth rate in 20114. Lowering the loan limits further to $417,000 would expand the pool by a total of 8 to 10 percent or $80 to $100 billion (Amherst, 2011, and JP Morgan, 2011). Relative to new home mortgage credit demand, estimated at around $520 billion for 20115, the new supply of quality loans for private securitization is modest.

The Impact of Raising the GSEs’ Guarantee Fees

12. Raising the GSEs’ guarantee fees to a level commensurate with capitals held by banks could raise mortgage rates by 50 to 60 basis points. If the GSEs were to gradually raise the guarantee fees as suggested by the Administration’s housing finance whitepaper, “as if they were held to the same capital standards as private banks or financial institutions”, guarantee fees could have to rise (U.S. Treasury/HUD, 2011). By one estimate, if capital held by the GSEs against credit risk were to rise from 45 basis points currently—as mandated by their charters—to roughly 400 basis points, a level banks would have to hold against their safest mortgages, guarantee fees would have to be around 80 basis points.6 By comparison, the historical average is roughly 20 basis points. The expected net increase in mortgage rates of 50 to 60 basis points is in line with current observations; the difference between GSE conforming mortgage rates and jumbo mortgage rates has been hovering around 50 basis points since April. For reference, the spread was 25 basis points during the halcyon days before the financial crisis before widening to 100 basis points during the financial crisis.

D. Conclusion

13. Reviving private mortgage securitization and ensuring that it stays on a sustainable footing needs to restore investor confidence without excessively increasing intermediation costs. In their current form, proposed risk retention rules could reduce the attractiveness of securitization as a risk-transfer mechanism for the issuer. And, with diminished capital relief, incentives for securitization may be reduced as well. As a result, mortgage rates could rise. On the other hand, the increase in rates is expected to be modest, ranging from 10 to 50 basis points. Furthermore, should risk retention rules restore investor confidence in structured products, securitization activities may be far more sustainable than those seen leading up to the financial crisis. Preliminary analysis suggests that the impact of proposals to trim GSEs’ footprint in housing financing—including lowering conforming loan limits—could spur a moderate increase in private securitization of quality prime mortgages, while the effect of raising guarantee fees on mortgage rates is expected to be limited, between 50 to 60 basis points. On net, analysts suggest that mortgage rates could rise as a result of risk retention rules and efforts to reduce the GSEs’ dominance in housing finance, but the new rates are not likely to restrict consumers’ access to credit.

Dodd-Frank Act Securitization Risk Retention Options

The proposed retention regulations provide for five retention options, although only three of them are applicable to RMBS:

  • Private-label RMBS issuers are likely to opt to retain an equal interest in each tranche (a “vertical” slice) to avoid consolidation under accounting rules, which would wipe out any regulatory capital relief (IMF, 2009). Also, vertical retention will likely result in lower regulatory risk charges, because the lion’s share of a typical transaction is made up of lower risk-weighted tranches rated AA/Aa and higher.

  • RMBS issuers are not likely to opt to retain just the first-loss or equity tranche (a “horizontal” slice), because it is the last tranche to be paid down (aside from scheduled principal payments), which could lead to long retention cost recovery delays.

  • A combination of vertical and horizontal slices that add up to the total required retention (A “L-shaped interest”).

References

  • Amherst Securities, April 2011, Presentation to IMF, “Outlook and Opportunities in the US RMBS Market”.

  • Baker, Dean, 2011, “Applying Arithmetic to the Mortgage 5 Percent Retention Rule”, http://www.cepr.net/index.php/blogs/beat-the-press/applying-arithmetic-to-the-mortgage-5-percent-retention-rule

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  • Deutsche Bank, 2011. “The Outlook”, May 25.

  • J.P. Morgan, April 2011, Presentation to IMF, “The Impact of new Regulations and Reforms on the Securitized Products Market”.

  • Hickok, Susan, and Daniel Nolle, 2009, “The U.S. Financial System in 2011: How Will Sufficient Credit Be Provided,” Office of the Comptroller of the Currency Working Paper No. 2009–6, November.

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  • Passmore, W., S. Sherlund and G. Burgess, 2005 “The Effect of Housing Government Sponsored Enterprises on Mortgage Rates”, Real Estate Economics, 33(3): 427463

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  • U.S. Department of the Treasury (U.S. Treasury) and Department of Housing and Urban Development (HUD), 2011, “Reforming America’s Housing Finance Market: A Report to Congress” (February).

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1

Prepared by Sally Chen and John Kiff.

2

Private-label MBS are securitized mortgages that do not conform to the standards of the GSEs and are bundled by private entities. Because they do not carry the GSE’s credit guarantees—formerly implicit and currently explicit under government conservatorship—private-label MBS are considered to carry more credit risks.

3

GNMA (a government owned corporation) structures about 25 percent of the RMBS market. Together, these “government-controlled entities” structure about 90 percent of the RMBS market.

4

Although mortgages are almost always originated by banks, funding for mortgage origination is dependent on several sources, including income from mortgage lending as well as selling loans to security bundlers, such as banks (i.e., private-label issuers) and the GSEs. In fact, structured finance has historically provided a useful role in credit provision.

1

Securitizers or sponsors are typically intermediaries that buy individual mortgage loans from originators—entities that initiate the loans—and bundle them together into securities sold to investors. In many cases, securitizers and originators are affiliated or the same entities.

2

If the securitizer retains exactly five percent, all of any premium is captured.

3

In a typical asset- or mortgage-backed security, the underlying loan portfolio cash flows are divided into several slices (or “tranches”) according to their risk-return characteristics. Tranche holders are paid in a specific order, starting with the “senior” tranches (least risky) down to the “equity” tranche (most risky). Holders of the “equity” tranche would be the first to suffer losses if some of the expected cash flows are not forthcoming (e.g., some loans default). They are in essence, buffers against losses for the more senior tranches. Once the equity tranche is depleted, then payments to the “mezzanine” tranche holders are reduced, and so on up to the most senior tranches.

4

In 2010, GSE mortgage purchases totaled $1.16 trillion. Based on year-to-date 2011 statistics, Fannie Mae’s purchase activity is expected to slow by 15 percent in 2011, while Freddie Mac’s, 4 percent.

5

New mortgage demand estimated is based on the historical average rate of 3.4 percent of nominal GDP, as per Office of the Comptroller of the Currency analysis in Hickok and Nolle (2009), and IMF GDP forecast.

6

Analysis in Deutsche Bank (2011) assumes that the GSEs would have to price in the same 15 percent after-tax return on equity that banks pursue in healthy markets.