Treasury Notes

 Five Questions with Dr. Michael Stegman on the Private Label Securities Mortgage Market

By: Adam Hodge

Today Treasury Secretary Jacob J. Lew announced a new Treasury-led effort to help jump-start the private label securities (PLS) mortgage market. To begin this initiative, Treasury is requesting input from the public on what could be done to encourage a well-functioning PLS market.  

In the next installment of “Five Questions,” we asked Michael Stegman, Counselor to the Secretary for Housing Finance Policy, to explain how the PLS market has historically functioned, and how a reinvigorated market could help expand access to credit and reduce the government’s footprint in the housing  market.

1. What role did the PLS mortgage market play in housing finance before the housing bubble?

Securitization has played a valuable role in the housing finance market, expanding access to credit for many qualified Americans by allowing the risks associated with extending mortgage credit to be allocated efficiently among investors with different appetites for taking credit and interest rate risk. Prior to the housing bubble, the private label securities – or PLS – mortgage market provided financing through lenders for a variety of borrowers that for one reason or another did not meet the underwriting criteria of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac or qualify for Federal Housing Administration (FHA) insurance. 

Pre-2002, approximately 50 percent of first lien PLS issuance was collateralized by loans too large to qualify for a government guarantee, commonly referred to as the jumbo market. Another 10 percent was collateralized by loans to borrowers with strong credit histories who were unable to provide the necessary income documentation required to qualify for a loan that could be purchased or guaranteed by a GSE or could be insured by FHA, generally because they were either self-employed, worked on commissions, or had irregular incomes. The remainder was composed of weaker credit-quality, subprime borrowers. These proportions changed significantly during the run-up to the housing bubble, as market discipline and underwriting standards broke down and investors sought securities that offered higher returns. 

2. What aspects of the former PLS market contributed to the financial crisis and how can this be avoided in the future?

Above and beyond irresponsible lending practices that were endemic to the mortgage market as a whole, the PLS market suffered from a number of deficiencies including conflicts of interest, inadequate investor protections, overreliance on credit ratings, and lack of transparency. 

Lenders did not take sufficient care when underwriting loans using an “originate-to-distribute” business model because they were able to package these loans into securities and sell them to investors or to the GSEs, while believing they retained little remaining exposure. Investors bought these securities under the assumption that their interests would be protected by a servicer who would seek to maximize value to all investors and by a trustee who would bring lawsuits against lenders to compensate investors if the quality of the underlying loans backing their securities were misrepresented. Instead, as defaults rose and PLS investors in even the safest tranches of the securitization’s capital structure sustained rising losses, disagreements over the duties and responsibilities of the trustee led to investors not being compensated for misrepresentations and defective loans. Moreover, the lack of transparency – notably, in the determination of monthly cash flows paid to investors – led to additional conflicts among servicers, trustees, and investors that contributed to the breakdown of the PLS market.

Since the crisis, we have made significant progress toward remedying many of these problems, notably by moving forward with the implementation of key parts of the Dodd-Frank Act. The Consumer Financial Protection Bureau (CFPB) issued Ability-to-Repay and Qualified Mortgage standards, requiring lenders to verify a borrower’s ability to repay a loan when extending mortgage credit. The risk retention rule, also mandated by Dodd-Frank, when finalized, will require securitizers to retain a minimum of 5 percent of credit risk or “skin in the game,” of the mortgage-backed securities they issue.  Additionally, we have made headway toward improving transparency in the PLS market. The Securities and Exchange Commission (SEC) has proposed a series of new and amended rules, known as Regulation AB II, governing disclosures on asset-backed securitizations, improving transparency for investors. The last remaining piece of the puzzle is putting in place standards and mechanisms to protect investors in residential mortgage-backed securities (MBS), while also clearly defining issuer responsibilities so that they have the confidence to return to the market at scale. 

3. How can a responsibly reformed PLS market help expand access to credit for qualified borrowers?

In the aftermath of the financial crisis, mortgage credit remains extremely tight, leaving many qualified Americans who have the desire and means to own a home without access to financing. Some of these prospective borrowers meet the underwriting requirements for purchasing or guaranteeing loans by a GSE or insuring loans by FHA, but they are not being served because lenders fear they may be forced to repurchase the loans if underwriting errors are found. But a significant segment of prospective borrowers simply do not meet GSE or FHA underwriting requirements. As I mentioned earlier, the PLS market has traditionally been a source of mortgage financing for these borrowers and should in the future play such a role. A healthy and responsible PLS market could also potentially provide more competitive pricing for certain borrowers who do qualify for a loan through a government-supported channel. 

4. How can a responsibly reformed PLS market help reduce the government’s footprint in the mortgage market?

Today, over 80 percent of the mortgages originated in this country are still funded through a government-supported channel, whether through the GSEs or with insurance provided by the FHA. There is no sound policy reason for the government to support the overwhelming majority of mortgage credit extended in this country when there is sufficient private capital able to responsibly bear this risk. A reformed housing finance system with private capital at its core can result in more nimble pricing of mortgage credit risk, more efficient allocation of capital, and more competitive rates for certain borrowers.

During the financial crisis, we saw the consequences of concentrating too much credit risk in a duopoly that became so big and so important to the overall economy that they needed to be rescued by taxpayers. Should there be another serious economic downturn that results in elevated borrower default rates, taxpayers could again be exposed to losses on mortgages supported by the government. As we undertake the important work of transitioning to a future housing finance system and winding down the GSEs, we need to lay the groundwork for a well-functioning, responsible non-government guaranteed channel for mortgage financing.

One reason for the government’s outsized footprint in the housing finance market today is because of countercyclical measures – specifically, the increase of conforming loan limits – implemented under the Housing and Economic Recovery Act of 2008, which were necessary to preserve access to credit in the face of market disruptions caused by the financial crisis. Although the broader economy has recovered significantly since the depths of the crisis, there are still concerns about the ability of the government to reduce its footprint in the housing market given the lack of private label securitization activity. The development of a well-functioning, responsible PLS market could help reassure stakeholders that reducing the GSE conforming loan limits would not impair the health of the mortgage market, raise mortgage rates, constrict mortgage credit, or unduly concentrate mortgage credit risk in the banking system.

5. More than five years have passed since the financial crisis. Why is now the right time for Treasury to take up this PLS initiative?

More than five years after the financial crisis, we have seen significant improvement across a variety of economic measures. Unemployment has declined and economic growth has rebounded. Many securitized markets that were disrupted during the financial crisis have regained momentum. The residential PLS market, however, is the lone holdout, with issuance levels today a mere fraction of pre-crisis levels.

There has been significant progress made on bipartisan housing finance reform legislation over the past eighteen months, which still remains the largest piece of unfinished business from the financial crisis. We view the development of a healthy and responsible non-government guaranteed PLS channel as an important component of a reformed housing finance system that will complement the enactment of comprehensive housing finance reform legislation consistent with the President’s core principles released in August 2013.

Adam Hodge is a Spokesperson for Domestic Finance at the United States Department of the Treasury.

Posted in:  Housing Finance
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