The Non-Agency MBS Market: Re-Assessing Securitization Market Conditions
Since the financial crisis began in 2007, the “Non-Agency” MBS market, i.e., securities neither issued nor guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, has been sporadic and has not rebounded from pre-crisis levels. In recent months, however, activity by large financial institutions, such as AIG and Wells Fargo, has indicated a return to the issuance of Non-Agency MBS. What is contributing to the current state of the securitization market for high-quality mortgage loans? Does the recent, limited-scale return to issuance by these institutions signal an increase in private securitization activity in this sector of the securitization market? If so, what is sparking this renewed interest?
The MBS Securitization Market
Three entities – Ginnie Mae, Fannie Mae, and Freddie Mac – have been the dominant engine behind mortgage-backed securities (MBS) issuance since 2007. These entities, two of which remain in federal government conservatorship and the third a federal government corporation, have maintained the flow of capital from investors into guaranteed MBS and ensured that mortgage originators have adequate funds to originate certain types of single-family mortgage loans.
Virtually all mortgage loans backed by federal government insurance or guaranty programs, such as those offered by the Federal Housing Administration and the Department of Veterans Affairs, are issued in Ginnie Mae pools. Mortgage loans that are not eligible for these programs are referred to as “Conventional” mortgage loans. In the current market environment, most Conventional mortgage loans are sold to Fannie Mae and Freddie Mac (i.e. “Conforming” loans) and are securitized in Agency-guaranteed pass-through securities.
The Non-Agency MBS Market
Not all Conventional mortgage loans are eligible for purchase by Fannie Mae or Freddie Mac, however, due to collateral restrictions (i.e., their loan balances are too high or they do not meet certain underwriting requirements). These are referred to as “Non-Conforming” loans and, for most of the past decade, have been held in portfolio at large financial institutions, rather than placed in private, Non-Agency MBS. The Non-Agency MBS market is further divided into sectors for “Qualified Mortgage” (QM) loans, non-QM loans, re-performing loans and nonperforming loans. This post deals with the securitization of QM loans through Non-Agency MBS programs.
Since the crisis, Non-Agency MBS issuance has been the exclusive province of JP Morgan and Redwood Trust, both of which continue to issue a relatively small number of deals each year. The recent entry of AIG into the Non-Agency MBS market and, combined with Wells Fargo’s announcement that it intends to begin issuing as well, makes this a good time to discuss reasons why these institutions with other funding sources available to them are now moving back to this securitization market sector.
Considerations for Issuing QM Loans
Three potential considerations may lead financial institutions to investigate issuing QM Loans through Non-Agency MBS transactions:
- “All-In” Economics
- Portfolio Concentration or Limitations
- Regulatory Pressures
Investigate “All-In” Economics
Over the long-term, mortgage originators gravitate to funding sources that provide the lowest cost to borrowers and profitability for their firms. To improve the “all-in” economics of a Non-Agency MBS transaction, investment banks work closely with issuers to broaden the investor base for each level of the securitization capital structure. Partly due to the success of the Fannie Mae and Freddie Mac Credit Risk Transfer transactions, there appears to be significant interest in higher-yielding mortgage-related securities at the lower-rated (i.e. higher risk) end of the securitization capital structure. This need for higher yielding assets has also increased demand for lower-rated securities in the Non-Agency MBS sector.
However, demand from investors at the higher-rated end of the securitization capital structure (i.e. ‘AAA’ and ‘AA’ securities) has not resulted in “all-in” economics for a Non-Agency MBS transaction that surpass the economics of balance sheet financing provided by portfolios funded with low deposit rates or low debt costs. If deposit rates and debt costs remain at historically low levels, the portfolio funding alternative will remain attractive. Notwithstanding the low interest rate environment, some institutions may develop operational capabilities for Non-Agency MBS programs as a risk mitigation process for future periods where balance sheet financing alternatives may not be as beneficial.
Portfolio Concentration or Limitations
Due to the lack of robust investor demand and unfavorable economics in Non-Agency MBS, many banks have increased their portfolio exposure to both fixed-rate and intermediate-adjustable-rate QM loans. The ability to hold these mortgage loans in portfolio has provided attractive pricing to a key customer demographic and earned an attractive net interest rate margin during the historical low-rate environment. While bank portfolios have provided an attractive funding source for Non-Agency QM loans, some financial institutions may attempt to develop diversified funding sources in response to regulatory pressure or self-imposed portfolio concentration limits. Selling existing mortgage portfolio assets into the Non-Agency MBS securitization market is one way in which financial institutions might choose to reduce concentrated mortgage risk exposure.
Some financial institutions may be under pressure from their regulators to demonstrate their ability to sell assets out of their mortgage portfolio as a contingency plan. The Non-Agency MBS market is one way of complying with these sorts of regulatory requests. Developing a contingency ability to tap Non-Agency MBS markets develops operational capabilities under less critical circumstances, while assessing the time needed by the institution to liquidate such assets through securitization. This early establishment of securitization functionalities is a prudent activity for those institutions who foresee the possibility of securitization as a future funding option.
While the Non-Agency MBS market has been dormant for most of the past decade, some financial institutions that have relied upon portfolio funding now appear to be testing the current viability of the Non-Agency MBS market. Other mortgage originators would be wise to take notice of these events, monitor activity in these markets, and assess the viability of this alternative funding source for their on-Conforming QM Loans. With the continued issuance by JP Morgan and Redwood Trust and new entrants such as AIG and Wells Fargo, -Non-Agency MBS market activity should be monitored by other mortgage originators to determine whether securitization has the potential to provide an alternative funding source for future lending activity.
In our next article on the Non-Agency MBS market, we will review the changes in due diligence practices, loan-level data disclosures, the representation and warranty framework, and the ratings process made by securitization market participants and the impact of these changes on the Non-Agency MBS market segment.