Premium Capture Reg Presents Hurdle for Non-Agency Lending
This column first appeared in the June 2011 issue of Asset Securitization Report (www.sourcemedia.com)</p
Thernlatest impediment to non-agency securitization stemming from the Dodd-Frank Actrnis the proposal to create “premium capture cash reserve accounts”rn(PCCRAs). This provision, contained inrnthe recent interagency document that proposed how the “risk retention”rnprovisions of the DFA would be defined and implemented, would require therncreation of a cash account to prevent structurers from attempting to monetize whatrnthey define as “excess spread.” </p
In myrnview, this proposal could be highly damaging to consumer mortgage lending and isrnpremised on a flawed understanding of securitization practices. It also represents another in a series of impedimentsrnto the revival of the market for non-agency securitizations.</p
Afterrnoutlining a narrow definition of “qualified residential mortgages” (QRMs) thatrnare exempt from the 5% risk retention requirements, the release then describesrna potential loophole:</p
Byrnselling premium or interest-only tranches, sponsors could thereby monetize atrnthe inception of a securitization transaction the “excess spread” that wasrnexpected to be generated by the securitized assets over time. By monetizingrnexcess spread…, sponsors were able to reduce the impact of any economicrninterest they may have retained in the outcome of the transaction and in therncredit quality of the assets they securitized.</p
The release goes on to state that:</p
The Agencies propose to adjust the required amountrnof risk retention to account for any excess spread that is monetized at thernclosing of a securitization transaction. Otherwise, a sponsor could effectivelyrnnegate or reduce the economic exposure it is required to retain under thernproposed rules.</p
Thernsolution proposed by the agencies would require sponsors seeking to structurernMBS that don’t meet QRM standards (and thus require the holding of a 5% riskrnretention piece) to fund a cash account. The account’s dollar value wouldrnrepresent the difference between the proceeds of a securitization and 95% ofrnits par value (accounting for the 5% risk retention already required by DFA). The reserve account would be junior inrnpriority to the retained interest and would have to be held for as long asrnbonds in the structure remain outstanding, making its present value extremelyrnlow.</p
The most damagingrnaspect of the PCCRA provision would be the impact it would have on the pricing andrnissuance of non-QRM loans, which comprise a large share of prime loans that arernnot eligible for agency execution. Keeprnin mind that lenders’ offerings are quoted as “points” given various note raternstrata, typically displayed as a matrix with a variety of rate/pointrncombinations. Relatively low rates are accompaniedrnby positive points to be paid at closing, while higher rates are quoted withrnnegative points (which are essentially rebates and are often used to fund bothrnclosing costs and lender add-ons and price adjustments). The offerings are calculated based on the netrnproceeds received for all of a loan’s components when sold to investors,rntypically through a securitization vehicle. rnSince excess interest is effectively rendered worthless under thernproposal, lenders’ ability to offer reasonable rates with negative points wouldrnbe limited, if not eliminated. Thisrnwould in turn hurt cash-strapped borrowers that must allocate their availablernsavings toward their down payments.</p
Thernproposal could, however, have an unintended impact on lenders’ ability to offerrnlower-rate loans requiring positive points. rnThe proposal’s definition of “premium” is the excess of a transaction’srnproceeds less 95% of its face value. AsrnI read it, this means that the sponsor would need to hold cash in the capturernaccount against loans with net securitized values below par but above 95%. This would make these loans uneconomical tornsecuritize. However, deeper discountrnloans could also be a problem under the DFA. rnA clause that revises the Truth in Lending Act states that loans canrnhave a maximum of 3% in points and fees in order to be classified as “qualifyingrnloans”; otherwise, they are treated as high-cost and potentially abusivernfinancial products. Ultimately, therninteraction between the PCCRA proposal and the qualifying loan provision may havernthe unfortunate result of limiting originators’ ability to securitize any non-QRM loans.</p
Thernlogic behind the proposal is itself highly questionable and betrays a naïvernunderstand of securitization mechanics. rnThe stated rationale is that structurers could figure out ways torneliminate or transfer their exposure to retained risk by monetizing “excessrnspread” through the sale of IOs and premium securities. However, the proposal’s utilization of thernterm “excess spread” is flawed. Whilernit’s technically defined as the difference between the collateral’s interestrninflows and the tranches’ coupon payments, the term typically is applicable tornsecuritizations of “alty” and subprime loans that have note rates high enoughrnto allow interest payments to be utilized as part of a transaction’s creditrnsupport. In writing that the monetizingrnof excess spread “…created incentives to maximize securitization scale andrncomplexity, and encouraged aggressive underwriting,” the document is confusingrnprime and non-prime securitizations. Asrna result, it would impose a set of complex and burdensome requirements onrnsponsors in order to effectively outlaw structures that are not economical forrnmost current production. This isrnespecially important in light of the narrow definition proposed for QRM loans;rnthe PCCRA provision would impact a large portion of issuance that would notrnqualify as QRMs but nonetheless have relatively strong credit attributes.</p
ThernPCCRA proposal also suggests that structurers could, by creating some form ofrnIO security, render a horizontal risk-retention piece as economicallyrnworthless. In that case, a superiorrnsolution would simply be to mandate vertical risk retention, which would forcernsponsors to hold a pro-rata share of the collateral rather than a first-lossrnpiece.</p
In fairness, therninteragency proposal includes a provision that may allow sponsors to avoid thernPCCRA requirement. The document statesrnthat “…the proposal would notrnrequire a sponsor to establish and fund a premium capture cash reserve accountrnif the sponsor does not structure the securitization to immediately monetizernexcess spread…” However, it does notrnelaborate on how sponsors could avoid triggering the requirement whenrnsecuritizing premium loans. Originators mayrnbe able to avoid the need for premium capture by holding excess servicing ratherrnthan securitizing it. (Inrnsenior-sub structures used to securitize prime loans, excess servicing isrntypically structured into WAC IOs. Thesernare pro-rata interest cash flows stripped from the premium loans backing therntransaction, and thus are neither senior nor subordinate in priority.) However, this raises a series of additional issues and concerns. Servicing is a volatile asset that is difficultrnto value, hedge and fund; the safety and soundness of the banking system is arguablyrnnot enhanced by forcing lenders to hold more servicing. It will also conflict with Basel III, which willrncreate onerous capital requirements for institutions that hold servicing thatrnaccounts for more than 10% of Tier I capital.</p
This proposal typifies therndifficulties that regulators are having, and will have, in effectivelyrnimplementing the DFA’s risk-retention concept without crippling the non-agencyrnsecuritization market. These issues havernimportant implications for both housing and the financial system. If the PCCRA concept is adopted, I expectrnthat the origination of non-QRM loans will be limited to lenders able to holdrnthem in portfolio. Given the limitedrnappetite of depositories for residential mortgages, the proposal risks starvingrnthe housing market of funds at a time when home prices remain under pressure. Moreover, this will serve to concentrate thernrisk of housing in the banking system, rather than dispersing it into the muchrnlarger capital markets.</p
However, the most disturbing aspectrnof the proposal is that it represents another element in the evolving regulatoryrnframework that is hostile to the securitization of residential mortgagesrnoutside of the agencies’ auspices. Therernis nothing in this proposal that is consistent with the goal, as stated in thernObama administration’s white paper on housing finance, of phasing out the GSEsrnand enticing more “private capital” into the system. Meanwhile, the housing market remains in arnfunk that is partially attributable to tight lending standards and originators’rninability to securitize non-agency mortgage production; this situation willrnonly grow more problematic when the ceiling on conforming balances is reducedrnthis fall. </p
It’s time for regulators,rnlegislators and the administration to stop paying lip service to the recoveryrnof the non-agency MBS market and begin to outline and implement policies thatrnsupport the widespread availability of mortgage funds to qualified borrowers.
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