This article originally appeared in Barron’s online on 11 April 2014.
There are unequivocal signs that the housing market is healing, even if reluctantly. Since December 2010, housing starts are up 68%. Foreclosures are down 38%. Inventories are down 32%. This is all-around good news – for the economy, for homeowners and for investors. However, there is a disconcerting and growing trend in the housing market that bears consideration as well: In 2013, an astonishing 99% of all new mortgage securities in the U.S. were issued by Fannie Mae or Freddie Mac (the so-called government-sponsored enterprises, or GSEs), or by Ginnie Mae, effectively meaning that all new residential mortgage securities have some form of government backing. This compares to 2005, when little more than half of new mortgage securities were government-sponsored or “agency” mortgages.
Why does this matter? First, it means that the government is the mortgage finance market, a fact that no one, including the government, particularly likes. Second, and very much related, it is an indication that investors, those like PIMCO who buy mortgages on behalf of clients such as pension plans, university endowments and 401(k) plans, do not have the appetite to buy any new mortgages but those that have the backing and the implied protections that government agency mortgages afford. Indeed, if we are to continue to restore the housing market, and at the same time provide adequate protection to private capital so vital to sustaining home values and promoting homeownership in this country, we need to do more.
Everyone – the GSEs, Congress, the Federal Reserve, investors and homeowners – is supportive of reducing the enormous footprint of the GSEs and bringing back private capital to the mortgage finance market, but as of now, that has not happened. Why not?
First, some necessary but technical background: Before the financial crisis, many of the residential mortgages that did not conform to the government’s underwriting criteria were instead originated by banks. The banks packaged these loans into pools and sold them into mortgage-backed private-label securitization (PLS) trusts. At the same time, the trusts would issue securities collateralized by these same loans, largely to institutional investors, including PIMCO.
The PLS trusts typically received promises from the originating bank relating to the quality of the underlying mortgage loans in the legal form of “representations and warranties.” For example, the originating bank would promise that “prudent underwriting practices” had been observed when the underlying loans had been made to the individual homeowners. The PLS trust hired both a trustee to administer the PLS trust and a servicer, often a subsidiary of the bank that originated the loan, to process interest and principal payments and to pursue any delinquencies. Both the trustee and servicer were required to give notice of any misrepresentations regarding the quality of the loans and compel the originating bank to buy the bad loans back at par (also known as a “put-back”).
Fast forward to the financial crisis, when the issues within the PLS mortgage market became apparent: A vast number of the mortgage loans sold to PLS trusts between 2005 and 2007 were “bad loans,” such as those infamous NINJA loans (no income, no job, no assets) that did not adhere to their associated representations and warranties. Nevertheless, not a single major PLS servicer proactively attempted to comprehensively “put back” these loans to their bank originators, perhaps because in many cases the servicers were subsidiaries of or affiliated with the originating bank. Likewise, with rare exception, PLS trustees did not pursue these claims, perhaps believing that they did not have a duty to do so. The net result was that investors in the PLS trusts bore the brunt of the losses resulting from these bad loans. Yet, as investors who simply owned these securities issued by the PLS trust, they had “no standing” and thus were prevented from directly suing the originators and servicers. This situation made it very difficult to hold the responsible parties liable.
Similarly, the manner in which servicers have been allowed to resolve their own liability relating to abusive origination and servicing practices, such as “robo-signing,” has been egregious and harmful to investors. Beginning with the National Mortgage Settlement and continuing through similar other government settlements since then, bank-owned servicers have been allowed to resolve their liability associated with their own abusive origination and servicing practices without actually paying for it. Instead, these settlements have permitted servicers to modify and reduce borrowers’ payment terms on PLS-owned mortgages to “pay” for the bulk of their own bad behavior – effectively meaning that servicers have been allowed to use the assets of investors to pay for their own wrongdoing. This is patently unjust, and settlements such as these are repugnant to investors. They should be repugnant to the trustees of PLS trusts as well; to date, however, trustees have done little to stop this practice.
So, how does all of this relate to my initial points about the lack of private capital in the marketplace? It is quite simple: The private mortgage markets will not attract meaningful new capital until institutional investors, such as PIMCO on behalf of its clients, are assured that these egregious practices will stop and never happen again. In fact, without significant reform in the private mortgage market, investors will continue to prefer to invest in the government-sponsored agency market since there are fewer unknowns and fewer risks.
While there has been significant effort and time spent on GSE reform in Washington, D.C., we think GSE reform will only be successful in reducing the government’s footprint if there is a viable private mortgage-backed securities market. Fortunately, we believe there are a few straightforward reforms policymakers could pursue that would make the private market a much more certain and desirable place in which investors, such as PIMCO clients, could invest. Unfortunately, at least as of now, these reforms have not been sufficiently considered in Washington.
For instance, we believe that one meaningfully positive change would be to modify, through legislation, the relationship among trustees, servicers and investors. Each party involved in the lending process should be held fully accountable for fulfilling their duties properly and in a manner that safeguards the interests of both the borrower and investor. Importantly, trustees and servicers need to have an explicit fiduciary duty to the PLS trusts at all times (not just in certain scenarios). This change would naturally incentivize trustees and servicers to proactively, and at all times, serve and protect the best interests of the PLS trusts. We believe that this would result in higher quality loans being sold to PLS trusts and significantly increase the effectiveness of the “put-back” mechanism. Moreover, we believe that this would greatly reduce the risk of servicers acting against the interests of PLS trusts by, for example, using PLS trust assets to settle damages for their own bad behavior.
Unfortunately, this simple – but powerful – reform was not included in the GSE reform bill introduced by Senators Tim Johnson and Mike Crapo recently. And though we applaud their efforts, we think this is a significant oversight: How do lawmakers intend on bringing private capital back to the market if they don’t address the fundamental issues in the private market that helped to precipitate the financial crisis?
Is including an explicit fiduciary duty to the PLS trust a panacea? No. But would it go a long way in bringing back investors, such as PIMCO clients, to a marketplace that is (or may soon be) desperately in need of private capital? Absolutely.