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The return of the private US Secondary Mortgage Market

Written by Michael McAlary

The private or institutional US Secondary Mortgage Market is coming to life. It’s taken a long time, so it is important to look at what is happening.

Before doing so, a brief overview of the US mortgage market is necessary as there are many similarities, but also some very important differences to the Australian market. The main difference is that the Australian market is dominated by the 4 Majors and is highly vertically integrated where the 4 Majors banks control the origination, do their own servicing and fund on a 60% retail/40%wholesale basis 90% plus of all mortgages. Whereas, the US mortgage market is segmented with the origination, servicing and secondary markets each are highly competitive. The Australian Secondary Mortgage Market requires investment tranches of $200 million, while US mortgages can be securitised individually or in tranches according to the investors’ requirements. The US money centre banks do securitise large tranches in the same way as the Australian market.

These GSE’s have been implicitly guaranteed by the US government, thereby protecting the investor, not the borrower. It was the US mortgage and related markets where the Global Financial Crisis (GFC) had its genesis. As we all know at that time investors did not understand what they were buying. The paper may have been rated AAA when in fact it was junk. So investors left the market because of the loss of trust in the product. As it is well reported on investigation, the GSEs books were found to be full of non-performing loans. The US Federal Reserve through its Quantitative Easing (QE) has been buying back these mortgages which have allowed the GSEs and the banks to re-capitalise their balance sheets while simultaneously the historically low interest rates are to encourage investment. This cheap money has driven equity markets. This is a well understood story.

There may not be much agreement in Washington on many matters, but there is one item that the White House, Democrats, Republicans and regulators agree on – In the future the US tax payers will never again bail out the mortgage industry. This is why the Tea Party and some sections of the Republican Party are trying to have Freddie and Fannie closed down, but what is more likely is that these organisations operating and risk frameworks will change. Initiatives such as Qualified Mortgages (QM) that defines the credit underwriting standards for a GSE securitisable mortgage and Qualified Residential Mortgage (QRM) that requires the originator and securitiser to carry first losses, unless it’s a QM. These compliance requirements are directed at shifting the risk from the tax payer to private enterprise.

QE has artificially suppressed secondary market price volatility. With the proposed end of QE on mortgages in October it is likely that price volatility will return to this market, as investors seek to price risk in this new world. At the moment there is an investment return expectation gap between the buy and sell side which is keeping investors out of the market; however this gap is narrowing and QM and QRM initiatives should help reduce it further. There is some debate that QM will only provide an artificial comfort, only time will tell.

There is also a push to have a single fungible security and QM and QRM are components of that goal so as to remove the price distortions between Freddie and Fannie paper which should improve liquidity. The goal is to have the market trade on credit quality, not on the underlying collateral, however this will take time to implement, if it’s ever achievable.

It has taken 6 years but now that many mortgages have been re-financed, clean-out of defaulters has occurred and with regulatory changes aimed at preventing poor lending practises the private or non-GSE market is starting to come to life. QE is ending and hedge funds and institutional investors are showing a renewed interest in mortgages for a number of reasons, including that the long term consequences of QE on the bond market are unknown. Investors are seeking bond like returns without necessarily having direct exposure to the bond market, the “new” secondary mortgage market may be the asset class that meets that need.

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