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The MBS markets: 1989 and beyond.

THE MBS MARKETS 1989 and Beyond

Moody's sizes up milestones that occurred in 1989 and the outlook for the mortgage securities markets at home and abroad.

The past year ends a decade that witnessed the expansion of mortgage securitization to a widening array of mortgage types and structures, as well as a geographic expansion beyond U.S. markets. At the same time, investors continue to be reminded of the various credit risks to which mortgage-backed securities may be susceptible.

Indeed, the recent collapse of Drexel Burnham Lambert raised questions concerning the risk of mortgage securities associated with a failed institution. Although Moody's analysis indicates that the bankruptcy is not expected to affect mortgage-backed securities issued by Drexel or by its subsidiaries, the event heightened credit concerns in an already nervous market.

After a review of 1989 and a presentation of the general outlook for the remainder of 1990, we will examine the domestic collateralized mortgage obligation (CMO), pass-through and home-equity markets.

1989 in review

* Structured mortgage transactions

grew modestly in 1989, as slow

economic growth together with rising

interest rates in the

first half of the year

held down new

originations. * Mortgage

securitization accelerated

overseas, especially in

the United Kingdom

and Australia. * The fortunes of the

U.S. savings and loan

industry continued to

decline, leading to a

$50 billion drop in

thrift holdings of

mortgage securities

in 1989. In order to

bolster flagging

capital ratios, thrifts sold

substantial amounts

of assets, including

mortgage securities. * Financial regulation exerted a major

influence on the fortunes of

mortgage securitization in 1989. This

influence came in the form of the

Financial Institutions Reform,

Recovery and Enforcement Act

(FIRREA) in the United States,

while in the U.K., similar impact was

derived from the Bank of England's

guidelines issued in February 1989,

which provided a framework for

treatment of loan transfers and

securitization. In Japan, the ministry of

finance continues to study the

possibility of allowing financial

institutions to securitize domestic

assets, including mortgages.

Worldwide, guidelines set by the

Bank for International Settlements

are turning attention to capital

adequacy; one way to improve capital

ratios is to securitize mortgages. * In the United States, government

agencies--including the Resolution

Trust Corporation, the Federal

Agricultural Mortgage Corporation

(Farmer Mac), Federal National

Mortgage Association (Fannie

Mae) and Federal Home Loan

Mortgage Corporation (Freddie

Mac)--have played or will play a

growing role in mortgage

securitization. Most dramatic was the

massive shift from private-issuer

CMOs to Fannie Mae and Freddie

Mac issuance. CMOs issued by

these two agencies accounted for 85

percent of the market in 1989, up

from 34 percent in 1988.

Credit risk in structured finance

Faltering U.S. real estate markets in the Southwest and Northeast focused attention on portfolios with collateral concentrated in those geographic markets. Similarly, in the United Kingdom increasing arrears on residential mortgage loans combined with stagnating house prices to test market assumptions about appropriate levels of credit enhancement in that market. Deteriorating collateral performance of two mortgage pass-throughs issued by ComFed Savings Bank, Lowell, Massachusetts--due in part to the bank's now discontinued limited-documentation lending program--led Moody's in March of this year to downgrade the securities from Aa2 to A2.

So-called "acts of God"--for example, the San Francisco earthquake in October--represent the most imponderable threats to collateral value. When assigning a rating of Aaa to commercial mortgage-backed securities from Bay View Federal Savings & Loan Association, San Mateo, California, although Moody's considered earthquake risk, ultimately no reasonable credit provision can factor in every enormity of natural disaster. Accordingly, Moody's reacted to news of the catastrophe by placing Bay View's issue on watchlist for possible downgrade, pending assessment of actual damage to collateral values. Subsequently, the Aaa rating was reaffirmed.

Events during 1989 also underlined potential legal risks to structured financings. For example, Moody's placed $1.5 billion of CMOs from Residential Resources, Scottsdale, Arizona on watchlist for possible downgrade in January when the company became the target in a series of lawsuits. Upon resolution of a portion of that litigation, the Aaa ratings were confirmed. Similarly, in June, Moody's assigned a prospective Aa1 rating to a whole-loan CMO from Ryland Mortgage Securities Corporation, Columbia, Maryland, concurrently placing it on watchlist for possible downgrade because of uncertainty over litigation involving various Ryland entities. The rating was subsequently reaffirmed based on certain structural improvements introduced by the issuer. Finally, in mid-April, Phoenix-based American Continental Corporation filed for protection under Chapter 11 of the Bankruptcy Code and included 11 of its direct and indirect subsidiaries in the filing, thus wrapping into bankruptcy protection Linfin Corporation, a limited-purpose subsidiary of Lincoln Savings and Loan Association. The filing triggered the first acceleration of a collateralized structured issue, as the trustee sold collateral to pay in full holders of Linfin's two mortgage-backed bond issues.

Regulatory risks

Certain structures in the United States have relied on written assurances by regulators concerning the integrity of structured vehicles in the event of receivership of a thrift institution. In the aftermath of FIRREA, some of those understandings were subject to question. Moody's met with representatives of the FDIC and was satisfied that certain investor concerns, including timely pay on mortgage-backed and collateralized bonds, had been addressed by the federal agency. Other concerns, such as the regulatory treatment of collateralized letters of credit issued by thrifts, had not.

Structured issues often depend on third party companies for a range of support, including collateral servicing, interest-rate swaps or guarantees, and credit support in the form of a letter of credit, surety bond, financial guarantee or pool indemnity policy. The rating of the structured issue is susceptible to any deterioration in the credit strength of the third party. For example, in October about $155 million of Domus Mortgage Finance No. 1 mortgage-backed securities was downgraded to reflect deterioration in the credit quality of the interest rate maintenance agreement counterparty. Similarly, in July, in response to an unsolicited acquisition bid for B.A.T Industries, Moody's placed the company's securities on watchlist for possible downgrade, along with about $2 billion of U.K. mortgage-backed securities insured by its wholly owned subsidiary, Eagle Star Insurance Company, Ltd.

More structured mortgage transactions during 1989 involved complex or unusual risks, including new kinds of collateral, notably home equity loans; limited-documentation loans backing mortgage pass-throughs; and a greater variety of lower-rated tranches in some structures.

Other trends that also increased credit risk continue to receive close attention from Moody's. Most important is heightened competition among transaction participants, including underwriters, trustees, lawyers, accountants and collateral credit enhancers. The potential pressure on credit standards is obvious. A striking example is the residential mortgage market in the U.S., where intense nationwide competition has led to relaxed underwriting standards, including limited- or no-documentation loans; similarly, lender competition is stretching LTVs on second mortgages. Competition to cut transaction costs has squeezed the fees paid to such transaction participants as corporate trustees, at the very time an increasing array of services are being demanded of them.

1990 outlook

Moody's expects the domestic, residential, structured mortgage market to grow by about 10 percent in 1990. The major factor restraining growth will be the sluggish national economy, which will be offset by other pro-growth influences, many of which were initiated in 1989.

One of the principal sources fueling the growth in 1990 will be the need to securitize mortgages that in previous years would have been held in portfolio by thrifts and banks. The thrift industry will continue to shrink, as will many banks as a result of capital pressures imposed by federal regulators. As economic activity continues, however, mortgages will continue to be originated and ultimately funded by investors. New investors, however, will require new forms in which to hold these assets--forms tailored specifically to their needs. Thus the realignment of the system of financial intermediation in the United States will give impetus to the structured finance market. Although mortgage securitization in the United States is at a mature stage overall, in Europe and the rest of the world, it is not. Moody's believes considerable progress was made in 1989 in laying the groundwork for mortgage securitization abroad and that we are currently on the cusp of explosive growth in those countries. Residential mortgages already have been securitized in the United Kingdom and Australia, with France and Italy soon to follow.

We expect the average credit quality of mortgage-backed securities to decline slightly in 1990. On the positive side, we expect a moderation in the growth of limited- and no-documentation loans packaged in residential mortgage pass-throughs. Furthermore, in the CMO market, we expect a continuation of the shift toward direct issuance by Fannie Mae and Freddie Mac, further improving credit quality in that sector. A number of negative factors will offset these trends, however. Weak economic conditions in the Northeast will cause an increase in delinquencies and losses in portfolios with loans concentrated in that region. In the United Kingdom, the credit quality of mortgage-backed securities will deteriorate, stemming from weakness in the housing market and the continued use of relatively risky, deferred-interest mortgage loans.


A total of 273 different collateralized mortgage obligations with a combined value of $94.5 billion were brought to market in 1989, an increase of 24 percent in dollar volume over that of 1988. Direct issuance by Fannie Mae and Freddie Mac skyrocketed to $80 billion--85 percent of the CMO market--compared with a base of $25.8 billion and a 35 percent share for the previous year. Issuance by affiliates of real estate investment trusts (REITs), which had been $13.6 billion, or 18 percent of the market in 1988, fell to $3 billion in 1989, with a 3 percent market share. CMO issuance by investment banks also declined sharply, from $35 billion in 1988 to $11 billion in 1989--a 69 percent decrease.

The overall increase in volume was fueled by an increased supply of fixed-rate, agency, pass-through collateral and by an estimated $50 billion of securities liquidated by thrifts in order to meet capital reserve requirements. The volume ceiling on Fannie Mae/Freddie Mac was removed in October 1988, making 1989 the first full year of unlimited CMO issuance. Foreign investors, particularly the Japanese, looking for new securities to invest in also contributed to the increased issuance volume in 1989. However, a reduction in CMO issuance by REIT affiliates, resulting from declining demand for CMO residuals by REITs, was triggered by the poor performance of REIT investments in floating-rate residuals.

Moody's expects 1990 to be a year of increased efficiency within the CMO industry because of competition and experience, with volume increasing 10 percent, to more than $100 billion. The modest increase in volume expected will be fueled by the continued, strong mortgage-backed security (MBS) production of Fannie Mae and Freddie Mac (whose joint market share will rise to more than 90 percent) based on forecasts of lower interest rates in 1990. This MBS production should cause an increase in new origination and refinanced mortgage loans, as well as the anticipated liquidation of existing MBSs by thrifts and the Resolution Trust Corporation. Whole-loan CMOs (which tripled in volume in 1989) and CMOs backed by GNMA securities will continue to offer opportunities to private issuers. The market liquidity of CMOs should improve throughout the 1990s because of (1) demand by a more diverse base of investors, (2) investor's increased ability to evaluate issues because of the availability of better data and analytic tools, (3) revaluation and trading by investment managers of their CMO portfolios, and (4) standardization of tranches, as investors demand that in structures.

Moody's expects CMO investors to continue focusing on the importance of third parties to CMO credit risk. A record number of insolvencies of parties related to CMO issuers in 1989 highlighted the structural and legal integrity of Aaa-rated CMOs. Moody's believes the bankruptcy-remote nature of Aaa-rated CMOs will continue to be tested in 1990, as more parties related to issuers will be in financial difficulty.

Rated mortgage pass-throughs

Total issuance of publicly rated residential mortgage pass-throughs in 1989 hit $15 billion, virtually unchanged from the record $15.1 billion volume of 1988. The small drop in issuance tracked total mortgage originations in 1989, which are estimated to show a slight decrease from 1988. However, the composition of the total shifted dramatically. This was influenced by the course of interest rates and by major regulatory changes introduced during the year. The downward trend in long-term interest rates, along with a relatively flat yield curve, resulted in a primary market shift from adjustable rate mortgages to fixed-rate financing. In the fourth quarter of 1989, nearly two-thirds of pass-through transactions were fixed-rate, compared with approximately 25 percent in all of 1988.

While interest rates fluctuate from month to month, the regulatory changes implemented in 1989 will have more long-lasting effects. New risk-based capital standards have caused issuers to shift away from the senior/subordinated security, which had become the dominant structure before 1989. This structure has become less viable because proposed risk-based capital regulations for some institutions state that a large amount of capital must be held by issuers retaining the subordinated class. By the final quarter of 1989, only 40 percent of issues used the senior/subordinated structure, down from 80 percent of pass-throughs issued in 1988.

The alternative credit enhancement chosen most frequently was a pool policy or letter of credit (LOC), which although used in only 5 percent of transactions in 1988, supported more than half of all pass-throughs by fourth quarter 1989. Despite their renewed popularity, pool policies and LOCs presented different challenges. These credit enhancements failed to provide coverage for many risks that would be absorbed by a subordinated class structure. For example, separate policies often had to be obtained to cover special hazard, fraud and bankruptcy. Compounding these problems, special-hazard insurance became increasingly difficult to obtain after the major earthquake hit northern California in October. External credit enhancement was proving to be more expensive than many issuers had anticipated.

Other events of 1989 included:

* The first rated pass-throughs

consisting of: London Inter Bank

Offered Rate (LIBOR)-indexed

ARMs, prime rate-indexed ARMs,

very high-balance (super jumbo)

loans. * The increasing use of multiclass

structures. * A record number of Baa2-rated

subordinate classes.

Regional deterioration of mortgage credit quality in a slowly growing national economy will continue to be a problem for the residential pass-through market. At the end of the 1980s, the Northeastern United States and the New York metropolitan area were experiencing sharp increases in mortgage delinquencies. These problems arose from an economic slowdown resulting in housing price declines in many areas. However, because of the diverse nature of its economy, the Northeast should not suffer price declines of the same magnitude as the oil patch states endured during the early part of the decade.

Another area of concern is the widespread use of limited- or no-documentation lending used in more than half of the loans in the pass-through market in 1989. A few issuers have pared back limited documentation programs as a result of rising delinquencies on poorly underwritten loans. However, strong competition in the high-balance loan market encourages the continued use of riskier underwriting practices.

1990 outlook

Major changes set into motion during 1989 will affect the mortgage marketplace throughout the 1990s and beyond. Risk-based capital standards have sent issuers scrambling to find structures that will minimize the amount of credit and interest rate risk retained on the balance sheet. In addition, the restructuring of the thrift industry will result in a further consolidation of mortgage originators and pass-through issuers. The share of the top 10 pass-through issuers rose from 54 percent in 1988 to 61 percent to 1989, and should trend up in the next few years.

Moody's projects public pass-through issuance will rise about 10 percent over 1989 levels to the $16-$17 billion range, based on forecasts of slightly lower mortgage rates in 1990. We expect this should bring forth new originations, as well as an increase in refinancing. The new capital standards and thrift liquidations should also be contributing factors to an increase in issuance.

Rated home equity loan securities

In 1989, Moody's assigned the first ratings to securities backed by open-end home equity loans, and assigned ratings to two pass-throughs consisting of closed-end second mortgages. Issuance of home equity/second mortgage securities in 1989 totaled $2.9 billion. While growth in new originations is expected to level or decrease, securitization has potential for expansion because the volume of home equity lines and second mortgages securitized in 1989 represents only a small fraction of the $300 billion of outstanding second-lien balances.

Many of the same forces that fostered securitization of residential mortgages have affected the second mortgage market, most importantly the desire of originators to remove assets from balance sheets. However, unlike the first-lien market, few lending institutions originate the large number of small balance loans needed to issue a security. In addition, second mortgages have a greater amount of credit risk than first mortgages and, therefore, need a larger amount of credit support to obtain a rating of Aaa or a rating in the Aa range.

Racing to enter the home equity market, many lenders eased standards for new borrowers. The growth in the use of nonstandard, limited- or no-documentation lending in the first-lien mortgage market spread to the second-lien market, becoming the norm. Delinquencies on home equity loans trended up throughout 1989, especially in areas experiencing weakness in home prices. As a result, many lenders are beginning to move toward stricter underwriting standards.

1990 outlook

Expect moderate growth in second mortgage lending in 1990, as originators adopt tighter standards in response to rising delinquencies. The large pool of outstanding second mortgages and home equity loans, along with a small increase in new originations should result in an increase in second-lien securitization in 1990. Moody's projects a 20 percent increase in second-lien securities in 1990, to a total volume of about $3.5 billion.

U.S. mortgage-backed and collateralized bonds

In 1989, the volume of mortgage-backed and other collateralized bonds and medium-term note issuances declined 48 percent, to $3.9 billion. Issuance decreased largely because of uncertainties and changes generated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). Before FIRREA's enactment in August 1989, new issuance by thrift institutions dropped off, as many market participants took a "wait and see" approach. After the law was enacted, uncertainty persisted with regard to the treatment of security interests in collateral supporting an issue if the issuer became insolvent. FIRREA raised concerns that the security interest might be vulnerable or that investors' receipt of principal or interest might be delayed following a thrift's receivership because of the claims procedure process set forth in the act. As a result of the uncertainty, only one mortgage-backed medium-note issue closed between the enactment of FIRREA and year-end.

Issuance volume in 1990 is uncertain but is expected to continue its downward trend. New origination will be constrained by the increased capital requirements for thrifts set forth in FIRREA. Many thrifts do not meet the new capital requirements and are not in a position to issue additional debt. New issuance of mortgage-supported securities is likely to shift to off-balance-sheet, pass-through securities.

Howard Esaki, Ph.d., is an assistant vice president in the structured finance group of Moody's Investor's Service, New York.
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Title Annotation:mortgaged-backed securities; includes related article
Author:Esaki, Howard
Publication:Mortgage Banking
Date:May 1, 1990
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