Thursday, February 17, 2011

What's holding back the restart of the private-label MBS market?

Testimony of Michael A.J. Farrell, Chairman, Chief Executive Officer and President Annaly Capital Management, Inc. Before the U.S. House of Representatives Insurance, Housing and Community Opportunity Subcommittee of the Committee on Financial Services Hearing on “Are There Government Barriers to the Housing Market Recovery?” (February 16, 2011 in Washington, DC)

Good afternoon, Chairwoman Biggert, Ranking Member Gutierrez, and Members of the Committee. My name is Michael Farrell, and I run Annaly Capital Management, the largest residential mortgage Real Estate Investment Trust (or REIT) on the New York Stock Exchange. I also oversee the management of Chimera Investment Corporation, the second largest mortgage REIT. Annaly and our subsidiaries and affiliates together own or manage about $100 billion of primarily Agency and non‐Agency residential mortgage‐backed securities (or MBS).

I represent an important constituency in the housing market, the secondary mortgage market investors who provide the majority of the capital to finance America’s homeowners. Just for the Annaly family of companies, we estimate that through our MBS holdings our shareholders collectively help finance the homes of almost one million American households.

I’d like to begin by focusing on the fact that secondary mortgage market investors provide 75% of the capital to the US housing market. That is, of the approximately $10 trillion in outstanding home mortgage debt in the US, about $7.5 trillion is funded by investors in MBS. Of that $7.5 trillion, about $5.5 trillion is held by rate‐sensitive investors in Agency MBS, with about $2 trillion in credit‐sensitive private‐label MBS. The balance, or about $2.5 trillion, is held in raw loan form, primarily on bank balance sheets. Since our country’s banks have about $12 trillion in total assets, there is not enough money in the banking system to fund our nation’s housing stock, at least not at current levels. It is thus axiomatic that without a healthy securitization market our housing finance system would have to undergo a radical transformation.

Right now, securitization is attracting significant amounts of private capital, at least to the part of the MBS market that is government wrapped. This is to be expected, as this market always gains market share in counter‐cyclical fashion. The problem is that the credit‐sensitive, non‐Agency sector of the market, or the so‐called private‐label market, is dormant, with only one small deal done in the last 2 ½ years.

I will now discuss several reasons why the private‐label market is not restarting.

First, the economics don’t work. In order for the math to work, either primary mortgage rates have to rise, the rating agencies’ senior/subordinate splits have to come down, and/or return requirements by the secondary market have to decline. And yes, for good or for ill, the private‐label market is still critically dependent on the rating agencies as the arbiter of credit quality.

Second, there is a higher yielding alternative for investors who want to take residential mortgage credit risk—legacy private label MBS and seasoned loans that have been repriced by the market after the events of the last few years. The return to investors from re‐securitizing legacy MBS is higher than securitizing new mortgage loans. As long as this relative value disparity exists, it will impede the restart of the new‐issue private‐label market.

The third reason is the difficulty in sourcing enough newly‐originated loans. Without the outlet to sell mortgages into securitizations, banks have gotten more comfortable holding non‐conforming loans on their balance sheets, but only by tightening underwriting standards, including requiring sizable down payments. As long as underwriting standards are so stringent, I don’t see a vibrant private‐label market developing.

The fourth reason is the uncertainty over the future regulatory environment. The many different mortgage modification programs and delays in foreclosures have made it difficult for investors to analyze cash flows. The uncertainty over the capital rules related to the definition of “Qualified Residential Mortgages” and risk retention and Basel III is also putting a chill on the lending markets and concentrating origination in only the few largest banks. Will lowering the conforming loan limit, reducing FHA’s reach or raising guarantee fees help re‐start the private label market? That is unclear. These efforts are a step in the right direction toward giving lenders more options and reducing the government’s footprint, but they don’t necessarily address the issues I have discussed. Those no‐longer conforming borrowers could face much tighter underwriting standards, and higher guarantee fees for conforming mortgages will likely just show up in non‐conforming mortgage spreads.

Finally, I want to get to the heart of the current debate: Can the private label MBS market come back to fill the credit gap that is currently filled by the GSEs? The short answer is: Yes it can, but not at the same price and not in the same size. Most investors in Agency MBS won’t invest in private label MBS at any price or only in much reduced amounts, because their investment guidelines preclude taking credit risk.

These investors include money market funds, mutual funds, banks, foreign investors, and governmental agencies. Some rates investors could cross over, but we won’t know how many or at what price until we know a lot more about a lot of things. But at the end of the day I have to refer back to my two market truths: Securitization is the source of 75% of the capital to the housing market, and the private label securitization market isn’t working right now.

Sunday, January 30, 2011

Following the Short Seller: Do Short Selling Bans Prevent Herding During Financial Crises?

By Pierre L. Siklos, Martin T. Bohl and Arne Klein

Abstract: In the literature on short selling restrictions, their impact on pricing efficiency liquidity and trading costs is mostly investigated. Surprisingly little is known about the effects of short selling restrictions on institutional investors' herding behavior. If short selling bans hinder institutional investors from herding during stock market downturns, regulators have a successful tool to prevent further stock price declines. However, our empirical findings for six stock markets do not support this hypothesis.

Saturday, January 8, 2011

Adverse Selection, Liquidity, and Market Breakdown (Bank of Canada)

By Koralai Kirabaeva

Abstract: This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.

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Wednesday, January 5, 2011

Systemic Risk and the U.S. Insurance Sector (SSRN)

By John David Cummins and Mary A. Weiss

Abstract: This paper examines the potential for the U.S. insurance industry to cause systemic risk events that spill over to other segments of the economy. We examine primary indicators that determine whether institutions are systemically risky as well as contributing factors that exacerbate vulnerability to systemic events. Evaluation of systemic risk is based on a detailed financial analysis of the insurance industry, its role in the economy, and the interconnectedness of insurers. The primary conclusion is that the core activities of the U.S. insurers do not pose systemic risk. However, life insurers are vulnerable to intra-sector crises because of leverage and liquidity risk; and both life and property-casualty insurers are vulnerable to reinsurance crises arising from counterparty credit exposure. Non-core activities such as derivatives trading have the potential to cause systemic risk, and most global insurance organizations have exposure to derivatives markets. To reduce systemic risk from non-core activities, regulators need to develop better mechanisms for insurance group supervision.

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Monday, January 3, 2011

CEBS final guidelines on Article 122a of the CRD

The Committee of European Banking Supervisors (CEBS) has today published its final guidelines on the application of Article 122a of the Capital Requirements Directive (CRD).

Article 122a of the CRD provides new requirements to be fulfilled by credit institutions when acting in a particular capacity, such as originator or sponsor, and also when investing in securitisations. These include retention on an on-going basis of a material net economic interest of not less than 5% (so called “skin in the game”), due diligence and disclosure.

Following the amendments made to the CRD relating to securitisations, CEBS is required to issue guidelines ensuring convergence of supervisory practices with regard to the application of Article 122a. In particular, guidance is required on the implementation of the retention clause by the originator, the sponsor or original lender and on the due diligence and risk management practices credit institutions are asked to carry out when investing in securitisation positions.

Besides fostering a common understanding among the competent authorities across the EEA on the implementation and application of Article 122a, the current guidelines provide clarity as well as greater transparency for market participants in order to assist compliance by credit institutions with the relevant requirements of the Directive. In particular, CEBS provides an updated framework for competent authorities to apply an additional risk weight for infringements of the provisions of Article 122a.

In delivering its guidelines, CEBS has benefited from the views gathered from market participants through the responses to the public consultation (CP40) which ended on 1 October 2010, and through a public hearing held on 22 July 2010.

CEBS expects its Members to adopt the guidelines into their national supervisory framework and apply them from 1 January 2011, that is, when the new Directive provisions come into force.

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Thursday, December 30, 2010

What We Don't Know We Don't Know (Gregory J. Gordon, SSRN)

Abstract: Do you read everything in your field today? Do you even know what everything means any more? Readers of scholarly research are faced with an overabundance of information due to interdisciplinary subject areas, access to research at earlier and multiple stages, and simply more research from more scholars. My simple definition of innovation is the ability to create new things by being exposed to a broader and deeper set of existing things, but broader and deeper have their limits. There is no substitute for reading and truly comprehending a specific article, but there aren’t enough hours in the day to read everything. We need better tools to know what research we need to read. We need to know what we don’t know.

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Saturday, December 25, 2010

The dark side of financial innovation (SSRN)

By Brian J. Henderson and Neil D. Pearson

Abstract: The offering prices of 64 issues of a popular retail structured equity product were, on average, almost 8% greater than estimates of the products’ fair market values obtained using option pricing methods. Under reasonable assumptions about the underlying stocks’ expected returns, the mean expected return estimate on the structured products is slightly below zero. The products do not provide tax, liquidity, or other benefits, and it is difficult to rationalize their purchase by informed rational investors. Our findings are, however, consistent with the recent hypothesis that issuing firms might shroud some aspects of innovative securities or introduce complexity to exploit uninformed investors.

Published in the Journal of Financial Economics ($$) but the working paper version is available here: