Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Joe Nocera

PIK Your Own Poison

Toomre Capital Markets LLC (“TCM”) has been quite concerned about the future of mortgage finance in America. Back in July 2008, TCM created the post Fannie Mae, Freddie Mac and Future of Mortgage Finance. The key point of this post was the need for “the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to ‘turn’ the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.”

Some four months later, the GSE’s have effectively been seized by the Federal government. Lehman Brothers has gone bankrupt. Merrill Lynch has agreed to be become part of Bank of America. And both Goldman Sachs and Morgan Stanley have become bank holding companies actively looking to attract deposits. As predicted in that July post, institutional investors have “gone on strike” against mortgage-backed securities (“MBS”). As a result, in the last week both residential and commercial mortgage backed securities have widened to extreme spreads against swap spreads. Those spreads narrowed considerably this week with the announcement that the Federal Reserve will be buying up to $100 billion in GSE debentures as well as $500 billion in agency pass-through securities.

Still, there is little discussion about the future of mortgage finance in America. In order for the American residential mortgage market to stabilize, there needs to be available financing for well-underwritten home mortgage loans. These purchases by the Federal Reserve are a temporary solution. There no longer is a savings and loan industry to provide the long-term holdings of MBS. The community and commercial banks are capital constrained and looking forward to greater losses on many types of loans as the credit crisis worsens becoming perhaps the worst recession since the Great Depression.

Part of the reason for the GSEs conservatorship was that it was deemed that their portfolios were too large for their capital bases, especially given projected future losses due to the decline in residential real estate prices. As mentioned above, the various traditional institutional investors who previously bought securitized MBS and their “sliced and diced derivates” such as CMOs, CDOs, and private pass-throughs are on a “buyer’s strike”. In many cases, these institutional investors also are trying to reduce their exposures to the mortgage sector.

Toomre Capital Markets LLC has long suspected that the securitization process will be key to answering this quandary about where longer-term mortgages should be financed in America. There is a critical problem that has been displayed in how that business was conducted prior to the current credit crisis. As a loan moved from the mortgage originator to the mortgage wholesaler to a warehouse facility to Wall Street and eventually on to institutional investors (blessed of course with a high-grade by one or more of the rating agencies), no one had a vested interest in the quality of the underlying mortgage loan. For several months now, it has been clearly understood that for the securitization process to restart, each part of the process will need to have some “skin in the game.”