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5/5/2020 Remarks by Counselor to the Secretary for Housing Finance Policy Dr. Michael Stegman Before the Structured Finance Industry Group 1s… U.S. DEPARTMENT OF THE TREASURY Press Center Remarks by Counselor to the Secretary for Housing Finance Policy Dr. Michael Stegman Before the Structured Finance Industry Group 1st Annual Private Label Symposium 11/12/2014 As prepared for delivery Thank you very much, Richard, for that kind introduction, and thank you to the Structured Finance Industry Group for giving me an opportunity to speak with you this morning about the reforms we think are necessary to catalyze a responsible, vibrant private label mortgage-backed securities market. The now-widely recognized structural deficiencies in legacy private label securitizations that came to light during the financial crisis shattered the trust of market participants – with the result that almost seven years after the collapse, this market is barely clinging to life. Concrete reforms are clearly needed to rebuild confidence and establish a resilient, sustainable architecture to bring back significant private capital to the US housing market. Those here today understand this imperative because many of you are directly engaged in the development of consensus-based industry standards and best practices as part of RMBS 3.0. My remarks this morning will highlight what Treasury is doing as part of our PLS initiative and how we see it complementing your efforts. In light of the Administration’s deep policy interest in returning private capital to the center of the housing finance system, I first mentioned back in January that we would begin a sustained engagement with stakeholders in order to gain a deeper understanding of the factors contributing to the market’s moribund state. Based on this dialogue, we concluded that Treasury was well positioned to help the market overcome its collective action problem. So in June, Secretary Jack Lew announced a Treasury initiative to facilitate the development of market standards and practices necessary for a well functioning, sustainable PLS market, which would begin by casting a broad net on this subject through a request for public comment. We heard from a mix of industry groups, including SFIG, investors, issuers, and service providers, and received informal feedback from many more market participants. These responses highlighted many key impediments we knew well – like conflicts of interest and inadequate enforcement mechanisms –and proposed a range of solutions, many of which we have probed more deeply through a series of roundtables with institutional investors and issuers and in focused conversations with trustees, due diligence firms, and service providers. We found broad recognition among market participants of the need for structural reforms, but little granularity on the reforms themselves or consensus about how they should be implemented or enforced. Some suggested that the new regime should be developed and overseen by an industry group without the need for legislation; others thought legislation was necessary. Still others thought that this was a job for existing regulators, and some even called on Treasury to develop and promulgate market standards or for that job to be given to a new industry-organized self-regulatory organization. We came out of this intensive consultation process with a strong conviction that the market-based problems of PLS should have a market-based solution. So, in the last month I began speaking publicly about the idea of a benchmark transaction, which would reflect an agreement of deal terms between issuers and a subset of highly influential institutional investors who have been sitting on the sidelines since the market collapsed. Why a benchmark transaction? There are at least three reasons for why we think it could help overcome the challenges facing the PLS market. First, we have heard that both issuers and investors are reluctant to allocate firm resources to a thinly traded market. Unlike today’s small and irregular issuances, the benchmark transaction would be composed of collateral from a number of sponsors and consequently, would be much larger than the deals coming to market today, ideally over a billion dollars of unpaid principal balance. With multiple sponsors and sufficient size, a benchmark transaction would result in more favorable allocations at issuance and improved liquidity in secondary trading. Successful execution and a proven template would encourage programmatic issuance, helping to make a case for front-end infrastructure investment by issuers and investors. Second, a sufficiently large benchmark transaction that is the product of a collaborative effort between investors and issuers would, by definition, represent the structural reforms necessary to attract back to the market those senior bond investors that have remained on the sidelines since the crisis, and consequently, become the de facto industry standard. It would guide the market away from catering to the lowest common denominator because its realization would mean that the deal terms were acceptable to those very investors who said they would never return to this market without sufficient protections. As we know, markets functions through imitation. Follow-on transactions would have an incentive to copy benchmark transaction features that have gained acceptance by a broad base of investors, particularly those features without which sponsorship by influential investors would not have been achieved. Third, unlike regulation or legislation, a benchmark transaction would leave room for innovation and evolution in the future but ground the market in a simple, transparent standard that could catalyze issuance and liquidity in the here and now. https://www.treasury.gov/press-center/press-releases/Pages/jl2694.aspx 1/3 5/5/2020 Remarks by Counselor to the Secretary for Housing Finance Policy Dr. Michael Stegman Before the Structured Finance Industry Group 1s… We envision that the benchmark transaction would establish a model set of documents and terms for the market, simplifying both the issuance and investment processes. Issuers would benefit from reduced operational and legal costs, while investors would be able to conduct due diligence more efficiently. However, issuers wishing to deviate from the standard could simply blackline differences in terms. As a result, the benchmark would serve not as a one-size-fits all solution, but as a point of departure for future transactions. In the absence of structural reforms that sufficiently protect investor rights today, the risk-reward profiles of alternative sectors, such as agency MBS are more attractive than AAA PLS, despite the wider spreads to be earned on the latter. Investors simply do not feel they are being compensated for the risk they are taking on in new issue PLS. We believe that a benchmark transaction with improved investor protections would help reverse this relationship, as investors would accept tighter spreads commensurate with the perceived reduction in risk. While enhanced investor protections do not come without additional cost, we believe they would also help eliminate some of the uncertainty premium these investors demand from this sector, which has kept them on the sidelines. We know that the benchmark transaction will not happen if the economics do not work, but we believe that increased demand from AAA investors at tighter spreads would result in improved execution for issuers, strengthening the economic case for securitization relative to portfolio investment. Now, I am sure most of you are thinking that the idea of a benchmark transaction is much easier said than done. Even if investors and issuers agree to sit down and work together to develop a market standard, how could their often conflicting interests be reconciled? Indeed, even the terms of small deals coming to market today differ markedly from each other despite the homogeneity and singular quality of the collateral. This reflects a lack of willingness on the part of some issuers to make concessions around a common standard. These issuers are content to offer the bare minimum terms necessary to place the limited amount of AAA-rated bonds created, structuring deals to the current size of the market instead of adopting the reforms required to expand the investor base. Since I first began speaking publicly about the impediments facing recovery of the PLS market, I have reminded stakeholders that market conditions will not always favor the retention of whole loans on balance sheet. This is precisely why laying the groundwork for an efficient, competitive, and reformed PLS market needs to be done today. Indeed, the curve has flattened by over 80 basis points since the beginning of the year, and if this dynamic continues, banks will find it increasingly unattractive to grow their portfolio investments in mortgage loans. But regulators and policymakers have little direct control over the shape of the yield curve. What regulators and policymakers do control, however – as you never miss an opportunity to remind us – is that government continues to play a significant role in housing finance, impacting the scope of the PLS market. Some stakeholders have argued that reducing GSE market share by lowering conforming loan limits, for instance, would catalyze the PLS market by increasing supply and improving liquidity. While a more central role for private capital in taking mortgage credit risk is at the core of the Administration’s vision for a reformed housing finance system, so, too, is broad access to mortgage credit for all credit-qualified borrowers. Absent the structural reforms necessary to attract sufficient investor demand to meet increased supply, we – like other policymakers – see a significant risk that prematurely reducing conforming loan limits would result in higher borrowing costs and restricted access to mortgage credit, hurting the health of the overall housing market. Earlier, I mentioned some of the efficiencies that we envision resulting from a benchmark transaction including scale, improved execution, and enhanced liquidity, and I could go on. But frankly, the single best economic argument for such a deal is that it would offer concrete evidence of private capital’s ability and willingness to provide mortgage credit at competitive rates to borrowers. A successful benchmark transaction and follow-on deals would support your argument to regulators and policymakers that a reduction of the government’s footprint in the mortgage market can be achieved without undesirable results for consumers. Given that large investors need liquidity, calls for a reduction in conforming loan limits make sense in the context of the potential volume that could be available for securitization through private channels. Even a modest reduction in the high cost area conforming loan limit could make a big difference in the amount of product available for securitization in PLS. However, based on our engagement with the institutional investor community, we have come to the conclusion that liquidity is not in and of itself a sufficient condition for their broad-scale return to the non-agency market. The financial crisis brought to light significant structural flaws in legacy PLS that included misaligned incentives, ineffective enforcement mechanisms, weak or no oversight of transaction parties, and lack of transparency. Until these flaws are remedied, there can be no return of the private label RMBS market at scale because there will not be sufficient investor demand for the senior bonds to sustain it. Some of these structural deficiencies are being addressed by the sponsor of this conference--through SFIG’s RMBS 3.0 initiative. You all have taken on the herculean task of seeking common ground among a broad cross-section of market participants; an effort that has now yielded a second edition of emerging consensus industry standards. But a set of standards in isolation is like the proverbial tree falling in the forest. A benchmark transaction can help incorporate RMBS 3.0’s consensus standards and best practices more concretely into the fabric of the non-agency market. The benchmark transaction would include whatever consensus terms have been achieved thus far by the RMBS 3.0 effort, serving as a first road test of sorts for these emerging market standards. While a benchmark transaction would help catalyze the market today, the ongoing RMBS 3.0 effort can form the basis for future oversight to ensure that its still-evolving standards are not watered down over time. Other structural deficiencies are being addressed through regulation, notably by the Securities and Exchange Commission’s revisions to Regulation AB. While such regulations provide a valuable foundation for necessary reforms, the terms of a benchmark transaction would serve as a more granular template that would build upon SEC’s minimum requirements laid out in AB II. Let me address three critical provisions of that rule that could be fortified by a benchmark transaction. First, since the rule’s completion, key stakeholders have expressed concern that it only applies to publicly registered offerings and does not regulate private placements. Issuers wishing to avoid the rule’s requirements can simply go the 144A private placement route; and given that most post-crisis private label RMBS transactions have been 144A offerings, the rule’s narrow scope does not create an incentive for this market dynamic to change. In this context, a benchmark transaction issued as a 144A offering can help expand the rule’s critical reforms to the broader PLS market as a “best practice,” rather than as an SEC mandate. Regardless of the format that issuers choose, we believe that enhanced disclosures and investor protections should be universal. Second, a weakness of legacy RMBS structures that Reg AB II seeks to address is the enforcement of repurchase obligations associated with breaches of representations and warranties. As a condition for shelf registration, Reg AB II requires an independent third party to review loans for compliance with representations and warranties upon the occurrence of a two-pronged trigger, including a pool-level delinquency threshold and an investor vote. https://www.treasury.gov/press-center/press-releases/Pages/jl2694.aspx 2/3 5/5/2020 Remarks by Counselor to the Secretary for Housing Finance Policy Dr. Michael Stegman Before the Structured Finance Industry Group 1s… Although this provision helps to address the confusion around loan reviews present in legacy deals, the market needs to build upon its minimum requirements to eliminate frictions that have contributed to the lengthy process of breach enforcement. Like SFIG, we believe that there should be loan-level triggers in addition to pool-level delinquency triggers in securitizations of newly originated collateral. Furthermore, we think it makes sense for the reviewer to recommend to the trustee whether or not the repurchase obligation should be enforced based upon its findings. Finally, serious consideration should be given to having deal documents direct the trustee to enforce the repurchase obligation upon receipt of the third party reviewer’s recommendation – without need for an investor vote. Third, to address the legacy challenges of securing enough investor votes to trigger action, the benchmark transaction can establish a market-wide standard for investor communication, not just as a requirement for shelf registration. We are actively engaging with service providers to find more seamless ways of facilitating investor communication as part of the investment process. Such efforts may leverage market-standard data platforms or establish online bulletin boards like those that have become customary in CMBS. The common theme among these structural enhancements is the need for prescription in order to empower transaction parties. We believe that the solution to the deficiencies of the legacy regime is in clarity of terms and contracts, not in the imposition of ambiguous mandates. Let me expand on this thought. A number of prominent investors have told us over the past year that a trustee fiduciary duty is not just the best way, but the only way, of accounting for all of the failures of the legacy model. Based on all of our work and irrespective of legacy terms and contracts, even if we believed in imposing a fiduciary duty, we have concluded the trustee is the wrong party for that duty going forward. The core competency of trustees is in carrying out administrative functions, not in forensic activities that require subjectivity and judgment, which is ultimately what a fiduciary must exercise. In order for a trustee to execute these administrative functions to the satisfaction of investors, it should be sufficient to draft strong contracts with clearly defined responsibilities. On the other hand, we believe that the role of an independent reviewer could be the cornerstone of a reformed set of investor protections. This party would be tasked with reviewing loans for breaches of representations and warranties and recommending appropriate remedies on the basis of such reviews, as well as potentially performing additional duties such as servicer oversight and cash flow reconciliation functions. In carrying out its duties, the independent reviewer would be granted access to loan files and have authority to conduct due diligence. We believe that serious consideration should be given to how this party would be compensated and what obligations it would have to the trust in order to properly align incentives. Most importantly, clearly delineated responsibilities and well-articulated rules are key to ensuring that the independent reviewer is most effective in its duties. Without well-defined responsibilities, the independent reviewer’s activities could expose the trust to soaring expenses, which would be unacceptable to credit rating agencies, never mind investors. Well-defined responsibilities could also help to ensure consistency across reviewers. Moreover, it would be hard to find parties who would be willing to accept the role of independent reviewer without bounding its obligations. What do I mean by well-defined duties and procedures? The devil is unquestionably in the details, and once again, an advantage of the benchmark transaction would be in bringing those details to the forefront. For starters, deal documents should define the triggers that would activate a breach review. The parties negotiating the benchmark transaction would have to agree on the specifics, but triggers such as serious or rolling delinquency, liquidation with a loss, or modification make sense to us. Similarly, for servicer review, triggers such as a pattern of above-average foreclosure timelines or severities could be appropriate. In both instances, sampling may also make sense. From there, we envision that the independent reviewer would perform the prescribed review with discretion to expand its scope. Finally, the independent reviewer would submit a summary of its findings and a clear direction to the trustee of whether or not to enforce a repurchase obligation on the basis of the review. In order to give investors’ confidence that their rights will be upheld, we can see merit in requiring the independent reviewer to conduct these activities solely with the interest of the entire trust in mind. Well-defined duties coupled with an obligation to perform those duties in the interest of the trust would likely be more effective in protecting investor interests than a vague mandate alone. For evidence of what happens when firms lack clarity around their responsibilities and obligations, one need look no further than the agency market in recent years. Lacking certainty around their obligations to repurchase defective loans, originators have significantly pulled back their lending to only serve those borrowers with little likelihood of default. Without clear “rules of the road” for doing business, market participants respond by exercising extreme caution or withdrawing completely. Both of these outcomes would have negative implications for the private label RMBS market. So where do we go from here? Our next step on the path to a benchmark transaction is to bring together key parties – issuers and institutional investors, as well as service providers – to begin work on developing an actual term sheet. As I said earlier, we think that the benchmark transaction can put into practice the industry consensus is being reached as part of RMBS 3.0, and so we encourage all of you to remain actively engaged in these vital efforts. At the same time, we at Treasury want to hear from you on how the terms of a benchmark transaction could best be structured to address your needs. You have an important seat at the table, and you need to use this opportunity to play a constructive role in reinvigorating this market. Thank you. ### https://www.treasury.gov/press-center/press-releases/Pages/jl2694.aspx 3/3
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