The Role of Mortgage Cooperatives in Risk Retention and GSE Reform

The following is an excerpt from Chapter 14 of Volume III of The Mortgage Professional's Handbook:


Tom Million, CEO
Capital Markets Cooperative

The mortgage cooperative model is positioned to retain and share risk on behalf of its members, offering possible solutions for risk-sharing structures and GSE reform.

The adoption of the Credit Risk Retention Rule issued by six federal regulators on October 21, 2014, as mandated by Section 941 of the Dodd-Frank Act, creates a number of difficulties for the emergence of a viable, broad-based, non-qualified mortgage market. The final rule is effective February 23, 2015. Asset-backed securities (ABS) collateralized by residential mortgages are required to comply beginning on December 24, 2015, and compliance with the rule with regard to all other classes of ABS is required beginning December 24, 2016. Under the risk retention rules, a sponsor of a securitization (or originator) of RMBS that are not backed solely by qualified residential mortgages (QRM) must retain a collective retained interest in the securitization of not less than five percent. Subject to certain exceptions, the rules prohibit the sponsor from hedging or transferring this retained interest.

Risk retention is complex and capital intensive.  To wit:  For securities backed entirely by residential mortgages, the prohibitions on transfer or sale (without the requisite risk retention) would expire: (1) the later of (a) five years after the date of closing or (b) the date on which the unpaid principal balance (UPB) of the mortgages in the pool have been reduced to 25 percent of the UPB at closing, but (2) in no event later than seven years after the transaction closes.

Small-to-middle market originators are simply not capitalized nor do they typically have the expertise to retain and manage such risk.  A cooperative model provides a solution for smaller lenders, without which the small-to-middle market would be effectively shut out of the ABS market.  A cooperative of lenders may hold and manage the 5 percent risk share, providing direct access to the issuance of non-QM ABS for cooperative members.

Few parties except for real estate investment trusts (REITs), certain hedge funds with long lives, and depository institutions will be able to hold such retained risk. Therefore, without a bridge of capital and expertise between originators and those willing to retain risk, parties will have an enormous incentive to originate loans that meet the criteria of a QRM.  Despite these significant complications, a niche market of non-QMs is likely to emerge, arising from the unfilled product needs of the residential mortgage markets with hedge funds, certain banks, and REITs leading the way.  The cooperative model can form a bridge between these niche market investors and the middle market. 

The development of the non-QM market is happening very slowly, and has not reached any meaningful scale.  The primary problem with the market currently, which will not be changed by risk retention, is selling the AAAs, which on a percentage basis of the aggregate pool of mortgage loans, including non-QM and non-QRM mortgage loans, are expected to be in the 90 percent range. A bigger challenge for the RMBS market isn’t finding buyers for the subordinate classes, but creating a world where institutional investors are comfortable buying the AAA tranches that are backed by non-QM loans.

A near-term step towards risk retention may be up-front risk sharing on agency originations. Up-front risk sharing allows lenders to secure deeper credit enhancement in exchange for lower Guaranty Fees and Loan Level Price Adjustments.  A cooperative can facilitate and consolidate small-lender execution options, and extend equal access to lenders of all sizes.  The cooperative model can be instrumental in shifting risk to the middle market, and disbursing risk away from “too-big-to-fail” institutions.

Various forms of the cooperative model have been put forth in conversations and proposals for reform of Fannie Mae and Freddie Mac. GSEs have always been significant players in the mortgage industry; however, post financial crisis, the GSEs have played a more influential role given the lack of non-agency mortgage credit available.  Post crisis, GSEs/FHA purchased over 90% of mortgage originations.  With the exception of Prime Jumbo, private mortgage securitizations have been mostly dormant since the crisis.

Since the crisis, a wide variety of proposals have been put forward regarding reform of the GSEs, and the movement away from Fannie and Freddie guaranteeing the majority of mortgages produced.  A consistent theme in these proposals is some form of government backstop that stands behind private capital sitting in first loss position. In any secondary market with a government backstop, the private capital bearing the risk will be structured as some form of private credit enhancement, born by entities organized in many different forms (e.g corporations, partnerships, LLCs etc).

Entities active in the mortgage market, generally referred to as mortgage credit guarantor entities (MCGEs), may be:  

1.      GSEs

2.      Private Mortgage Insurers

3.      Banks and other depositories

4.      REITs

5.      Bond insurers

6.      Mortgage Cooperatives

While the legal structure and contractual arrangements differ among the entities above, the substance of their role in absorbing credit losses is inherently very similar. These entities had either private capital, or a combination of private and government capital, backing the credit-risk coverage they provided to investors.  The general idea is that mortgages will be submitted to MCGEs for underwriting and pooling, the MCGEs will price and hold capital for credit risk on loans, and catastrophic credit risk will be back-stopped by a Federal government guarantor.  Note that the Dodd-Frank risk retention requirements essentially mandate some level of entity-based risk-bearing by security issuers and/or originators.   

Read the rest of this chapter in The Mortgage Professional's Handbook!

Tom Millon is one of the top executives in the U.S. residential mortgage industry.  He is an expert in mortgage finance and a frequent public speaker.  Mr. Millon founded CMC as a one-man operation in 2003, and has grown the firm in to one of the nation’s leading mortgage banking operations.  CMC’s national client base of community banks, credit unions, and independent mortgage bankers originate over $100 billion of residential mortgage loans annually, ranking CMC among the top five mortgage originators.  Prior to founding CMC, Mr. Millon built several leading mortgage trading and risk management operations, and was a trader on Wall Street and the Chicago Board of Trade.

Mr. Millon graduated from the Wharton School of Business of the University of Pennsylvania in May 1986.  He holds the Chartered Financial Analyst (CFA) and Certified Mortgage Banker (CMB) designations.  Mr. Millon is the Chairman of CMC’s Board, and he is on the Board of the Wharton School’s Institute of Urban Research.  He is a member of the National Futures Association, the Association for Investment Management and Research, and the Security Analysts Society of San Francisco.  Mr. Millon provides significant time and support to charitable organizations focused on autism research and on mentoring disadvantaged student athletes.