NEW YORK (
) -- The foreclosure crisis that has ignited a selloff in shares of
Bank of America
and other big banks has likely had an even greater impact on the market for mortgage-backed securities (MBS).
Mortgage-backed securities were arguably the eye of the storm in the financial crisis. Though MBS have been around for decades, they grew increasingly risky and complex in recent years, and played a large role in allowing policymakers and investment chiefs around the world to underestimate the size and scope of the housing bubble.
Who in 2007 considered, for example, how large
had become, and made the connection between the giant insurer and people who quit their jobs and began flipping houses for a living in places like Arizona and Florida? Highly complex derivatives of mortgage-backed securities, such as collateralized debt obligations (CDOs) and even more complex things known as CDOs squared, were the link.
Some 80% MBS in 2009 and 2010 were issued by government sponsored entities (GSEs), compared to about 20% in 2007, according to
data. Two of those GSEs,
guarantee or own 53% of the $10.7 trillion in U.S. mortgages, according to
The GSEs, as well as many other private and public entities that bought MBS, are expected to challenge the legality of billions of dollars worth of those securities, on the grounds that they contain mortgages that were sloppily underwritten by banks.
Bank of America
each are thought to face billions of dollars worth o potential "putbacks" of mortgages they underwrote and/or serviced improperly.
These disputes are only the latest blow to a market that has pulled back sharply since the crisis. As the chart above shows, U.S. issuance of MBS fell from well over $1 trillion in 2006 to less than $200 billion in 2008. While the market has come back slightly, it remains more than 50% below its peak--and that was before the latest crisis, which appears to have put sand in the market's already slow-moving gears.
"I don't see
MBS coming back at the moment, and I would even say it has taken a step backwards because of multiple legal and regulatory issues," says John Uhlein, president of Grenadier Capital and the former chairman and CEO of Ambac UK. "You are not going to see too many banks do securitizations when there is this amount of concern from investors. The integrity of the whole securitization model is being questioned."
Others are less pessimistic, even though "cautious optimism" may be a more apt description of their view of the MBS market.
"We have spoken to all the investment banks and they are all interested in restarting their conduits," says Rick Seehausen, president and CEO of LenderLive. "There is hope that the tide is beginning to turn, and perhaps in 2011 we will see MBS again."
Seehausen says that investment banks are recognizing they need to get "closer" to the credit risk and will be looking to verification on a loan by loan basis rather than relying on the past industry practice of "random sampling" loans to determine risk.
In terms of mortgage products, Seehausen says that plain vanilla loans will be the only risks investors would be willing to buy. "These are all going to be full doc loans with a very heavy focus on collateral," he says. "Jumbos will be ultra high credit quality, and we are a long way away from Alt-A."
Chris DiAngelo, partner and co-head of the structured finance group at the New York-based law firm of Dewey & LeBoeuf, believes a back-to-basics approach can help the securitization market recover.
"If you think about it, mortgage lending for single and multi-family is an ideal asset for securitization because it gives predictable cash flows," he says, "but if you are securitizing a billion a week in option ARMs, like Countrywide was doing, then you don't really get normal bonds on the other end."
Still, DiAngelo thinks a full-fledged market revival even of more sensible MBS will take time.
"It will take all of 2011 to get the product side and Fannie and Freddie to get straightened out," he says. "Then you have things happening in the background, such as changes in the offering documents
on securitizations that can't take place until the mortgage documents and product issues are figured out."
One important issue that the market must sort out, according to Grenadier Capital's Uhlein, is whether the risk of a faulty loan should sit with investors or issuers.
"The risk of loss has to go somewhere, and during the boom years the issuers like Countrywide were so strong that they could transfer risk that couldn't be underwritten by investors" Uhlein says. "Going forward now, you need clarity on reps and warranties. You need issuers to hold capital against the risk of a put back."
And once the market has started humming again and memories of the crisis grow dim?
"In five years MBS will not be wildly different from before, but the products will be more regulated," says securitization attorney DiAngelo. "I'm not sure if it will be better."
Written by Dan Freed in New York
Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.