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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2016

Trends Signal a Potential Liquidity Crisis Ahead

Addressing the lack of private-investor participation in the secondary market is key to avoiding a tipping point

Author Malcolm Gladwell’s famous book “The Tipping Point” illustrates how even small events or details can have major consequences by essentially acting as the straw that breaks the camel’s back.

Among the agents and theories of change outlined in “The Tipping Point” are The Stickiness Factor, The Law of the Few, The Power of Context and Broken Windows Theory. Each can apply to every aspect of life, including the use of social media, grocery-shopping habits and even economic trends — such as the housing market.


Pretend it’s 2008. What comes to mind? Layoffs? Hard times? Fraud? Recession?

For a topic or event to be deemed sticky, it has to be intriguing or memorable. That’s what makes it grab and hold the public’s attention. In other words, it has to stand out in some way for it to stick in the public consciousness.

The 2008 housing crisis became a memorable, or “sticky,” event, as is demonstrated by the making of the movie “The Big Short” — a film set against the world of high finance and the collapse of the housing bubble. If Hollywood takes notice of an event, it’s betting the American public will remember that event.

Hollywood was betting that the housing crisis was “sticky” in moviegoers’ eyes. That bet paid off with an Oscar nod for best adapted screenplay and a tidy worldwide box-office gross of more than $130 million. That’s not bad for a movie about complicated financial concepts.

The housing crisis is a sticky subject, all right. That means people remember the crisis. Does that mean another one’s coming? Actually, it might — especially because a certain group of people still remember it all too well.

The few

In a scene from “The Big Short,” actor Ryan Gosling uses the block-stacking game Jenga to represent the failed mortgage bonds making up the U.S. housing market. The collapse of that market — of the Jenga-like tower of bonds — hurt a lot of people, crushing private mortgage investors in particular.

Groups of people that contribute to an event’s tipping point don’t have to be large. What matters is who they are, what they know and what they do with the information. Gladwell identifies these key influencers people as “mavens.” Private mortgage investors represent the mavens of the housing crisis because it hit them the hardest. Ever since the 2008 housing-market collapse, they have studied the loans they take on with jaded, practiced eyes. They will do anything to avoid another housing meltdown.

In fact, because of investor hesitancy, most of the mortgages sold on the secondary market today are purchased by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and not by private investors.


Context matters, or as Gladwell explains, tipping-point events are affected by the times and places in which they play out. In the case of the housing market today, the context signals caution ahead.

In 2018, per prior Congressional action, the GSEs are set to wind down their investment portfolio business to a minimal level, essentially making it impossible for them to rebuild capital. This is not to say necessarily that the GSEs will be gone after 2018, but they are now operating under a conservatorship that was meant as a temporary solution. At some point, perhaps by 2020, the GSEs will, at the very least, be reformed — but how that reform will look, or whether it will work, is unknown.

Today, there is a dearth of private-investor participation in the residential mortgage-backed securities (RMBS) market, which is a major source of liquidity in today’s housing market. The RMBS market works by allowing lenders to sell home mortgages they originate into the secondary market, where securities are issued against those loan pools, assuring lenders and investors, including the GSEs, have a steady and fluid source of new capital.

Lenders now sell the bulk of their loans to the GSEs. That’s a heavy load. If the GSEs’ role is downsized — or eliminated — as part of any future reform, that could have a profound impact on the liquidity of the RMBS market.

In 2018, the GSEs, and the role they now play
in the secondary market, will reach a crossroads.

In 2006, private investors (or non-agency players) accounted for 56 percent of new RMBS issuance. By 2007, when private investors saw the writing on the wall with respect to the housing bubble, non-agency issuance had dropped to 38 percent. Today, non-agency RMBS issuance stands at about 5 percent of the total market. Above all other issues, the 2008 mortgage crisis was arguably about liquidity — or the lack of it.

The implementation of the new Truth in Lending Act and Real Estate Settlement Disclosures Act Integrated Disclosure (TRID) rules this past October has raised the stakes even higher. TRID requires lenders to adhere to strict consumer-disclosure guidelines that revolve around a set of standardized forms provided to borrowers. Errors or other problems related to those disclosures and forms can delay loan funding and even create potential legal liabilities for the owners of those loans, such as private investors who purchase them with the goal of securitizing the mortgages.

Consequently, TRID errors are creating some hiccups in the packaging of home loans for the secondary market. If private investors were already shunning the RMBS market to a large degree before TRID, how can they be convinced to come back to the market now that the new regulations are in play?

There needs to be a paradigm shift soon, or the housing market could face a new liquidity crisis in the near future, which may fuel yet another housing-market collapse.

Broken windows

In the 1990s, the New York Police Department started cleaning up signs of gang violence in neighborhoods. The theory was that by repairing and reducing these small indicators of crime, it helped to ward off other criminal activity. The converse was deemed true as well — that small signs of crime, such as broken windows, could encourage more serious criminal activity.

TRID violations are similar to broken windows in the eyes of private investors. Many industry experts see these errors as minor typos or oversights; however, in sufficient volume and not adequately addressed, these errors can lead to much bigger problems. Among the market concerns is that these TRID errors could be deemed contractual violations of the loan origination agreements, and that risk extends to any investor purchasing those home loans, including secondary-market players.

Add in the other regulatory changes put in place since the financial crisis, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, and you have a cocktail for a potential crisis. If borrowers go into default, and their attorneys discover TRID violations, there are additional delays and costs associated with the foreclosure process. In extreme cases, borrowers will be able to rescind their mortgage contracts. Private investors understand those risks, and the additional liability created if loan originators don’t get TRID right.

It’s already starting to happen. WJ Bradley Mortgage Capital recently closed its doors because its warehouse lines of credit were clogged with non-agency loans that the company couldn’t sell because of TRID-related problems. The company’s liquidity dried up. Nonbank lenders cannot operate without liquidity.

The elephant in the room is not that private investors are afraid of a few TRID violations. Remember, many of them already weren’t buying loans before TRID was implemented. The problem is what the TRID violations represent. They are yet another indicator — broken windows — to the sidelined private investors that they should avoid a return to the RMBS market because the risks outweigh the potential return. That isn’t likely to change absent changes that lead these investors to dramatically shift how they now perceive RMBS risk.

Final straw

If these various “tipping point” factors are added up, the cumulative effect seems to indicate that a mortgage crisis may be brewing in the U.S. housing market that could hit sometime after 2018 — when the GSEs as we know them are slated to be wound down, or reformed.

Bad underwriting and loans built on false collateral caused liquidity to flatline in the 2008 mortgage crisis, and our country went into a type of fiscal cardiac arrest. Underwriting criteria were eventually stabilized to keep the mortgage market afloat with government-backed guarantees, but that was meant to be a temporary solution.

If we had truly recovered from the last housing-market crisis, the government would not still be serving as the secondary-market backstop for 95 percent of home-loan originations. It has been eight years since the last housing bubble burst, and private money still has not come back into the market at anywhere near pre-crisis levels. The financial collapse of 2008 has never really healed.

Absent major change and reforms, we are not headed for another housing crisis. Rather, we may be heading for a resurgence of the last housing crisis — another liquidity cardiac arrest, this time because of the risk tied up in the supply chain.

•  •  •

In 2018, the GSEs, and the role they now play in the secondary market, will reach a crossroads. It is vital that these agency players do not go away completely. The restructuring of the GSEs, and how the RMBS market resolves the issues surrounding TRID violations, are tricky subjects fraught with political implications.

Even so, if policymakers don’t find a way to create a paradigm shift that somehow convinces private investors to come back into the RMBS market before the GSEs are wound down, the housing market could well tip into another crisis. In such a crisis, the secondary market for home mortgages would all but dry up. Community and warehouse lenders would likely make it more difficult for people to buy homes. Even some of the big banks might be unable to handle the liquidity drought, depending on how long the problem lasts. This could lead to layoffs, hard times and recession — a difficult version of déjà vu.


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