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86–292 PDF 2014

S. HRG. 113–145 

HOUSING FINANCE REFORM: FUNDAMENTALS OF 

A FUNCTIONING PRIVATE LABEL MORTGAGE– 

BACKED SECURITIES MARKET 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED THIRTEENTH CONGRESS 

FIRST SESSION 

ON 

EXPLORING THE STATUS OF THE PRIVATE LABEL MORTGAGE BACKED 

SECURITIES MARKET SINCE THE FINANCIAL CRISIS OF 2008 

OCTOBER 1, 2013 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JOE MANCHIN III, West Virginia 

ELIZABETH WARREN, Massachusetts 

HEIDI HEITKAMP, North Dakota 

MIKE CRAPO, Idaho 

RICHARD C. SHELBY, Alabama 

BOB CORKER, Tennessee 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

TOM COBURN, Oklahoma 

DEAN HELLER, Nevada 

CHARLES YI, Staff Director 

GREGG RICHARD, Republican Staff Director 

LAURA SWANSON, Deputy Staff Director 

ERIN BARRY FUHER, Professional Staff Member 

ELISHA TUKU, Senior Counsel 

RIKER VERMILYE, Legislative Assistant 

GREG DEAN, Republican Chief Counsel 

CHAD DAVIS, Republican Professional Staff Member 

HOPE JARKOWSKI, Republican SEC Detailee 

DAWN RATLIFF, Chief Clerk 

KELLY WISMER, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

(II)

C O N T E N T S 

TUESDAY, OCTOBER 1, 2013 

Page 

Opening statement of Chairman Johnson ............................................................. 1 

Opening statements, comments, or prepared statements of: 

Senator Crapo ................................................................................................... 2 

WITNESSES 

Martin S. Hughes, Chief Executive Officer, Redwood Trust, Inc. ....................... 4 

Prepared statement .......................................................................................... 29 

Responses to written questions of: 

Senator Kirk .............................................................................................. 62 

Senator Coburn ......................................................................................... 63 

John Gidman, President, Association of Institutional Investors ......................... 5 

Prepared statement .......................................................................................... 34 

Responses to written questions of: 

Chairman Johnson .................................................................................... 65 

Senator Kirk .............................................................................................. 65 

Senator Coburn ......................................................................................... 69 

Adam J. Levitin, Professor of Law, Georgetown University Law Center ........... 7 

Prepared statement .......................................................................................... 40 

Responses to written questions of: 

Chairman Johnson .................................................................................... 71 

Senator Kirk .............................................................................................. 72 

(III)

(1) 

HOUSING FINANCE REFORM: FUNDAMENTALS 

OF A FUNCTIONING PRIVATE LABEL MORTGAGE–BACKED SECURITIES MARKET 

TUESDAY, OCTOBER 1, 2013 

U.S. SENATE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Committee met at 10 a.m., in room SD–538, Dirksen Senate 

Office Building, Hon. Tim Johnson, Chairman of the Committee, 

presiding. 

OPENING STATEMENT OF CHAIRMAN TIM JOHNSON 

Chairman JOHNSON. Good morning. I call this hearing to order. 

Today we meet to examine the private label mortgage-backed securities market, the barriers that exist in the current market that 

prevent private capital from reentering, and how this market fits 

into any housing finance reform effort. 

At the height of the housing boom, private capital represented 

more than 50 percent of the mortgage market. Today it is closer 

to 5 percent. While Government-backed loans represent 95 percent 

of the current market, the volume of Government-backed loans has 

not changed that much. What has changed is a major reduction in 

volume by the private market. 

I think we can all agree that the private market should play a 

more substantial role in our housing finance system than it is currently. That said, we must be certain that any new system we design will actually attract private capital. 

For securitization to work well, especially in the PLS market, the 

underlying loans must be well underwritten and there should be 

greater transparency. The Wall Street Reform Act includes key reforms, such as QM, QRM, and disclosure requirements, that will 

help prevent another crisis caused by high-risk loans that were 

bundled and sold to investors. Final rules, along with higher guarantee fees, will provide strong incentives for the private market to 

return. 

Additionally, the recent crisis showed us weaknesses in the current loss mitigation and foreclosure process. We should look at 

ways to eliminate barriers to reasonable loss mitigation efforts that 

are ultimately in the borrowers’ and investors’ interest. 

With any reform, we must create the necessary conditions to 

bring private investors into this market while at the same time 

sustaining structures like the To-Be-Announced market. The TBA 

market is a key component to ensure access, affordability, and liVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
2 

quidity for borrowers and investors, and it allows for the existence 

of the 30-year mortgage, important to millions of Americans. We 

will have future hearings on these issues, but if private capital 

were to take any first-loss position ahead of a future Governmentguaranteed security, we must make sure it is compatible with the 

TBA market. 

These are extremely complex issues, and there are no easy answers. That is why we are exploring the role of private capital 

early in our series of in-depth housing finance reform hearings this 

fall. We must get this part right. As we have learned, private capital may not always participate in all segments of the housing finance market under all economic conditions. Any steps this Committee takes to refocus and redefine the Government’s role and improve the securitization process in the housing finance system must 

foster stable private capital flows, provide access to smaller lenders, and not price the middle class out of affordable mortgage products. 

Clearly, we have our work cut out for us, and I look forward to 

this morning’s discussion. 

Senator Crapo, do you have any opening statement? 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Yes, and thank you, Mr. Chairman. 

We have just passed the 5-year anniversary of the conservatorship of Fannie Mae and Freddie Mac, and now the Federal Housing 

Administration has announced that it will require a nearly $2 billion draw from the Treasury, almost double the amount that was 

projected in the President’s 2014 budget. This announcement highlights the reality that we must act now to reform the Governmentsponsored enterprises and the larger housing market. 

As we noted during our last hearing, the Committee will examine 

individual components of our housing finance system through a series of hearings intended to produce bipartisan agreement by the 

end of the year. 

Today we take a more in-depth look at our first issue as we hear 

from witnesses on the private label securitization market. This 

being one of the first topics we discuss should indicate just how important a vibrant, well-functioning private mortgage-backed securities market is to our housing finance system. 

Unfortunately, today’s private label market is a tiny fraction of 

what it was prior to the financial crisis. The Federal Housing and 

Finance Authority’s latest conservators’ report showed that the 

Federal Government, through Fannie, Freddie, and Ginnie Mae, 

backed nearly 100 percent of the mortgage-backed securities that 

were issued in 2012 and the first quarter of 2013. 

It is clear that private capital is on the sidelines and that the 

Government needs to reduce its footprint. Our goal should be to 

identify what particular challenges face the private mortgagebacked securities market, be they regulatory, legal, or structural 

hurdles. To that end, this hearing gives us an opportunity to learn 

why private capital is sidelined in our mortgage market and what 

needs to be done to bring the mix of the private sector and the Government into an appropriate balance. 

3 

We have seen some experimentation in the private label market 

this year, but it is too early to tell what momentum will flow from 

those deals. I welcome the recommendations our witnesses have to 

bring back private capital into this critical segment of our economy 

while protecting the U.S. taxpayer from a future bailout scenario. 

In particular, I am interested to hear your views on whether the 

private label inactivity is rooted in a lack of confidence in the 

transparency, in risk mitigation, and alignment of interests in the 

mortgage chain. Could a lack of confidence in the private label 

space drive investors to overvalue the Federal support afforded 

through GSEs by comparison? What commonsense reforms can we 

put in place to restore investor confidence? 

I have heard that a lack of standardized documentation for securities issuance and process for the review of mortgages within 

securitized pools is a reason why investors are hesitant to reenter 

the private label market. What reforms are necessary to achieve 

adequate uniformity? What kind of progress has there been for private label market participants to come to administration on standards for issuance of review of mortgages, including representations 

and warranties or other issues? 

I have heard that the question of eminent domain has created a 

lot of uncertainty with respect to investors’ willingness to enter the 

private label market. What are the impacts that you see in the private label space from these eminent domain policies? I would also 

like to hear our witnesses’ views on what they anticipate the private label market will look like in the future. 

I hope that as we proceed with these reforms we will build upon 

the momentum that has recently been generated on both sides of 

the Capitol and the White House. 

Time is of essence, and the GSEs continue in an unsustainable 

conservatorship, and the FHA’s financial condition continues to deteriorate. Chairman Johnson and I moved the FHA solvency bill 

out of Committee earlier this year, and it is time for us to engage 

on broader reforms. And I want to take this opportunity to thank 

the Chairman for his eager willingness to work with us to build a 

bipartisan solution and to move forward expeditiously. 

I remain strongly committed to working with the Chairman and 

all of my colleagues toward a bipartisan solution and a process to 

fix these difficulties soon. 

Thank you, Mr. Chairman. 

Chairman JOHNSON. Thank you, Senator Crapo. 

Are there any other Members who would like to give brief opening statements? 

[No response.] 

Chairman JOHNSON. I would like to remind my colleagues that 

the record will be open for the next 7 days for additional statements and other materials. Before we begin, I would like to introduce our witnesses. 

Mr. Martin Hughes is the chief executive officer and member of 

the board of directors of Redwood Trust, Inc. 

Mr. John Gidman is an executive vice president and chief information officer at Loomis, Sayles & Company. Mr. Gidman is also 

president of the Association of Institutional Investors. 

4 

And, finally, Mr. Adam Levitin is a professor at the Georgetown 

University Law Center and is the Chair of the Mortgage Committee of the Consumer Financial Protection Bureau’s Consumer 

Advisory Board. 

Mr. Hughes, you may proceed. 

STATEMENT OF MARTIN S. HUGHES, CHIEF EXECUTIVE 

OFFICER, REDWOOD TRUST, INC. 

Mr. HUGHES. Good morning, Chairman Johnson, Ranking Member Crapo, and Members of the Committee. I appreciate the opportunity to be here today. My testimony will focus on the current 

state of the private MBS market and actions that can be taken to 

fully accelerate its return. 

Redwood currently operates a prime jumbo loan conduit where 

we acquire mortgages from originators for pooling and sale primarily through our Sequoia private securitization platform. 

In addition, we recently received our seller/servicer licenses from 

Fannie Mae and Freddie Mac. This will enable us to work with the 

enterprises to find ways for Redwood to invest in the first loss credit risk and the loans we sell to the enterprises, thereby putting the 

enterprises in a second-loss credit position. 

The private sector of the U.S. secondary mortgage market consists of portfolio lenders who are primarily banks and private label 

issuers such as Redwood, although banks may be issuers as well. 

I firmly believe over the long term private label mortgage 

securitization will remain a very necessary and efficient form of 

mortgage financing. 

Many have speculated on why the private label MBS market is 

not fully flourishing today. There is no single answer to this question, and there are a variety of factors that must be considered. 

Some of these factors will be self-correcting over time while others 

will require structural or legislative change. I have specific changes 

to recommend, but I would first like to offer the following broad observations that explain the current state of the private market. 

First, as a result of the increase in the conforming loan limit, 

there are simply fewer jumbo loans being created today. 

Second, the enterprises have had a significant pricing advantage 

over the private MBS market. This advantage has been reduced 

somewhat as guarantee fees have been increased over the past 2 

years. 

Third, and importantly, major banks, which were significant 

issuers of private MBS, have made a business decision to hold significantly more jumbo loans in portfolio rather than securitize them 

or sell the loans. 

Fourth, AAA investors still have questions of confidence in 

whether their rights and interests in the securities they purchase 

would be respected and, consequently, that their investments 

would be safe and secure. 

And, fifth, it is a Catch-22, and that is, in order to for the private 

label market to attract more investors, the asset class needs to be 

larger and more liquid. On the other hand, the private lable MBS 

asset class cannot achieve a larger liquid critical mass as long as 

it is too small for investors to justify allocating analytical and monetary resources to private label MBS. 

5 

These issues are solvable. Market and Government policy makers 

can work together to fully restore the private label MBS market. 

The key to our success will require a primary focus on the needs 

of institutional investors that buy the senior classes of mortgagebacked securities. Simply put, these investors have the money, and 

without their participation, there is no market. 

Fortunately, addressing investors’ concerns is not a complicated 

task. It requires better risk mitigation, transparency, and alignment of interests throughout the mortgage chain. We can achieve 

this by correcting the structural deficiencies and conflicts in 

securitization that became apparent in the wake of the financial 

crisis. 

My written testimony goes into more detail about the following 

recommendations: We must establish best practices for representations and warranties and other key securitization terms. We must 

establish binding arbitration as the minimum standard for dispute 

resolution of representation and warranty breaches. We must require that securitization trusts create the position of a credit risk 

manager. We must address servicer responsibilities and conflict of 

interest issues. We must also control the systematic and loan-level 

risk of second-lien mortgages by giving first-lien holders the ability 

to require their consent to a second lien if the combined loan-tovalue with all other liens will exceed 80 percent. And we must reduce the Government’s participation in the mortgage market by reducing the enterprises’ conforming loan limits on a safe and measured pace. 

In conclusion, the U.S. mortgage market is a complex system 

with many parts and key participants. Each plays a supportive role 

in creating a highly liquid and efficient market. The private label 

MBS market will once again assume a major role, alongside the 

Government-supported sector, as the issues I have discussed begin 

to get resolved. 

Thank you, and thank you for being here on this important day. 

Chairman JOHNSON. Thank you. 

Mr. Gidman, please proceed. 

STATEMENT OF JOHN GIDMAN, PRESIDENT, ASSOCIATION OF 

INSTITUTIONAL INVESTORS 

Mr. GIDMAN. Thank you. Chairman Johnson, Ranking Member 

Crapo, and Members of the Committee, thank you for inviting me 

here today to testify regarding the fundamentals of a functioning 

private label mortgage-backed securities market. 

My name is John Gidman. I am an executive vice president of 

Loomis, Sayles & Company in Boston, Massachusetts, but I am testifying here today in my role as president of the Association of Institutional Investors. The association is an organization of some of 

the oldest and largest institutional investment advisers in the 

United States. All our firms have a fiduciary duty to put our clients’ interests first. Put simply, it is not our money. 

Collectively, the association’s members manage investments for 

more than 80,000 pension plans, 401(k)s, and mutual funds on behalf of more than 100 million American workers and retirees. Our 

clients include companies and labor unions, public and private pension plans, mutual funds, and families who rely on us to prudently 

6 

manage their investments, in part due to the fiduciary duty we owe 

these organizations and families. 

We recognize the vital role housing finance markets play in our 

society. These markets have traditionally provided generations of 

families pathways to gain home ownership. For decades, this defined the American Dream. Much of this mortgage financing has 

ultimately been provided by our clients who relied on the strength 

and depth of these markets to provide them the income they needed for retirement. 

The PLS market has improved since the bottom of the financial 

crisis. However, the absolute volume remains a very small fraction 

of what it was before the crisis. And there is a vast gulf between 

the types of loans funded by the private label securitization market 

and those that are supported by the GSEs. 

Typically now PLS loans average approximately 66 percent loanto-value and a 760 FICO score, with very few second liens and no 

mortgage insurance. Borrowers have 20 to 50 percent equity in the 

property, and the average home price of these mortgages is over $1 

million. These high prices, combined with large downpayments and 

very high credit quality, have led to a situation where the current 

PLS standards cannot be used to finance mortgages for the majority of Americans. 

Institutional investors want to be able to invest in the full range 

of the mortgage sector on behalf of our clients. There is pent-up demand. However, as fiduciaries, we cannot increase our conviction 

in this market without meaningful structural reform. Therefore, we 

fully support Congress’ efforts to reform the mortgage market. The 

recently introduced Housing Finance Reform and Taxpayer Protection Act has moved the debate in the right direction. The bill’s risksharing mechanisms offer a promising solution that we believe 

could work if investors’ concerns are addressed. 

The legislation also provides helpful language regarding issues 

like standardization of documentation and enforcing representations and warranties. The bill, however, does not address three fundamental investor concerns which we would like to touch on today. 

First, any mortgage market reform legislation should include, in 

our view, trustee fiduciary duties to oversee the maintenance of 

trusts and enforce put-back obligations for faulty loans with regulatory oversight and private causes of action for breaches. Situations like last year’s AG mortgage servicing settlement, where 

trustees and servicers were able to sacrifice the assets of trust investors’ pension plans in favor of their bottom line, underscore the 

need for these duties. 

Second, we believe the ability-to-repay rulemaking will lead institutional investors to avoid the PLS market. We agree with holding 

originators accountable for predatory lending by allowing defaulting borrowers to sue lenders for irresponsible lending. However, 

the rule includes assignee liability which we believe allows the borrower to sue any subsequent buyer of the loan, even if they were 

not the lender who made the bad loan in the first place. 

And, third, certain jurisdictions are considering implementing a 

program designed and aggressively marketed by a private fund. 

Under the program, the city would rent out its local eminent domain power to seize performing mortgages, held in interstate 

7 

trusts, in order to restructure the mortgages at a profit for the 

fund’s investors. If mortgage market reform does not address this 

scheme and eminent domain is used, we will have to weigh the possibility that all future mortgage contracts might not be upheld, and 

our clients could lose their value in those investments. 

As the Committee continues to consider housing finance reform, 

we hope these perspectives support your efforts. Each suggestion is 

intended to help rekindle a vibrant secondary mortgage market, accomplish your goal of reducing the Government footprint, and avoid 

adverse consequences that will ultimately affect the millions of 

Americans who rely on these markets to save for their families’ 

needs. 

Thank you for your time today, and I look forward to answering 

your questions. 

Chairman JOHNSON. Thank you. 

Professor Levitin, you may proceed. 

STATEMENT OF ADAM J. LEVITIN, PROFESSOR OF LAW, 

GEORGETOWN UNIVERSITY LAW CENTER 

Mr. LEVITIN. Good morning, Mr. Chairman Johnson, Ranking 

Member Crapo, and Members of the Committee. Thank you for inviting me to testify this morning, and thank you for continuing 

today with your important work on housing finance reform. 

Housing finance is a huge market, some $11 trillion of debt outstanding, and it is vitally important to our economy as it affects 

things ranging from the home-building and home-furnishing industries to the value of what is the single largest asset for many families. 

There is widespread recognition that reforms are needed in the 

housing finance market, and yet this is also an area in which reforms must proceed with caution as there are potentially serious 

consequences from getting it wrong. Rule 1 in housing finance reform should be, ‘‘Do no harm.’’ 

Now, there is reasonable disagreement on the details of reform, 

but the overwhelming evidence makes clear that we cannot rely on 

private label mortgage-backed securities, or PLS, to be the backbone of the housing finance system. 

PLS are mortgage-backed securities that lack any sort of Government or GSE guarantee whatsoever. I want to make clear that 

when I refer to PLS, I am not talking about what S.1217 envisions 

for the FMIC guaranteeing with a 10-percent first-loss piece. 

Historically, prior to 2004, PLS were a small part of the housing 

finance market, never accounting for more than 15 percent of the 

financing in the market. Between 2004 and 2007, however, PLS 

provided the high octane rocket fuel that drove housing prices into 

the stratosphere before the bumpy reentry that we all know all too 

well. 

The PLS market has not rebounded. Indeed, it remains basically 

dead. There have only been around 17,000 mortgages that have 

been financed by the PLS market since 2008. That is fewer than 

the number of mortgages financed in the District of Columbia last 

year. And as Mr. Gidman laid out, these have been ultra, ultra 

prime mortgages. 

8 

There are many reasons why the PLS market has not rebounded, 

but key among them is it has not solved many of its internal market structure and incentive problems relating to the roles of trustees, servicers, and enforcement of representations and warranties. 

And there are reforms, as I discuss in my written testimony, that 

can be undertaken to improve PLS. 

Ultimately, though, even an improved PLS market cannot 

change the fundamental math. By a very generous estimate, capital markets will be able to support no more than around $500 billion annually in mortgage credit risk. The U.S. housing finance 

market needs anywhere between $1.5 trillion and $4 trillion in annual financing, depending on market conditions. 

Capital markets are insufficient to support the amount of credit 

risk needed to sustain the U.S. housing market. They can plan an 

ancillary role, but they are simply incapable of providing the foundation for the market. 

Instead, a discussion of how to rebuild the housing finance system needs to be based around some form of a hybrid public–private 

structure with first-loss private capital sitting in front of a public 

guarantee. 

A rebuilt housing finance system also needs to have the capacity 

for the Federal Government to step into the breach as needed during countercyclical events when private capital flees from the market. 

And I would say there are really two salient lessons that we 

should have in mind from the recent financial crisis and how the 

housing market responded. The first is that when things started 

getting hairy in 2007 and 2008, private capital fled. But for the 

continued operations of the GSEs and FHA, the market would have 

entirely collapsed, and we would have been in another Great Depression. 

But there was a consequence from the Federal Government stepping into the breach, and that is the second lesson: that the Government is on the hook for the losses in the system, and herein lies 

the challenge, I think. There is a fine line to walk between needing 

to preserve the stability of the housing finance market, particularly 

in times of economic crisis, and that is something that only a Federal guarantee can really do credibly; but also wanting to avoid the 

problems that come from public allocation of capital, such as politicized underwriting and the socialization of losses. 

There are reasonable disagreements on how exactly to craft a solution to that, but I think it is going to have to take the form of 

some sort of hybrid public–private housing finance system. S.1217, 

the Corker-Warner bill, represents one possible template for doing 

so. Another possible template would be based on amending the 

charters for the existing GSEs and, among other things, requiring 

first-loss private capital on their MBS. 

I believe there is more work to be done on these proposals, but 

bills like S.1217 are moving in the right direction. I am happy to 

discuss the technical details of S.1217 and other proposals, but I 

would emphasize that it is important not to lose sight of the forest 

for the trees in housing finance reform. The structure of a housing 

finance market is a means toward housing policy, not an end in 

and of itself, and, therefore, it is critical that any redesigned sysVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
9 

tem be charged, I think explicitly, with preserving the widespread 

availability of the 30-year fixed-rate mortgage, the continued existence of a TBA market that allows for interest rate risk hedging and 

preclosing rate locks, as well as fair access and affordable housing 

and multifamily housing options. 

I look forward to your questions. 

Chairman JOHNSON. Thank you all very much for your testimony. 

As we begin questions, I will ask the clerk to put 5 minutes on 

the clock for each Member. 

Professor Levitin, what is the one key lesson the market learned 

about MBS investing after the financial crisis? 

Mr. LEVITIN. I think the key lesson we learned is just how flighty 

private capital can be. The housing finance market needs constant 

reinvestment flows in order to sustain housing prices in the market. And what we learned from 2008 is that private capital will flee 

to safe assets in times of economic uncertainty, and this can actually have the effect of worsening an economic downturn because of 

the critical role of the housing market in the economy. 

So I think the critical lesson we have learned is that we need to 

have some sort of Government and I think explicit Government 

role in the market for market stability purposes. 

Chairman JOHNSON. Mr. Hughes, would standardization of private label MBS terms and documentation be an effective means of 

bringing private capital back into the market? 

Mr. HUGHES. Yes. I would think—you know, there has been some 

standardization so far. I think there needs to be farther to go both 

on representations and warranties, both the definition of what 

those representations are, and then, more importantly, what the 

enforcement mechanisms are. 

But I think there is a number that I lay out in my written testimony where I think the securitization terms, reps, warranties, can 

be improved and standardized. 

Chairman JOHNSON. Mr. Gidman, in MBS pools with troubled 

loans, how do we address conflicts or barriers affecting private 

label MBS mortgage trustees and servicers? 

Mr. GIDMAN. I think in terms of lessons learned from the financial crisis, many of those have been talked about today by other 

witnesses and alluded to in your opening statement and in others. 

The central issue for us in GSE reform going forward is really the 

role of the trustee and also the role of the servicer. For us, we believe that transparency in their activities and alignment of interests, specifically with an enumerated fiduciary duty, is a critical 

gap in the existing PLS market that has not yet been fixed, and 

without it being fixed going forward, it is hard to see how investors 

could come back into the PLS market in a meaningful way. 

Chairman JOHNSON. Professor Levitin, is there enough stable 

private capital to stand in front of a Government guarantee for 

MBS in good and bad economic times? Is this compatible with the 

TBA market? 

Mr. LEVITIN. Well, the answer really depends on how much private capital you want, first-loss private capital you want. If you are 

looking for 10-percent first-loss private capital, such as envisioned 

in the Corker-Warner bill, I think there is a bit of a question about 

10 

that, whether there is enough private capital, and part of the answer depends on how you are going to define capital. Does it have 

to be real capital in terms of, you know, dollars or Treasury securities in an escrow account backing something up? That I am skeptical that there is enough if we define capital in very strict terms. 

If we define capital more loosely, allowing derivatives to be 

counted as capital, for example, then, yes, there would be, but 

there are risks because that is not the same quality of capital if 

we do that. 

As far as a TBA market goes, the critical thing for having a TBA 

market is having interchangeable liquid securities. A TBA market 

is a market in forward contracts on mortgage-backed securities. So 

parties are buying and selling these securities before they come 

into existence. 

If there is geographic information about the loans in an MBS 

pool, it is not possible to have a TBA market, and this means there 

is a real conflict between private label securities which do not have 

a TBA market and actually having a TBA market, because private 

label securities include information about geographic—about the 

geography of the loans in the pool because investors know that affects credit risk. But when you have credit risk in the equation, you 

cannot have a TBA market. 

Chairman JOHNSON. Mr. Gidman, the GSEs have started a credit 

risk sharing program for their mortgage pools. What is attractive 

and unattractive to private investors in these deals? 

Mr. GIDMAN. We think generally the approach that has been advocated in the recent housing reform package that has been drafted 

and circulated to the members and in the industry is a promising 

approach. Referencing specifically, I think, the STACR deal that recently came out, we found that to be promising in many ways 

structurally. The sole deficiency that prevented firms like mine 

from taking a substantial position really related to the absence of 

a rating because our investment guidelines require that. But generally the structure of the approach we think is attractive and interesting and merits further development. 

Chairman JOHNSON. Senator Crapo. 

Senator CRAPO. Thank you, Mr. Chairman. 

Mr. Hughes, I noted in my opening statement that it is time for 

the Government and, thus, the U.S. taxpayer to reduce their footprint in the mortgage market. In your testimony, you note that the 

Government should begin to reduce its participation at least in one 

way by the reduction of conforming loan limits. 

As we consider appropriate transition away from the status quo, 

do you have suggestions as to what rate and on what timeline we 

should proceed? Do you believe that the private market could readily absorb a larger percentage of the mortgage market now? 

Mr. HUGHES. Yes, I would think it would have to be done on a 

safe and measured basis. You know, I can see it coming down—if 

it came down by 5, 10 percent each year for several years, to bring 

it back down in line. I think the conforming loan limit, if we went 

back to the old OFHEO standards on how it would be calculated, 

the loan limit today would probably be $330,000. So I think it is— 

but it needs to be done on a basis where there is not a shock to 

the system, and I do think private capital steps in in one of two 

11 

ways: either through banks’ balance sheets or through private 

securitization. 

Senator CRAPO. Thank you. And, again, Mr. Hughes, on another 

matter, investors in the mortgage markets need certainty. Senate 

bill 1217 in Section 223 calls for the development of uniform 

securitization agreements and definitions of reps and warranties 

for securities that are covered by the guarantee. 

As one of the few people who have been able to put together a 

private label deal in this crisis, could you please describe how you 

have approached these issues? 

Mr. HUGHES. Yes. So when we initially opened up or tried to 

open up private securitization, we reverse-engineered from investors to figure out what would be best practices. And for us, best 

practices are, again, a complete rewrite of reps and warranties, 

binding arbitration, and another feature that Redwood has is that 

we invest in the credit securities. So you as a senior investor know 

that the person that is actually selling you the securities has, in 

Dodd-Frank parlance, ‘‘skin in the game.’’ But we have found that, 

you know, investors will come back to the extent that there are 

best practices. 

Senator CRAPO. Thank you. 

And, Mr. Gidman, you noted in your testimony that some local 

governments are exploring utilizing eminent domain to seize underwater mortgages from private investors and restructure them 

into more favorable terms for the borrowers. In fact, one municipality—Richmond, California—has even voted to move forward 

with the idea and is actively recruiting other cities to join it. 

As a long-time industry participant in the mortgage-backed securities market, what have you observed to be the impact of this proposed use of eminent domain on prospective investors in private 

mortgage securities? 

Mr. GIDMAN. Thank you, Senator. I think there has not been an 

impact yet because our industry generally believes that it is highly 

unlikely to occur. However, the recent action you alluded to in California, it certainly becomes more possible. 

Speaking specifically about the legacy PLS issue and the challenges that homeowners face with mortgages that are underwater 

and struggling to pay those mortgages every day, we strongly advocate for the expansion of HARP to private label securities. We 

think that provides a transparent, public policy, standardized 

mechanism to address many of these needs. 

With regard to eminent domain, when we look at the recently introduced Housing Finance Reform and Taxpayer Protection Act, it 

is well structured. It is comprehensive. It aligns interests. It promotes transparency. But a critical component of it is investors taking first-loss risk. If the Federal Government allows, in our view, 

the use of local eminent domain powers to undermine national 

housing policy going forward, investors will not be able to take on 

the first-loss risk in the future. 

In our view, in order for GSE reform to have a chance at success, 

the Federal Government needs to use its tools now preemptively to 

protect the housing finance market. 

Senator CRAPO. Thank you, Mr. Gidman. And one more question 

for you on another topic—assignee liability. You noted in your testiVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
12 

mony that Dodd-Frank expanded legal vulnerabilities that creditors, assignees, or other holders of a residential mortgage loan may 

be subject to if they initiate foreclosure. This creditor or assignee 

liability has been cited by many experts and participants, such as 

you, as being one current impediment to the return of private investment in mortgage-backed securities. 

Could you please explain further why you believe the assignee liability issue is so negatively impactful on how private capital views 

the mortgage market? 

Mr. GIDMAN. So I think this really goes back to the central role 

and the question of the trustees and whether or not they have a 

duty to act solely in the best interests of the trust or whether or 

not conflicts inherent in vertically integrated financial services organizations that provide origination, issuance, servicing, and trustee services will be so conflicted that they are not able to act in the 

best interests of the trust. 

We believe that, given our recent experience with the AG settlement, where originators of bad loans, organizations that were involved in predatory lending were able to pay with funds by trust 

investors, including pension funds and other institutional investors. 

There has been a recent case that is in the press which is not yet 

settled, but we are very skeptical about where $4 billion of those 

dollars might come from, because we saw what happened in the AG 

settlement. 

And so the shame for us is that without greater transparency 

and alignment of interests, particularly around the role of the 

trustee but also the servicer, it is really putting a gate in front of 

the entire trillion dollar PLS market potential. 

Senator CRAPO. Thank you. 

Chairman JOHNSON. Senator Warren. 

Senator WARREN. Thank you, Mr. Chairman, and thank you, 

Ranking Member Crapo, for having this hearing. 

And I particularly want to welcome Mr. Gidman. Thank you. I 

am glad you are here from Massachusetts. I understand you are 

from Hull, and so welcome and thanks for your work with the Association of Institutional Investors. It is really important work. 

I want to ask a question about countercyclicality. You know, we 

have seen that the housing market is naturally procyclical, that 

when things are going well, lending becomes overextended; and 

when things are going poorly, lending decreases dramatically. 

So I believe it is important for regulators to have the authority 

to exert countercyclical pressure on the housing market. Peaks will 

not be so high, but the valleys will not be so low, and that reduces 

the risk of a future taxpayer bailout. 

So one way to exercise countercyclical pressure is to raise Government guarantee fees during boom periods and lower them during declines in the market. But that will not work unless the regulators have authority to exert countercyclical pressure on the private label market as well. Otherwise, when guarantee fees go up 

during the boom period, it will just drive everyone over to the private label market. 

So my concern is how regulators can exert countercyclical pressure on the private label market. Professor Levitin, could you 

weigh in on that? 

13 

Mr. LEVITIN. Sure. There is a tool missing in the regulatory toolbox, and that is that regulators do not have the ability to control 

the amount of leverage in the housing finance market. In other 

words, the tool regulators need to have is the ability to limit combined loan-to-value on new mortgages being originated at any point 

in time. 

So regulators can affect the housing market by interest rates, but 

that affects—that is a blunderbuss. It is not a surgical tool for the 

housing market. It affects other markets. Controlling loan-to-value 

limits, if you gave it to a regulator—I am not sure which, but let 

us say the Federal Reserve—that would give them a targeted tool 

for dealing with overheating of the housing finance market, and 

this is something that is actually done outside of the United States 

in some countries. Hong Kong—it is a small market, but Hong 

Kong does this. Canada and Spain have systems that get to a similar result even though it is not formally through LTV limits that 

apply to originators. 

Senator WARREN. Yes. So let me just ask, Mr. Hughes, do you 

agree as an issuer of private label securities that the Government 

should address the inherently procyclical nature of private label 

housing finance market? 

Mr. HUGHES. I would agree. 

Senator WARREN. And would you agree with Professor Levitin’s 

suggestion of a tool doing it by regulation of loan-to-value ratios, 

or would you do it a different way? 

Mr. HUGHES. I think loan-to-value ratios are important. They 

have been overlooked in QM or QRM. I think, you know, what investors look at from an investor side, the most important criteria 

in determining whether there is a risk of default, it is the amount 

of equity in the property. Yes, I think that would be one important 

way of—— 

Senator WARREN. So you would support some regulation in this 

area. 

Mr. HUGHES. Correct. 

Senator WARREN. And, Mr. Gidman, would you like to weigh in 

on that? 

Mr. GIDMAN. I agree with your observation completely. The GSEs 

or the Federal Government play an important role in housing finance to provide that countercyclical capability. You know, I think 

QM and the LTV ratios have been discussed as a key component, 

but another one could be in terms of levers that are available to 

the Federal Government is capital ratios with the originators. 

Senator WARREN. Got it. 

Mr. GIDMAN. But there are tools, there are mechanisms, and 

what we do not want to happen is for GSE reform to be procyclical 

rather than provide the backstop that is necessary in terms of crisis. 

Senator WARREN. Right. Thank you very much. 

Let me ask one other question. Even if the private label market 

represents only 20 percent ultimately of the overall housing market, it still would be a multi-trillion-dollar market that it is dealing 

with. Given the size and importance of the market, I worry that 

there will still be an implicit Government guarantee that will affect 

the risks taken on by private actors. 

14 

So I hear from a lot of people that the new QM and QRM rules, 

along with the SEC’s eventual revisions to Regulation AB, will adequately limit the risk that can be taken on by participants in the 

private market. 

Professor Levitin, do you agree with that? 

Mr. LEVITIN. I am not sure, but I have concerns. We do not know 

exactly what the final QRM rule will look like, much less Reg AB, 

which seems much less advanced in its promulgation. 

To the extent that loans are QM, it will significantly limit market risk by ensuring the borrowers have the ability to make monthly payments, but there is not an LTV component to QM, as noted. 

What makes me more skeptical—what makes me skeptical here 

is that I think that a fair amount of the market eventually will not 

be QM. My impression is that a lot of the financial services industry does not fully understand QM and the consequences of a mortgage not being QM. There is actually a fairly weak remedy provision. 

If a mortgage is underwritten without ability to repay—I guess 

it is not underwritten in that sense—and it does not happen to 

meet the QM safe harbor, there is no penalty just for that. There 

has to also be a default on the mortgage. There has to be a foreclosure following that default. The homeowner is going to have to 

be willing to litigate the foreclosure. So we are talking about really 

a very small number of cases. And then if that happens, the homeowner has a defense in the way of set-off against the amount of 

money owed, but it is actually a very small set-off by statute. I 

think there is some interpretive room in the statute, but I think 

in most cases we are probably talking basically about set-off of attorneys’ fees plus $4,000. That is not a lot. There really is not much 

risk from a mortgage not being QM. I think once the market understands that, a lot of mortgages will not be QM. 

Senator WARREN. All right. Well, I am very concerned about this, 

but I see that I am over my time, so I am going to—I very much 

want to hear from the others. I will submit questions for the 

record. 

Thank you, Mr. Chairman. 

Chairman JOHNSON. Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and I thank each of 

you for coming in and for meeting with members of the staffs and 

members here just about the best way to go forward and for the 

work of your organizations. 

I think what all of you have said is that the model that a large 

group on the Committee are looking at that puts private capital in 

front of any kind of Government backstop is a very good model to 

go alongside private label financing. Is that correct? And would you 

like to expand? Go ahead. 

Mr. HUGHES. Yes, I do think it is a good model. Obviously, you 

know, if we develop into three markets where you have a totally 

Government-supported market, a hybrid market where private capital takes the first risk, and then a totally private—you know, 

through private label securities, I think is the right blend of mortgage tools to have adequate liquidity in the marketplace for borrowers. 

15 

Mr. GIDMAN. When we look at the mortgage markets, we look at 

it as a whole. We think there is a component which is a GSE and 

an explicit Government guarantee, and there is a purely private, 

but they need to work hand in glove. And when we look at the 

framework that has recently been introduced, we think it is 

thoughtful, and it is well structured, and it provides a mechanism 

that would naturally provide that to happen. 

Going with, you know, reducing conforming limits on their own, 

no matter how measured the pace, will not bring private money 

back into the market without the kind of structural reforms specifically around the role of the trustee, reps and warranties, and 

transparency and timeliness of loan-level data. But we think there 

is more than enough room and there is certainly pent-up demand. 

Senator CORKER. OK. 

Mr. LEVITIN. I would agree with everything that Mr. Hughes and 

Mr. Gidman said, that we have three markets: the Government, 

the hybrid, and the private label market. All of them need reform. 

I think the Committee is quite well aware of the issues with FHA 

right now, but the core part of the market is going to be the hybrid, 

and that is I think where we need to pay a lot of attention, but 

we still need to also do reforms, as Mr. Gidman noted, for PLS 

Senator CORKER. So one of the things the bill seeks to do is to 

create uniform PSA to have a clear definition of reps and warrants, 

to have electronic registration so that it is regulated, create uniform data so investors can actually analyze data sets, and very importantly, I think, make sure that second liens cannot just be piled 

on the first liens without the first-lien investor being aware of that. 

Are these helpful, are these steps that are in this bill, proposed 

bill—an actual bill, I guess, are these helpful in bringing in private 

capital? And would they also be helpful if some of those standards, 

as I think Ms. Warren was alluding to, if those standards were also 

evident in the private label market itself? 

Mr. GIDMAN. We think that that language and those provisions 

that you mentioned are extremely helpful, but they are not sufficient without some of these other structural reforms that all of us 

have talked about. 

We think that, you know, it is a really promising approach. It is 

very well engineered in terms of the overall bill, and it addresses 

almost all the concerns that institutional investors would have. 

Senator CORKER. OK. 

Mr. HUGHES. I would echo that. I also thank you for putting in 

the second-lien provisions. But we would be an investor. We invested in the Freddie Mac transaction in STACRs. We are a company looking to take and invest in mortgage credit risk. And there 

are different ways to express it. If we can express that through the 

private label market, totally private, we will do it there. But we 

would also, you know, be very open to putting private capital ahead 

in a hybrid type model. 

Senator CORKER. OK. Well, listen, thank you for your testimony, 

and especially mentioning some of the things that you think can 

make legislation even better. I think all of us who have been working on this for some time realize there are a lot of improvements 

that can be made, and we appreciate your testimony and look forward to trying to incorporate some of the suggestions you have 

16 

made into the bill that has been produced. So thank you very 

much. 

Chairman JOHNSON. Senator Reed. 

Senator REED. Well, thank you very much, Mr. Chairman, and 

thank you, gentlemen, for your testimony. 

Mr. Hughes, you suggest in your testimony the need for service 

performance triggers, servicers, so that servicers effectively can be, 

you know, removed if they are not functioning properly. And Chairman Johnson and Senator Crapo were very helpful in getting language in the FHA Solvency Act which would have a similar situation where a servicer could be removed and an approved servicer 

would replace them. 

Can you comment on just the need for these triggers for 

servicers? 

Mr. HUGHES. Yes. I think it is critically important that from an 

investor’s standpoint, if a servicer is not following their responsibilities under the agreement, that there is some mechanism to remove 

them. If there are conflicts, if they are not resolving problem loans 

on a timely basis, if they are not giving good service, you know, like 

under any other contract, I think there should be provisions, if you 

do not live up to the terms of the contract, you should be in a position where you could be removed. 

Senator REED. Thank you. 

Professor Levitin, I want to get back to a point that you raised 

with the Chairman, and that was—and I think both Senator 

Corker and Senator Warner have done a superb job in sort of advancing dramatically the progress on the bill. But one of the premises is 10-percent private capital up front. The question is: Is that 

sufficient? Or is it too much? 

The other question is: It could be private capital in the transaction investing into the entity, but it could be raised by debt on 

the other side, which would—essentially be a lot of leverage that 

is—we saw that in the crisis. Do we have to worry about both those 

things? 

Mr. LEVITIN. I think potentially we do. Whether 10 percent is the 

right amount, I do not have an opinion on that. I think we would 

want to get as much first-loss private capital as we can. You know, 

the higher you raise it, the better that would be in terms of protecting the public fisc. But it is also a question of what constitutes 

that first-loss capital and what is really backing it up. And I think 

you are right to be concerned about the need to look through what 

is capital for, let us say, FMIC purposes in S.1217 and say, well, 

really, that is only backed up by more borrowing. Are we just building a pyramid of leverage? I think that is a concern. 

And one area that I think S.1217 could be improved in is being 

more explicit in what constitutes capital for bond guarantors and 

for any kind of private label execution of the 10-percent first-loss 

piece. 

Senator REED. There is another aspect, too, as you alluded to in 

your responses, that there are times when the market can provide 

adequate capital, the market is, you know, actively, and eagerly 

looking. And then there are times of economic distress when there 

has to be more sort of Government involvement. So that would sugVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
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gest that this capital number would have to be sort of adjusted, if 

you will, for public policy purposes by the Government. 

Is that a fair, general assumption? 

Mr. LEVITIN. I think it is, and I think that there is reason to 

have some concern about that, because to the extent that you have 

an accordion-like Government commitment to the market, that 

raises the possibility of—it raises the question of who is exercising—who is playing the accordion and how politicized is the accordion going to be played. 

The Corker-Warner bill is cognizant of the need—you know, of 

the need for the Federal Government to step in if the market runs 

into real trouble. There is a provision in the Corker-Warner bill; it 

is a limited provision, though. It lets FMIC step in and waive the 

10 percent for, I believe, 6 months. Hopefully that would be enough 

time, if necessary, for FMIC to get an extension from Congress. But 

I worry about any bill that requires the system to come back to 

Congress. I mean particularly with what is going on right now—— 

Senator CORKER. Yes. 

Mr. LEVITIN. ——I worry about whether the political system is 

going—will function. 

Senator WARNER. Shocked. Shocked. 

[Laughter.] 

Senator REED. I have another question, but I think you have answered all the questions with your last response. 

I think one of the issues that we are trying to collectively come 

up with an appropriate response to, is how do we have a system 

that is, you know, independent of pressures other than responding 

to the market conditions. I mean, one of the examples that we have 

lived through, the long, long, slow rise of the mortgage market 

from the depths of 2008, 2009, if there had been a 6-month statutory window, that window might have been too small. 

So, again, I think we have got to think harder on some of these 

issues. But what Senators Warner and Corker have done already 

has been extraordinarily helpful. 

Thank you. 

Chairman JOHNSON. Senator Toomey. 

Senator TOOMEY. Thank you, Mr. Chairman, and thank you to 

the witnesses for being here. 

In the interest of time, maybe I could just posit an assumption— 

and by all means, correct me if I am wrong—that all three of the 

panelists would agree that if municipalities did begin to claim eminent domain as a power, a justification for confiscating mortgages, 

that that would have a chilling effect on the ability to attract private capital into the mortgage market. Mr. Hughes, do you agree 

with that premise? 

Mr. HUGHES. Absolutely. 

Senator TOOMEY. Mr. Gidman, I think you generally did in your 

response to Mr. Crapo’s—— 

Mr. GIDMAN. You would have no need to proceed with GSE reform. 

Senator TOOMEY. OK. And—— 

Mr. LEVITIN. I am not prepared to totally agree. 

Senator TOOMEY. OK. 

18 

Mr. LEVITIN. I think it really depends on the scale that we see. 

To the extent that there are eminent—I am not a supporter of the 

eminent domain proposals that exist. But I think it is important 

to recognize why they exist. They exist because of a failure in the 

servicing of mortgage loans, and that needs to be addressed. Once 

it is, we will not have the eminent domain proposals. 

Senator TOOMEY. And presumably one of the reasons for concern 

about using eminent domain this way is the rule of law and the 

sanctity of the contract and the importance that—well, our entire 

society, but in particular private investors would place on being 

able to rely on a contract. So I wonder if anybody has any concerns 

about the FHFA’s third amendment to the preferred stock agreement where it could be argued that the Government unilaterally 

changed the terms of an agreement that had been in place. I want 

to give a quick quote and ask your reaction. 

Randy Guynn is the head of the Financial Institutions Group at 

Davis Polk and an expert on bankruptcy and related matters for 

decades. He stated last week at an NYU seminar on the GSEs— 

and I will quote. He said, ‘‘If the Government gets away with the 

dividend sweep of Fannie and Freddie, it will establish a dangerous 

precedent for the rights of analogous stakeholders of failed banks 

and systemically important financial institutions under the FDIA 

and the OLA.’’ And I might add to that list any potential successor 

to Fannie and Freddie. 

Do any of you share a concern about that? Mr. Hughes. 

Mr. HUGHES. I am not an expert in the area. I really do not have 

any insights. 

Senator TOOMEY. OK. Mr. Gidman. 

Mr. GIDMAN. I do not either. I am sorry. 

Mr. LEVITIN. I do share your concerns on this, and I would note 

it does not just affect investors, but it also affects the Affordable 

Housing Trust Fund, which the Federal Government has not been 

paying into. 

Senator TOOMEY. Thanks. Then let me switch topics here since 

we did not get too much discussion on that topic. 

Dr. Levitin, you indicate in your testimony that you believe that 

the capital markets would be able to support no more than $500 

billion annually in mortgage credit risk, which considering the size, 

the multi-trillion dollars of credit risk that investors routinely take, 

private investors take in corporate bonds, commercial paper, financial—you know, short-term financial paper, consumer credit of various kinds, how do we know that there is only $500 billion worth 

of demand for credit risk in the mortgage market? 

Mr. LEVITIN. Sure. I cannot say precisely that it is $500 billion 

and not 499. This is a ballpark figure. But I think that we can see 

the ballpark figure is not even close. 

The reason that we—the basis of my analysis is looking at the 

private label market in the past, that before 2004, we had a private 

label securitization market, and it never amounted to more than 15 

percent of—— 

Senator TOOMEY. But didn’t it always have to compete with the 

Government-guaranteed market, at least implicitly? 

Mr. LEVITIN. Sure, but to the extent that you do not have a Government-guaranteed market, if you just got right of it—— 

19 

Senator TOOMEY. Right. 

Mr. LEVITIN. ——the money that is invested in the Governmentguaranteed market is not money that is investing in—that is taking on credit risk. Those are interest rate risk investors. Some of 

them might be willing to take the A piece in a private label 

securitization, sort of the senior piece, but placing the B piece is 

much more difficult, and it is just not—I do not see any indications 

that there is a large pool of money willing to take on first-loss credit risk on U.S. mortgages. 

Senator TOOMEY. Isn’t it true that the nature of the credit risk 

on a mortgage declines over time? I mean, if you—the duration of 

a mortgage, the average life weighted by any reasonable measure, 

is typically less than 10 years. By the time you are approaching 30 

years on a mortgage, credit risk is often becoming de minimis because the loan-to-value ratio is becoming so good. 

Mr. Hughes, do you agree that there is only $500 billion worth 

of private capital willing to take credit risk in mortgages? 

Mr. HUGHES. I think it is probably not a—probably a fair estimate, but the real questions are—you know, the way I would look 

at it is if you did some tranching of the 10 percent, such that you 

could get people like Redwood, who would be, you know, happy to 

come in and try and take the first-loss credit risk and then tranche 

it up so that you access different pockets of investors with different 

risk profiles rather than just say put everybody in the 10 percent. 

You know, having said that, the 10 percent is a pretty large 

number, and I look forward to understanding more about how 

much that is going to be capital, can you use any kind of leverage, 

and how would it work. But I think in particular, some tranching 

of that so that those people best able to take the risk, the deep 

credit risk, are in that position. 

Senator TOOMEY. I see I am out of time, Mr. Chairman, but I 

would just observe that we have private investors who routinely 

take trillions of dollars worth of credit risk year in and year out 

across an enormously wide range of securities, and why we would 

assume that suddenly there would not be a willingness or ability 

to match investor demand with the corresponding section of the 

mortgage industry, I find that baffling. 

Chairman JOHNSON. Senator Warner. 

Senator WARNER. Thank you, Mr. Chairman. I want to thank you 

and Ranking Member Crapo for your work in holding these hearings. 

Picking up on Professor Levitin’s comment about our 

functionality, or lack thereof, I just want to again make the appeal 

to you—and I know the staff is working very hard on this issue— 

that time is not on our side in GSE reform, that this may be the 

one area under your leadership where there is broad bipartisan 

agreement and we could actually not only get a bill out of Committee but on to the floor. 

I am afraid that the forces of the status quo at some point, and 

the notion that we would have a system, when you kind of reflect 

back, that has a private entity in the old model, that has shareholder value, appreciation goals, Government backstop, and public 

service goals all wrapped into one in any kind of ongoing, funcVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
20 

tioning entity just, you know, as somebody who has looked at this, 

does not seem like it makes a lot of sense. 

I do want to make a couple comments following up on Senator 

Toomey’s comment. Professor Levitin, I do not know whether your 

$500 billion number is right or not. It seems relatively reasonable 

to me. I would argue that in the hybrid proposal, S.1217 has suggested we expect to see a growing PLS market. That is going to 

take private capital. And with the 10-percent private capital risk 

guarantee on the hybrid model, that is going to take capital, too. 

So I think, you know, that number may expand a bit, but I think 

that it is kind of a reasonable assumption. And I will come to a 

question here ultimately. 

I guess the other part I would make—and I think that both Senator Reed and Senator Warren raised this issue on the countercyclical, and I think there are ways perhaps it could be improved, 

but there is this notion—I think there is a recognition that 1217 

has, that there are ability of three keys—we put the Fed, FMIC, 

and Treasury to turn that down if private capital flees. So we do 

not have a system where we are kind of left without any tools at 

all. Maybe there are ways to improve it. And I think Senator 

Reed’s comments were good as well, and I want to again come to 

Mr. Hughes. 

One of the things that I have thought—and we have had a lot 

of discussion on the 10-percent number. We all believe skin in the 

game. You have talked about the value of private label, Mr. 

Gidman has as well, skin in the game. Clearly, 1217 puts a lot of 

skin in the game, which, again, better guarantees that that Government backstop will never be hit. That is more than double what 

would have been required in the last crisis. And Professor Levitin 

has raised I think the appropriate question. You know, does 1217 

get the definition of capital right? Which is terribly important, and 

I am anxious to hear more feedback. 

But I want to come back to Mr. Hughes and maybe all three of 

you to comment, not only definition of capital, but if you have got 

that 10 percent—let us assume for argument’s sake that we have 

struck a bit too high, which I would rather err on the side of safety. 

But shouldn’t there be an ability perhaps to tranche part of that? 

Can’t the market be a better—have a better ability to figure that 

out—and, respectfully, as smart as these Senators are and our staff 

are—than a group of legislators? So can you drill down a bit more 

on that tranching idea? And I would like to hear from each of you. 

Mr. HUGHES. Yes, I think it is incredibly important to do some 

tranching because investors have different risk profiles, and on the 

private side, totally private side, in, you know, a PLS transaction, 

the senior investors are bringing most of the capital, but most of 

the risk is in the subordinate securities, you know, below that. So, 

again, I would think, you know, if the number was 10 percent, or 

something, breaking that down probably—if you would expect in 

this pool of loans probably you are going to have—25 basis points 

of loss would probably be a reasonable assumption for well-underwritten that maybe, you know, you tranche out the first 2 percent, 

which would be 5 times—which would be 10 times coverage and 

then, you know, move up from there. But, yes, I think it would be 

a very appropriate way of attracting capital. 

21 

Mr. GIDMAN. So we think we agree that the tranching is particularly important, but in terms of the absolute number or prescribing 

the number at 10 percent, we really believe that it is an important 

lever, countercyclical lever for the market, and that it should not 

be necessary to come back to Congress to change that lever. We 

think that it is something that the Federal Mortgage Insurance 

Company should have as a tool in its toolkit. 

Mr. LEVITIN. There are certainly ways to tranche the 10 percent. 

It could be tranched on the initial issuance, or it could be tranched 

subsequently. Basically you could—someone could buy that 10 percent and resecuritize it, issue tranched credit link notes. There are 

lots of ways to allocate that 10-percent credit risk within the market. 

I am not real concerned about that, even though there may need 

to be some adjustments to the QRM rulemaking to make sure that 

if the market wanted to retranche the credit risk, it would not— 

there would not have to be extra capital help because of that. 

Senator WARNER. Well, again, I want to thank all the witnesses 

for their testimony and the fact that they have endorsed the directional approach, and I am, again, looking forward to working with 

the Chairman and the Ranking Member to fine-tune and get this 

right. Again, I just hope and pray that we do not miss this window. 

Thank you, Mr. Chairman. 

Chairman JOHNSON. Senator Johanns. 

Senator JOHANNS. Mr. Chairman, thank you, and let me, if I 

might, join with the comments of Senator Warner. I think we have 

a window of opportunity here, but I think that window closes for 

a whole variety of reasons that I will not go into. But I really appreciate what the Chair and Ranking Member are doing here because I think they are laying out a process by which we take some 

bipartisan ideas and then build a final piece of legislation. 

In that vein, some months ago the Chairman brought us all together in kind of an informal work session and went around the 

room to the Banking Committee Members and said basically, ‘‘Tell 

me what you would like to accomplish through GSE reform.’’ And 

we had an opportunity to list the three, four, five, six things, whatever, that were important to us. 

I would suggest in a pretty bipartisan way members listed the 

30-year mortgage as one of the things that they would like to preserve at the end of GSE reform. 

We have not touched on that today that I recall, and I would like 

to hear your thoughts on the importance of making sure that whatever structure we end up with keeps that 30-year mortgage opportunity in place. And, Mr. Hughes, I will start with you, but we will 

just go right on down the table. 

Mr. HUGHES. Yes, I think keeping a 30-year fixed-rate option 

available to borrowers I do think is very important. There are all 

sorts of other options down the spectrum that you can get through 

hybrid loans, whether it is 5 years, 10 years. But I think giving a 

borrower the option where they can be fixed for 30 years, if that 

is what they want, is important. 

Senator JOHANNS. Great. 

Mr. LEVITIN. From a policy perspective, we agree that a 30-year 

mortgage is an important vehicle for borrowers. 

22 

Senator JOHANNS. Great. Professor. 

Mr. LEVITIN. A 30-year fixed-rate mortgage is the keystone of the 

American housing finance system. It is a uniquely American product, and it is one that has served the American people very well 

for nearly 75 years now. 

It is important to recognize that the private label securitization 

market has never produced 30-year fixed-rate mortgages on a wide 

scale by itself. Basically, if you want to do lots of 30-year fixed-rate 

mortgages, you need to have some sort of Government guarantee. 

That is how the 30-year fixed was created in the first place. 

Senator JOHANNS. Mr. Gidman, do you have something to offer 

on that? I noticed that you were listening to that testimony closely. 

Mr. GIDMAN. Well, I think the professor is generally right in 

terms of the history, but I think there is room in the market for 

private label securitization out, you know, well beyond 10 years. 

But as a foundation of the housing finance market in the United 

States and uniquely American, the 30-year mortgage is very important. 

Senator JOHANNS. Great. There has been a lot of discussion as 

the legislation was put together about the 10-percent—I do not 

know what you would call it—‘‘skin in the game’’ provisions or 

whatever. We had a witness a few weeks ago that talked about 5 

percent, you know, and I guess you can debate those numbers. 

I am fascinated by this idea of tranching, and I would like to 

hear from somebody a little more thoroughly on how that would be 

set up, how that would work, because the one thing I want to avoid 

from my vantage point is, you know, the wizard adjusting the dials 

on the economy and dial this and dial that. I want more market 

forces involved in this. So talk to me about how the tranching—Mr. 

Hughes, we will start with you again. 

Mr. HUGHES. I would envision very similar to how the PLS market works right now. So in our transactions, there is tranching of 

bonds of—up to probably 93 percent is AAA. 

Senator JOHANNS. OK. 

Mr. HUGHES. And then 7 percent below that is a series of securities. The deepest credit securities is probably 2 percent, and then 

you work your way up from BBB, A, AA securities. And really what 

happens and why tranching is important is losses go from the bottom such that if there are losses in a Redwood deal, the first bond 

that gets torn up is our bond, but the bond above us is protected 

until our bond goes away. 

So, therefore, investors have a different risk depending on where 

they are on that tranching. So somebody may be more comfortable 

at the AA level. Where we would be more comfortable, you know, 

we think there is more yield and opportunity at the deep credit 

level. 

Mr. LEVITIN. The one concern I would raise with tranching is 

that tranching creates conflicts between investors potentially, that 

when you have a security that is not a complete pass-through for 

all investors, you are binding longs and shorts together in the same 

deal, and they are not going to want the same things, be it on interest rates, on things like cleanup calls and deals, on servicing, 

and I think that puts a lot of pressure then on making sure that 

the trustee and servicer provisions and the deals are done right, 

23 

and there is, I think, a very important set of reforms that need to 

be done in that space. 

Senator JOHANNS. OK. Mr. Gidman, did you have anything to 

offer? 

Mr. GIDMAN. I do, yes. Tranching opens up the deals to a greater 

world of investors because it allows you to taper the risk and target 

it to the investors that have the appropriate appetite. But what the 

absolute number is and how that tapering or tranching occurs I 

think is a market force that could be guided by a Federal institution. 

Senator JOHANNS. OK. Thank you, Mr. Chairman. 

Chairman JOHNSON. Senator Heitkamp. 

Senator HEITKAMP. Thank you so much, Mr. Chairman and 

Ranking Member. I think these hearings have been extraordinarily 

helpful to me as we kind of work through this process. 

My questions are really just twofold, and one is about the timing 

of reform. And I think what you hear is a sense of urgency in this 

room that if we do not do this fairly soon, we will not have the opportunities for reform, even in a year, that we have today. And I 

just want to get kind of affirmation of that because I sense some 

urgency, but like we know, nothing very—nothing happens very 

quickly in this place, as I am finding out as a new Member. 

Professor, can you tell me what you think is right now the window for the maximum number of options that we have to do reform 

correctly? 

Mr. LEVITIN. I want to be careful that I do not expressing my 

opinions on what is politically feasible. 

Senator HEITKAMP. Just imagine the moon. Imagine the moon. 

They will do whatever we want to do. 

[Laughter.] 

Mr. LEVITIN. We need to fix this market. It is not in an acute 

condition where it needs to be fixed tomorrow. I think it is more 

important that we get this right than that we do it sooner. I would, 

therefore, probably err on the side of caution. 

Senator HEITKAMP. What timeframe? 

Mr. LEVITIN. Timeframe, I mean ideally, you know, all else being 

equal, you want this done as soon as possible, but I think it has 

to be done right. I do not think I can really lay out a timeframe 

for doing this. 

Senator HEITKAMP. Mr. Gidman. 

Mr. GIDMAN. Our view really is that the time is now. The framework that has been laid out there is very thorough, it is comprehensive, it is well engineered. The structural fixes that we have 

sort of identified we think are—there should be bipartisan agreement on that. 

The thing that we are concerned about that makes this more 

timely from our standpoint, again, is back to the eminent domain 

issue. If a single municipality exercises eminent domain to seize 

performing loans, regardless of the public use arguments, regardless of fair value arguments, if they do that, it will make it very 

difficult for institutional investors to remain in that market let 

alone increase our involvement in that market, which could make 

efforts toward GSE reform moot. 

24 

Senator HEITKAMP. If I could just, before we move on to Mr. 

Hughes, make the point, I think you said earlier in your testimony 

that there have not been adjustments for the eminent domain issue 

as of yet because you do not see this as catching fire and spreading 

across the country in a large way today. Is that correct? 

Mr. GIDMAN. We think it is so harmful to the national mortgage 

markets that ultimately the Federal Government will step in with 

its tools to make sure that it does not happen. 

Senator HEITKAMP. So your risk evaluation on the eminent domain issue is more based on being able to come here and, you 

know, create a firewall, so to speak. 

Mr. GIDMAN. Well, we look at the recent letter from the FHFA, 

which directed the GSEs and how they should act with regard to 

the municipality. But we think it is really not an issue of a single 

municipality or a single approach. We think it is a national housing finance policy that you all would be highly incented to protect. 

Senator HEITKAMP. Mr. Hughes, your thoughts on timing? 

Mr. HUGHES. Yes, I have a high sense of urgency to get something done. I would think you would want to do changes to the PLS 

market hand in glove with anything that may get done with the 

enterprises. I think there will always be arguments it is too complicated, the TBA market is not going to do it, and there will be 

all sorts of bogeymen out there. But at the end of the day, you need 

to tackle it. You need to start it. You need to begin a process and 

to resolve those things. 

Senator HEITKAMP. One last question, and it is directed to you, 

Mr. Gidman. You had suggested that there was room in the private 

market for the 30-year fixed-rate mortgage. Can you tell me what 

the impediments are today for the private market to get involved 

in the 30-year fixed-rate mortgage and explain why it is that in 

your earlier testimony you were talking about million-dollar houses 

with 50-percent equity? You know, why aren’t you taking the 

$300,000 home on a 30-year fixed-rate today? 

Mr. GIDMAN. Well, I think, you know, the critical factors for us 

are not the size of the loan. It is the quality of the loan, it is the 

amount of equity in the property, it is the lack of other liens and 

weights on that loan. And I think without the structural repairs 

with regard to the role of the trustee, the uncertainty around assignee liability or eminent domain, it is very difficult for us on behalf of our clients to embrace innovation further down the range 

of the mortgage market. 

Senator HEITKAMP. Just begging the indulgence of the Chair, so 

if some of these issues were addressed, you would see more active 

participation. 

Mr. GIDMAN. Yes, I think you would. 

Senator HEITKAMP. Thank you. 

Thank you, Mr. Chairman. 

Chairman JOHNSON. Senator Brown. 

Senator BROWN. Thank you, Mr. Chairman and Senator Crapo. 

Thank you both for doing this hearing. 

In 2011, Congressman Brad Miller of North Carolina and I introduced the Foreclosure Fraud and Homeowner Abuse Prevention 

Act to make the securitization process work better for investors 

and for borrowers. You have in your testimony supported some proVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
25 

visions of that bill which I would like to ask you about—mention 

and then ask you about: one prohibiting mortgage servicers from 

holding a second lien on property that has a mortgage they service. 

Senator Corker mentioned that. Mr. Hughes and Professor Levitin 

suggest that second liens can create perverse incentives, as you 

know, particularly when the same party is servicing the first lien. 

Like Mr. Gidman, I was concerned about the national mortgage 

settlement affecting mortgage investors. I warned Secretary Donovan that investors in pension funds for working Ohioans, for example, should not pay for Wall Street mistakes. Unfortunately that is 

what happened. 

My legislation with Congressman Miller would clarify that bond 

holder protections in the Trust Indenture Act apply to mortgagebacked securities investors, as Professor Levitin suggests. 

Mr. Gidman, you noted that vertically integrated financial institutions often serve as issuers, trustees, originators, and servicer, 

sort of the whole vertically integrated, if you will, creating conflicts 

of interest and incentives not to identify deficiencies that harm investor trust. If all three of you would briefly in a minute or so discuss why the reforms that you have proposed that are in our bill 

are important protections for investors, including applying the 

Trust Indenture Act, and how these reforms will address these 

clear conflicts. Mr. Gidman, do you want to start? 

Mr. GIDMAN. Yes, I think that the current language that has 

been proposed goes a long way toward addressing those structural 

issues that we have all talked about, whether it is standardization 

of reps and warranties, ready availability and timely access to 

loan-level data, and alignment of interests. 

Mechanically—you know, we use the term ‘‘fiduciary duty’’ in my 

industry because that is what we know, that is what we live under. 

Whether it is a fiduciary duty or whether it is a fix to the Trust 

Indenture Act, I am not sure what the right mechanics are. But we 

certainly know that the trustee needs to act solely in the best interest of the trust, and they need to have the capacity to have effective oversight of their servicers and there needs to be mechanisms 

for the end investors to be able to have enforcement that has teeth 

and rights of private action for breach. We think all of those are 

important. 

Senator BROWN. OK, and the fiduciary duty is part of this. 

Mr. Hughes. 

Mr. HUGHES. I would echo most of that. I do believe you need a 

mechanism within the trust to actually enforce rep and warranty 

claims. I would say to me the biggest single failure of private label 

was the fact that the reps and warrants either were weak, they became unenforceable, and it was the basis for all the lawsuits that 

we have today. So I think having discipline beforehand very clear 

on servicers’ responsibilities, representations and warranty, what 

the authority of the trustee is, what the authority of a credit risk 

manager is, is incredibly important in bringing back institutional 

money to this space. 

Senator BROWN. Professor Levitin. 

Mr. LEVITIN. Yes, there is really nothing new under the sun in 

the financing world. The Trust Indenture Act was a response to 

vertical integration in the mortgage bond market in the 1920s. 

26 

There is a huge SEC report from 1936 written by William O. Douglas and Abe Fortis, two future Supreme Court Justices, detailing 

all of the abuses. It reads like the playbook for what we have seen 

going on in the last few years. 

I think the ultimate—you know, fiduciary duties are important, 

but trustees have fiduciary duties after there is an event of default 

for a trust. The problem is getting to that event of default, and I 

think what the—part of the solution needs to be to split up the different duties the trustees do. They have some ministerial functions, 

they have some financial guarantor functions, and they also have 

an enforcement function. The enforcement function needs to be 

split off from the other functions and given to a party with no conflicts whatsoever, and also fiduciary duties. 

Senator BROWN. Thank you. Let me ask Mr. Gidman and Mr. 

Hughes a question about PLS accountability in terms of both employees and institutions, and I want to read something that was in 

Mr. Levitin’s written testimony: a ‘‘study by the Center for Public 

Integrity found that senior executives from all of the 25 top 

subprime lenders during 2005–2007 were back in the mortgage 

business as of 2013 . . . it is easy enough to move from the 

securitization desk of a failed investment bank to another or to an 

investment fund. The lack of SEC and DOJ prosecution of either 

individuals or institutions related to pre-2008 PLS merely underscores the lack of consequences of securitizing noncomplying mortgages . . . it is unlikely that reputational sanctions are sufficient 

to keep the PLS market in check.’’ 

Just briefly, do you agree or disagree, Mr. Gidman and Mr. 

Hughes? 

Mr. GIDMAN. I had not heard that statistic before. What I do 

know is that greater transparency and alignment of interests can 

go a long way toward protecting the integrity of the market going 

forward, and those are lessons that we should have learned from 

the crisis. 

Senator BROWN. Mr. Hughes. 

Mr. HUGHES. A couple things. First, I sign a certificate with each 

securitization we do that goes out under my signature. 

And I would say, second, I think a very important part of it from 

a Redwood Trust standpoint is that we actually hold skin in the 

game. We actually hold the credit securities as incredibly important because, you know, we represent shareholders. If we are putting together a bad pool and there are consequences to investors for 

that pool, the person that is going to bear the most risk for that 

pool is Redwood Trust. 

Senator BROWN. Thank you, Mr. Chairman. 

Chairman JOHNSON. Senator Merkley. 

Senator BROWN. He is not here. 

Chairman JOHNSON. Senator Hagan. 

Senator HAGAN. Thank you, Mr. Chairman and Ranking Member, and I do appreciate you holding the hearings, and I, too, agree 

that there is a sense of timing for GSE reform, and I appreciate 

this hearing. 

I wanted to follow up on Senator Heitkamp’s question on eminent domain, and I know that Senator Toomey also started talking 

about eminent domain. Mr. Gidman, you reiterated to Senator 

27 

Heitkamp your thoughts. I was just wondering, Mr. Hughes, if you 

could talk about the eminent domain proposals that are out there 

and how that could be bad for investors and for businesses—and 

for borrowers. 

Mr. HUGHES. You know, if it went through and that became a 

way of taking over property that would belong to investors, I think 

it would have a dramatic effect on private securitization. 

Senator HAGAN. And when you say ‘‘dramatic effect,’’ can you expand on that? 

Mr. HUGHES. I think if you are an investor and you now have 

a risk that someone could take your collateral out of your pool and 

you do not get adequate compensation for that, yes, I think that 

would be a risk that you had not planned on. 

Senator HAGAN. Mr. Gidman. 

Mr. GIDMAN. It would lead us to have to price that risk into our 

decision making, and given a world of asset classes to invest in, I 

think it would have an immediate and chilling effect on the entire 

asset class. 

Senator HAGAN. And how do you correspond that with the use of 

eminent domain today? 

Mr. GIDMAN. In the case eminent domain today—we will use the 

Big Dig as the example. It was real property. There was an unquestioned public interest and public use, and the owners were 

compensated according to objective measures of fair value. 

In the case of eminent domain that has been most recently discussed, you know, a local municipality is seeking to use eminent 

domain to seize assets that are held by retirees and pension participants across the United States, and it is unclear both of the 

public use in terms of the likely effect of that action within the municipality, and then because it is a private for-profit enterprise 

driving the deal, it is hard to see how fair value could be paid and 

have it work out. 

We think that this issue is really a public policy issue, and expanding HARP is the approach to keep homeowners in their homes 

and really have that effort be in lockstep with a broader housing 

market finance reform. 

Senator HAGAN. Thank you. 

Mr. Levitin, in your testimony you indicated that the PLS can 

only provide the financing for at most an eighth of the U.S. housing 

market’s peak annual financing needs. Can you discuss what constrains the size of that market? And how can Government guarantees work together with the private label securitization? 

Mr. LEVITIN. There is a limited amount of market demand for 

credit risk on mortgages that—you know, I might be wrong on the 

actual number there, but—— 

Senator HAGAN. How did you come up with that number? 

Mr. LEVITIN. By looking historically at the level of investment in 

the private label securitization market before the bubble, basically 

taking even—I am assuming that the bubble starts in 2004. Some 

people might disagree with me. But at 2004 levels, we would only 

get up to around $500 billion in investment in private label securities. 

Even if I am wrong by a factor of 2 or 3, the problem is the math 

is not even close, that if in peak years we have needed as much 

28 

as $4 trillion of investment, private label just is never going to be 

able to support that. It may be an important component of the market, but it is not going to be the backbone of the market. And I 

think that we need to try and improve the private label component, 

but we also have to remember that it is not going to be the core 

of the market. 

Senator HAGAN. Mr. Hughes, you mentioned in your testimony 

that Redwood recently invested in Freddie Mac Structured Agency 

Credit Risk notes. Can you discuss the benefits of that transaction 

in more detail? And how are the products able to distribute the 

credit risk from the GSEs into the private sector? 

Mr. HUGHES. Yes, we participated in the transaction. Again, we 

are in the business of investing in credit risk. We found the bonds 

to be attractive. 

I would note that one of the things in that transaction that I 

would hope in future transactions they could fix is that they kept 

30 basis points of risk at the Freddie Mac level. If you think 30 

basis points of risk is the risk in the pool, well, then, it really did 

not sell the actual risk. And I know part of it was to facilitate getting a transaction done, getting investors in, ‘‘Hey, investors, you 

do not have to worry.’’ My hope would be over time that they would 

begin to sell first-loss credit risk to private investors—— 

Senator HAGAN. Thank you, Mr. Chairman. 

Mr. HUGHES. ——I think second getting a rating on the bonds 

would also bring more liquidity because more investors could participate. 

Senator HAGAN. Thank you. 

Chairman JOHNSON. I would like to thank the witnesses for 

being here today. This hearing is adjourned. 

[Whereupon, at 11:27 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions supplied for the record follow:] 

29 

PREPARED STATEMENT OF MARTIN S. HUGHES 

CHIEF EXECUTIVE OFFICER, REDWOOD TRUST, INC. 

OCTOBER 1, 2013 

Introduction 

Good morning Chairman Johnson, Ranking Member Crapo, and Members of the 

Committee. My name is Marty Hughes, and I am the CEO of Redwood Trust, Inc., 

a publicly traded company listed on the New York Stock Exchange. I appreciate the 

opportunity to testify on what can be done to accelerate the return of a robust private secondary mortgage market. 

Background on Redwood Trust 

Redwood Trust commenced operations in 1994 as an investor in residential mortgage credit risk. We do not originate or directly service residential mortgages. We 

currently operate a prime jumbo loan conduit through which we acquire individual 

closed loans from banks and mortgage companies, primarily for pooling and sale 

through our Sequoia private securitization platform, which creates and issues mortgage-backed securities (MBS). 

Senior investors in MBS issued through our platform have protection from credit 

risk as a result of our investment in the subordinate securities issued in each 

securitization, which enables the senior securities to obtain triple-A ratings. Although this has not been the case for most issuers of MBS, in Dodd-Frank parlance, 

having ‘‘skin in the game’’ has always been a component of our business model, 

which demonstrates our alignment of interest with senior investors. From 1997 through 2007, Redwood securitized more than $35 billion of mortgage loans through 52 securitizations. The average loan size was $372,000 and, interestingly, 27 percent of the securitized loans were prime loans with balances under 

Fannie Mae and Freddie Mac’s (the ‘‘GSEs’’ or the ‘‘Agencies’’) conforming loan limit. 

Since we resumed the securitization of newly originated jumbo mortgage loans in 

2010, we have securitized an additional $8 billion of loans in 20 transactions. As 

a result of our securitization and investment activities, we feel well qualified to comment on the state of the private residential mortgage market and the steps needed 

to increase the participation of the private sector in the broader housing finance 

market. 

To supplement our jumbo mortgage loan business, we recently received our Seller/ 

Servicer licenses from both Fannie Mae and Freddie Mac and we intend to add 

Agency conforming loans to our product menu. Additionally, we invested in Freddie 

Mac’s recently issued Structured Agency Credit Risk (STACR) notes. This was the 

first Agency transaction completed as part of the strategic initiative of distributing 

credit risk from the GSEs into the private sector. Furthermore, we look forward to 

working with the Agencies to find ways for Redwood to invest in the ‘‘first loss’’ 

credit risk on the loans we sell to the Agencies, thereby putting the Agencies in a 

‘‘second loss’’ credit position. 

If we achieve our goals, our business would include investing in the credit risk 

on both jumbo prime loans (through private securitization) and Agency conforming 

loans (through contractual arrangements with the Agencies and investments in 

STACRs and similar investments). 

Overview 

Broadly speaking, I view the mortgage market as having two distinct sectors. The 

first is the Government supported sector, which includes the FHA/VA, Fannie Mae, 

and Freddie Mac. The other is the private sector, which consists of portfolio lenders, 

primarily banks, and private label MBS issuers, such as Redwood Trust. 

Each of these sectors has made vital contributions to the development of the mortgage market over time, for the benefit of millions of homeowners. However, in the 

wake of the financial crisis, Congress is now appropriately considering how to reform and improve each sector. My testimony will focus on the private label MBS 

sector of the mortgage market, although it is not possible to discuss reform of one 

sector in isolation of consideration of reforms in the other sector, as the two impact 

each other significantly. 

The U.S. mortgage market needs multiple financing sources to ensure there are 

deep sources of liquidity for good borrowers to readily obtain affordable mortgage 

loans. I would argue that it is critically important for private label MBS to return 

and play a significant role in mortgage finance, as it has in the past. This can be 

accomplished by bringing traditional institutional senior investors back to the private label MBS market to efficiently address borrowers’ credit needs. 

I firmly believe that over the long-term, private label mortgage securitization is 

a very efficient form of mortgage financing. As a Federal Reserve staff working 

30 

paper described securitization, it ‘‘has the potential to lower the cost of credit to 

businesses and households by reducing financial institutions’ funding costs’’ and ‘‘it 

can produce securities that cater to the risk-return preferences of investors.’’ 

Through the securitization process, an investor is able to buy assets that match 

their appetite for risk, using variables such as duration, interest rate risk, and high 

or low credit risk. This tailoring of risk is what draws trillions of dollars into the 

U.S. mortgage market. 

Many have speculated on why private label MBS is not fully flourishing today 

while other asset-backed markets for commercial MBS and credit cards have rebounded. There is no single answer to this question. There are a variety of factors 

that must be considered to explain the current state of the private label MBS market. Some of these factors will self-correct over time, while others will require structural and legislative change. 

Later in this testimony, I will offer specific recommendations for possible structural and legislative changes. But first, I would like to offer the following broad observations about the market: 

• As a result of increases in the conforming loan limit, there are fewer non-Agency jumbo loans being created. 

• The GSEs have had a significant pricing advantage over the private MBS market. This advantage has been reduced as guarantee fees have increased over the 

past 2 years. 

• Pre-crisis, major banks were significant issuers of private jumbo MBS (especially for 30-year fixed-rate loans). These banks now have over $2 trillion in excess reserves at the Federal Reserve and have made an investment decision to 

hold significantly more jumbo loans in portfolio to build their asset base and 

increase net interest income, rather than securitize or sell the loans. For example, in 2012, jumbo loan originations totaled $200 billion and private label MBS 

securitizations totaled only $3.5 billion. 

• Traditional senior investors still have questions of confidence regarding whether 

their rights and interests in the MBS they purchase will be respected and, consequently, that their investments will be safe and secure. 

• My last observation is a Catch-22. For private label MBS financing to attract 

more investors willing to invest at attractively priced levels, the asset class 

needs to be larger and more liquid. But in order to attract more investors, the 

asset class first needs a larger critical mass, so investors will see the value in 

dedicating resources to analyze and monitor the sector. 

The Current Private MBS Market 

The mortgage loans that are currently being securitized through our platform are 

probably more similar than many perceive to the loans currently being guaranteed 

by the GSEs, except for the average loan amount, as noted in the table below. 

31 

The GSEs have done a very good job of building loan quality. A large percentage 

of the loans currently guaranteed by the GSEs would meet Redwood’s guidelines 

and, while our primary focus has been on the prime jumbo mortgage market, we 

are prepared to securitize prime loans of any size if the conforming loan limits are 

reduced. 

We believe that if and when the conforming loan limits are lowered, both banks 

and securitization sponsors will step in to finance loans above the lowered limits at 

affordable rates, and the typical jumbo loan characteristics will increasingly resemble conforming loan characteristics. As for credit quality, the credit performance of 

our post-crisis securitizations has been stellar. No investor in the senior securities 

has incurred a credit loss and currently we have only one loan that is more than 

60 days delinquent. 

Interest rates to borrowers on conforming versus jumbo loans are narrowing closer to historical norms. On September 25, 2013, Redwood was purchasing prime 30- 

year fixed-rate jumbo mortgages within a rate of 4.875 percent. This compares to 

Wells Fargo’s prime 30-year fixed-rate Agency conforming rate of 4.375 percent for 

the same date. The spread between these two rates of 0.50 percent is about 0.25 

percentage points higher than the historical average. That also represents a dramatic improvement from the 2.00 percentage point spread that was in effect at the 

peak of the financial crisis in 2008. The current spread is solid evidence that private 

capital will provide borrowers with loans on reasonable terms if investors are presented with well-structured securitizations that also have a proper alignment of interests between the sponsor and the senior investors. 

How To Build a Robust Private MBS Market 

Focus on Investor Concerns 

Investors are the single most critical variable to consider as you take steps to promote a robust private MBS market. Simply put, investors have the money, and 

without their participation, there is no market. Many potential senior MBS investors, who previously had significant asset allocations to invest in private MBS, now 

have little or no participation at all. This is unfortunate because the financial world 

has ample liquidity and investors are combing through different asset classes in 

search of safe, attractive yields. On a relative value basis, there is no logical reason 

why private MBS should not play a much larger role as an attractive investment 

class, as it was in the past. 

So how is confidence restored among investors? Broadly speaking, I believe we 

need to first address investors’ demands for better risk mitigation, transparency, 

and alignment of interests throughout the mortgage chain. Redwood’s transactions 

prove that it can be done. We have listened to investors and worked hard to meet 

their new requirements for investing in private MBS by putting together transactions that included comprehensive disclosures, better and simpler structures, new 

enforcement mechanisms for representations and warranties, and skin in the game. 


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Correct MBS Structural Deficiencies and Conflicts 

The private market will have difficulty growing at the velocity needed without the 

combined efforts of market participants, Congress, and regulators to correct structural deficiencies and conflicts in securitizations. It is critical that we strengthen the 

structural foundation that supports securitization so that investor protections are 

given greater emphasis. In traditional securitization structures, investors have relied on a trustee and a servicer to administer a securitization. The governing documents have not always addressed or contemplated all of the potential situations 

that could face the servicer or trustee, nor have they always provided an investorfriendly mechanism for initiating and resolving disputes. The following recommendations will correct the structural deficiencies and conflicts: 

• Establish best practices in representations and warranties and other key 

securitization terms through the creation of a Private Market Advisory Committee (with investors holding a majority of the membership) that is given responsibility for developing new best practice standards. The standards would 

not be mandatory, but each securitization would be required to clearly disclose 

any variation from the standards. 

In many cases, representations and warranties have been weak and inconsistent 

and have been difficult for investors to compare from one sponsor to another and 

from one transaction to another. In addition, it has been costly or difficult to enforce 

the originator’s or sponsor’s obligations to repurchase loans where there has been 

a breach. We believe the representations and warranties now required by the GSEs 

serve as a strong benchmark. 

• Establish binding arbitration as a minimum standard for dispute resolution of 

representation and warranty claim disputes in private label MBS. 

The Agencies are large and powerful institutions that have the ability to effectively enforce representation and warranty claims relating to loans they purchase 

and guarantee. In the private label MBS sector, however, there has not been a comparable force behind the enforcement of representation and warranty claims. Some 

originators have resisted or stalled the process for legitimate claims, resulting in 

costly litigation. These circumstances have led to deep investor mistrust. Furthermore, investors unable to rely on this protection have fled the securitization market 

and continue to sit on the sidelines. In order to correct this problem, we recommend 

requiring a formal dispute resolution process for ensuring enforcement—specifically, 

a binding arbitration standard. New best practice standards for representations and 

warranties, coupled with binding arbitration, would provide investors with assurance that any allegation of a violation of representations and warranties will be 

thoroughly investigated and pursued in an efficient manner. 

• Require that securitization trusts create the position of Credit Risk Manager to 

manage representation and warranty claims and monitor servicer performance 

and actions. 

The Credit Risk Manager (CRM) would be an independent third-party unaffiliated 

with any interest in the transaction and would have two primary responsibilities. 

The first would be to identify, investigate, and pursue claims for breaches of representations and warranties. This is important in the event the senior investors and 

the party that owns the first loss security disagree on whether or not to pursue a 

claim. The second responsibility would be to conduct ongoing surveillance of the 

servicer’s activities and report to the trustee and investors the results of the review. 

Although a servicer is engaged to service mortgage loans in a securitization pool for 

the benefit of the investors, the investors have no real way of ensuring that the 

servicer is performing its duties because no independent review or quality control 

of the servicer’s decisions currently exists. The securitization documentation should 

provide for the CRM to have the same access to loan information and original loan 

files as the servicer to ensure that the CRM has the information necessary to perform its responsibilities. 

• Establish clear and objective uniform standards governing the responsibilities 

and performance of a servicer in its role as a fiduciary of the trust. 

When we focus on the role of servicers in the securitization structure, we note 

they have sometimes been placed in the position of having to interpret vague contractual language, ambiguous requirements, and conflicting directions. In their role, 

they are required to operate in the best interest of the securitization trust and not 

in the interest of any particular bond investor. In practice, without any clear guidance or requirements, they invariably anger one party or another when there are 

33 

disagreements over what is and is not allowed—with the result of discouraging some 

senior investors from further investment in private MBS. 

• Prevent servicer conflicts of interest by prohibiting the owner of a second lien 

mortgage from being the servicer of the first lien mortgage on the same property. 

Currently, most second lien mortgage loans are owned by the same banks that 

perform servicing on the homeowner’s first lien mortgage. Because these banks generally do not own the first lien mortgage they are servicing, they have a strong incentive to place their financial interests as a second lien holder ahead of first lien 

investors when taking actions as servicer on behalf of a securitization trust. For example, a servicer could refuse to approve a loan modification or a short sale that 

would benefit both the first lien mortgage holder and homeowner, because doing so 

would directly harm their financial interest as the owner of the second lien mortgage loan. 

Fortunately, there is a simple fix to this problem. Simply prohibit the owner of 

a second lien mortgage from operating as the servicer of the first lien mortgage on 

the same property. Servicing a delinquent loan is a nuanced, complicated process 

and investors must believe that their servicers are acting as honest agents throughout. No amount of disclosure or other half-measures will alleviate these concerns. 

The only meaningful solution is to definitively break the economic link between first 

lien mortgage servicers and second lien mortgage holders. 

• Establish servicer performance triggers to serve as benchmarks and as an objective means for possible removal of the servicer. 

Servicers need to live up to servicing performance standards and triggers should 

be established to give investors the ability to hold servicers to these standards. The 

triggers, which could be set by the Private Market Advisory Committee I proposed 

above, might include, among other things, average loss severity, adherence to foreclosure timelines, and average REO liquidation timelines. The triggers should be reviewed on a periodic basis. If a servicer fails a trigger, servicing could be terminated. Mechanisms must be established to facilitate collective action by investors 

when a trigger event occurs and there is a failure on the part of the trustee to take 

action. 

• Control the systemic and loan level risks relating to second lien mortgages by 

giving first lien holders the ability to require their consent to a second lien if 

the combined loan to value (CLTV) with all other liens will exceed 80 percent. 

During the housing bubble, homeowners extracted record levels of home equity 

through second lien loans. Second lien loans also acted as a substitute for cash 

downpayments to purchase houses. At the peak in 2006, these loans totaled $430 

billion. 

The rise of home equity lending increased the monthly payment obligations for 

borrowers and reduced the amount of equity remaining in their homes, leaving borrowers vulnerable to home price declines. As a result, 38 percent of the borrowers 

who used these loans found themselves underwater (or owing more than the value 

of their houses), compared to only 18 percent of those who did not. Even for wellunderwritten, prime loans, the presence of a second lien correlated with increased 

defaults by as much as 114 percent. 

The rise of second liens has had another, less-widely understood effect: it substantially increased losses for investors and chilled their interest in investing in newly 

issued MBS. To understand why, it is necessary to understand how investors evaluate mortgage loans. While a borrower’s credit report, income verification, and other 

underwriting factors are important to investors in evaluating credit risk, perhaps 

the most important factor is the amount of a borrower’s equity, or the borrower’s 

downpayment. The amount of a borrower’s equity is probably the most predictive 

factor of a borrower’s future performance: borrowers with 20 percent or more equity 

have lower default rates, while those with no equity are quicker to default and walk 

away from their home. 

Second liens undermine an investor’s ability to analyze risk by making downpayment information unreliable. Imagine this scenario: a borrower applies for a first 

mortgage with a 40 percent downpayment—this is a loan that would historically 

have very low default risk. As a result, the borrower is offered a great loan at a 

low rate. One week after taking out the loan, the borrower takes out a second mortgage from a different lender for the remaining 40 percent of the property value. The 

borrower no longer has any equity and the default risk and potential loss severity 

on the first lien is higher than before. This is not a fantasy scenario: approximately 

34 

70 percent of borrowers in prime, privately securitized mortgages issued between 

2004 and 2007 took out second liens subsequent to obtaining a first mortgage. 

This level of uncertainty has a highly consequential impact on how investors assess mortgage related investments. Since investors have no way of knowing which 

borrowers will cash out their equity, they must assume that everyone will. This uncertainty leads private investors to demand higher rates in return for the increased 

risk, and the cost of home ownership goes up for everyone. 

We believe that placing some reasonable restrictions on the origination of second 

lien mortgages will restore investor confidence and speed the transition of the mortgage market away from taxpayer exposure. We propose that first lien holders have 

the ability to require their consent to a second lien if the combined loan to value 

(CLTV) with all other liens will exceed 80 percent. If the consent is not given, then 

the borrower can still obtain a home equity loan, but will need to refinance the first 

mortgage (and pay off the first lien holder) using a standard cash-out refinance loan 

product. This proposal would allow borrowers to tap into their equity, while preserving a level of protection for investors in first liens. This new restriction is intended only to protect first-lien lenders, and investors, from excessive equity being 

extracted later, without their knowledge or consent. 

• The Government should begin to reduce its participation in the mortgage market, gradually and at a measured pace by reducing the conforming loan limits. 

For many years prior to the financial crisis, the Government mortgage market 

(GSEs, Federal Housing Administration, and Veterans Administration) and the private mortgage market have coexisted to serve the needs of borrowers. In the aftermath of the financial crisis, the Government’s share of the mortgage market has increased to approximately 90 percent. If the conforming loan limits are reduced, I 

believe the private market would aggressively compete for those loans that exceed 

the new limit without any market disruption, similar to when the temporary increase in the conforming loan limit (from $625,500 to $729,750) was allowed to expire in September 2011. 

• Remove the uncertainty caused by unfinished regulations. 

The incomplete status of regulations required by the Dodd-Frank Act has constrained the development and growth of the private MBS market. Markets require 

certainty about the rules of operation so that regulatory compliance can be assured. 

Investors will continue to be cautious about entering the private MBS market out 

of concern that final regulations might soon turn a good business decision into a bad 

one. Markets typically manage to adapt to new regulations and continue operating 

under the new rules. The private label MBS market is no different. 

Conclusion 

The U.S. mortgage market is a complex system with many parts and key participants. Each plays a supportive role in creating a highly liquid and efficient market. 

The private MBS market will once again assume a major role, alongside the Government supported sector, as the issues I have discussed begin to get resolved. Thank 

you. 

PREPARED STATEMENT OF JOHN GIDMAN 

PRESIDENT, ASSOCIATION OF INSTITUTIONAL INVESTORS

OCTOBER 1, 2013 

Chairman Johnson, Ranking Member Crapo, Members of the Committee, thank 

you for inviting me to testify here today in support of your overall efforts toward 

housing finance reform and specifically regarding fundamentals of a functioning private label mortgage backed securities (PLS) market. 

My name is John Gidman. I am an Executive Vice President of Loomis, Sayles 

& Company in Boston, Massachusetts, and am testifying here today in my role as 

President of the Association of Institutional INVESTORS (the Association). The Association is an organization of some of the oldest and largest institutional investment advisors in the United States. All our firms have a fiduciary duty to put our 

clients’ interests first. Put simply, it’s not our money. 

Our member firms manage investments for more than 80,000 pension plans, 

401(k)s, and mutual funds on behalf of more than 100 million workers and retirees. 

Our clients include companies and labor unions, public and private pension plans, 

mutual funds, and families who depend on us to help them provide for their retirements, to have funds available to educate family members, and to support their financial aspirations. 

35 

Our clients are able to rely on us to prudently manage their investments in part 

due to the fiduciary duty we owe these organizations and individuals. We recognize 

the significance of this role and my testimony today is intended to reflect not just 

the views of the Association but the financial interests of the companies, labor 

unions, municipalities, workers, and retirees we ultimately serve. 

We recognize the vital role robust housing finance markets play in our society. 

These markets traditionally provided generations of families, across a variety of income levels, pathways to gain home ownership. For decades, this defined the American Dream. Much of this mortgage financing has ultimately been provided by pension plans, 401(k)s, and similar funds whose investors valued collateralized income. 

Through these investment mechanisms, workers and retirees relied on the strength 

and depth of these markets to provide them income they needed for retirement. 

Lessons Learned From the Housing Crisis 

Institutional investors, like all participants in the mortgage market, have learned 

many lessons from the financial crisis. We learned that the stress of high unemployment and the decline in housing prices exposed certain structural weaknesses in the 

securitization framework. 

We recognize the critical role trustees play in the functioning of PLS mortgage 

markets but believe that they were not and are still not legally compelled, nor financially incented, to appropriately safeguard the interests of the trusts they represent. 

We are keenly aware that the incentives of the originator and the buyer of the 

risk were not and are still not aligned, because the originator typically sells all, or 

nearly all, of their economic interest in the securitization. This is a fundamental difference from other securitization markets, such as automobile or credit card markets, where the issuer retains significant first-loss risk and has very strong incentives to underwrite conservatively. 

Institutional investors see that documentation was not and still is not standardized and that the strength of representations and warranties varies depending on 

the issuer. 

Institutional investors also consider that the enforcement of existing contracts 

was and is still weak, particularly where vertically integrated financial institutions 

often serve as issuers, trustees, originators, and servicers, creating conflicts of interests and incentives not to identify deficiencies that harm investors’ trusts. 

As a result of these structural weaknesses, little has improved in legacy residential mortgage backed securities (RMBS) reporting, enforcement of representations 

and warranties, or oversight of servicer performance. A typical monthly report today 

for legacy RMBS securities is not transparent as to who is servicing the loans, on 

what basis particular actions were taken by the servicer, or even regarding reconciling cash that came in and out of the trust. Recently, large portions of the legacy 

RMBS market have also seen servicing duties transferred from one firm to another, 

without investor consent or effective challenges from trustees, even in situations 

where investors would have likely been opposed to such a change. 

Overview of the Current PLS Market 

The absolute volumes of new issuances remain a very small fraction of what they 

were before the 2008 crisis. However, today, the quality of the collateral underlying 

the PLS market has generally improved. New issue RMBS markets have reopened 

as of 2011, and grew in 2012 and 2013, but with issuances primarily in the ‘‘Jumbo 

Prime’’ space, or high credit quality loan balances well above the conforming limits. 

The fundamental structural and process weaknesses for nonagency RMBS 

securitization have not been fixed in the current PLS market. The issuance process 

itself is very opaque. Ratings continue to be shopped, issuers are still incentivized 

to water down representations and warranties, and continued variability in structures and documentation make the market more challenging for investors and raise 

the costs of funding. 

Additional uncertainty has also been added to the market due to concerns that 

make it harder for investors to price risk, which consequently makes it harder for 

investors to justify investing in the sector. Included among the factors increasing 

uncertainty are: (a) the potential use of eminent domain by local governments to 

seize mortgages held in interstate trusts; (b) assignee liability; and (c) settlements, 

such as the Department of Justice’s and various States Attorneys General settlement—the National Mortgage Settlement—using PLS trusts’ funds to remedy allegations of inappropriate, unlawful, or illegal behavior on behalf of the issuer or 

servicer—behavior in which investors had no role. 

We do not believe that the PLS market is robust enough, given the current structural risks, to sustainably absorb significantly more supply, especially if the supply 

includes deals with lower subordination levels or collateralized by loans from borVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00039 Fmt 6621 Sfmt 6621 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
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rowers with less pristine credit and lower downpayments (higher loan-to-value ratios). In other words, we are talking now about the vast gulf between home mortgages averaging between $250,000 to $300,000, supported by the agencies, and 

those for homes over $1,000,000 owned by borrowers with pristine credit and high 

equity. 

Buy-and-hold institutional investors will either require much higher yields—yields 

that are likely to render credit unavailable to those middle-class borrowers most in 

need of it—or will likely not participate in sufficient size to support the market 

without significant structural reforms. 

Current PLS Market Borrowing Characteristics and Loan Level Data 

As I alluded to, from a credit perspective, the types of loans currently being 

securitized are of a very high quality. Typically, the loans have a 66 percent average 

loan-to-value and a 760 average FICO score, with very few second liens and no 

mortgage insurance, so borrowers have 20–50 percent equity in the property. In the 

majority of deals, only the senior (typically AAA-rated) part of the securitization is 

being sold, so the amount of risk being taken by the private market is relatively 

small. The average home price of the mortgages being securitized is over $1,000,000. 

These high prices, combined with large downpayments and very high credit quality, 

has led to a situation where the current PLS standards cannot be used to finance 

mortgages for the majority of Americans. It should be noted that the PLS market 

did provide loans of average and even below-average credit quality before the crisis 

and there is likely funding available to do so, if investors become convinced that the 

issues exposed by the financial crisis have been addressed. 

The following table shows the volume and average credit characteristics of Jumbo 

Prime issuance from 2011 through 2013. 

There is also a need for continued access to robust loan level data. Prior to the 

crisis, investors did receive some loan level data for RMBS. Today, data for new 

issue deals contains more information and more accurately represents credit risks. 

However, we do not have access to the actual loan documents. We believe that full 

access to actual loan documents is important and this data should not be restricted 

by requiring the use of expensive commercial data services. Immediate, free access 

to the actual loan documents should be reasonable, as the documents are readily 

available and investors in the trust legally own the documents as owners of the 

loans. However, even with complete data sets or access to the loan documents, we 

believe our information will never be as perfect as the originators’ information. To 


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level the playing field and promote an open and transparent market, we believe 

other factors, such the creation of a fiduciary duty for trustees, better quality reporting, and standardized representations and warranties are more important to investors than loan-level data. 

General Thoughts on Housing Reform 

While the PLS market has improved since the financial crisis, in our view, meaningful regulatory and operational changes must be made before the market can fully 

recover. Institutional investors want to be able to invest in the mortgage sector, on 

behalf of our clients, as the credit quality of newly originated mortgages has improved. However, as fiduciaries, we cannot put our investors’ savings and assets at 

risk in bonds that have a significant and unquantifiable downside risk. 

Therefore, we fully support Congress’ efforts to reform the mortgage market. In 

doing so, we believe Congress should consider the agency market and the PLS market as part of one interconnected mortgage finance system. We believe that any regulation or legislation that reforms one market needs to consider the impact on the 

other market. Today, institutional investors favor investing in the agency market 

because there are fewer unknowns and many of the key investor concerns are mitigated when dealing with that market. The PLS market can redevelop, but the private market’s reliance on the Government-sponsored enterprises (GSEs) will not organically decrease unless there are safeguards put in place to protect the PLS market. 

S.1217, the Housing Finance Reform and Taxpayer Protection Act, which was introduced earlier this year by Senators Bob Corker (R-TN) and Mark Warner (D-VA), 

and is cosponsored by six other bipartisan Members of the Senate Banking Committee, addresses some of the Association’s concerns and generally we think this legislation moved the debate in the right direction. 

The bill’s risk-sharing mechanism offers a promising solution that we believe 

could work if investors’ need for a fiduciary standard for trustees is mandated. In 

July 2013, Freddie Mac issued the first risk-sharing deal in the RMBS market, 

called STACR 2013-DN1. We believe it was a positive sign that institutional investors were willing to take subordinate credit positions on this portfolio of agency 

mortgages, indicating that institutional investors may also be willing to take on risk 

under a Corker-Warner system. 

The legislation also provides helpful language to address investor concerns with 

the PLS market regarding issues like standardization of documentation and enforcing representations and warranties. Title II, Subtitle C of S.1217, in particular, reflects many of the transparency and oversight principles that we believe are vital 

to increasing investor confidence in the mortgage market. We appreciate the inclusion of these provisions and hope they are part of any other GSE reform legislation 

considered by the Committee. 

S.1217, however, did not address several fundamental investor concerns. These 

issues include: (1) creating a fiduciary duty for trustees and servicers; (2) addressing 

the assignee liability provisions included in Section 1413 of the Dodd-Frank Wall 

Street Reform and Consumer Protection Act (Dodd-Frank Act), now implemented by 

the Consumer Financial Protection Bureau (CFPB) in its Ability-to-Repay Rulemaking; and (3) limiting the ability of local municipalities to use eminent domain 

to seize residential mortgages held in trusts across State lines. Some of these concerns were highlighted by the crisis; others have arisen since the crisis. Each must 

be addressed by any mortgage market reform package that progresses through Congress, if one of the goals of the legislation is to incentivize private capital to return 

to the PLS market and stay in times of market stress. Each of these issues is addressed below. 

Fiduciary Duty for Trustees and Servicers 

Investor confidence is a foundation of the PLS market, therefore investors should 

have proper recourse to the parties. However, since the financial crisis began, a failure in the structure of the PLS market has been apparent: trustees do not have a 

regulated fiduciary duty to bondholders. 

To address these concerns and create better investor confidence, any mortgage 

market reform legislation should include trustee fiduciary duties to oversee the 

maintenance of trusts and enforce put-back obligations for faulty loans with regulatory oversight and private causes of action for breaches. 

Recent developments have underscored the lack of trustee fiduciary duty as the 

ongoing critical gap in the PLS marketplace. Situations like last year’s Attorneys 

General mortgage servicing settlement (the AG Settlement), where investors were 

not involved in the negotiations, and when faced with a significant conflict of interest, trustees and servicers were able to sacrifice the assets of trust investors in favor 

38 

of their own bottom line. Without a clear fiduciary duty for trustees, trustees and 

servicers are incented to act as they did under the settlement. Servicers have overwhelmingly favored writing down loans owned by private PLS pension and fund investors rather than writing down principal on loans owned by the banks. 

The AG Settlement, while unprecedented, is also not an isolated example of a situation where trustees or servicers act in their financial interest rather than in the 

best interests of investors. Recently, for example, there have been media reports 

that a large vertically integrated bank may settle an $11 billion deal with State and 

Federal regulators related to investigations into the bank’s sale of RMBS that were 

packed with bad loans. This amount reportedly would include $4 billion in relief for 

struggling homeowners, similar to the AG Settlement, and it is not clear at this 

point whether this settlement would allow that bank again to meet its obligations 

by using funds from PLS trusts. Like the AG Settlement, investors have not been 

involved in the negotiations, and if the settlement allows it, that bank would be 

incented to meet at least part of its obligations with trusts’ assets, therefore assets 

of American savers, because no one has a fiduciary duty to act in the best interests 

of the trusts’ investors—in effect, the $4 billion would be paid by American workers 

and retirees out of their pension assets. 

Implementing a fiduciary duty for trustees would also spur further investment in 

the market, because investors would be assured that the trustee was acting in the 

best interests of the trusts’ investors and incentives were properly aligned. Further, 

a fiduciary standard would improve the quality of trusts, as only good mortgages 

would be placed into the trusts, and mitigate conflicts of interest for situations 

where the same entity serves as both servicer and trustee. 

In addition to incentivizing private capital to return because investors’ rights 

would be better protected, creating a fiduciary duty would also reduce the incentives 

that currently exist to invest with the GSEs. Under the current model, the GSEs 

are often more attractive because they are partners to their own contracts. Investing 

with the GSEs ensures that an entity, the GSE, has proper recourse if there is a 

problem. By creating a fiduciary duty, private capital will be encouraged to continue 

investing in the PLS market, ultimately increasing the market share for the private 

market and reducing the Government footprint. 

Assignee Liability 

We believe that assignee liability once implemented and as currently defined in 

regulation will lead institutional investors to avoid the PLS market. 

The Dodd-Frank Act and the CFPB’s subsequent regulations create a path for a 

defaulting borrower to sue the lender for irresponsible lending. We agree with this 

principle and believe that it is good to hold originators accountable for predatory 

lending. However, the statute and regulations also create assignee liability, which 

essentially means that if the originator sells the loan, the buyer of the loan can be 

sued even though they were not the lender that made the bad loan in the first place. 

In the case of the PLS market, the trustee for the transaction would be the lawsuit 

target, and any legal, settlement, and damage costs would come out of collateral 

cash flows. 

Such lawsuits are also not limited to the loan amount. Rather, potential damages 

awarded against the PLS trust, as the assignee, could equal to the sum of all finance charges and fees paid by the borrower (up to 3 years’ worth from the origination of the loan), plus actual damages, court costs, and attorneys’ fees. We expect 

that damage awards could amount to thousands of dollars per loan, and a typical 

RMBS bond includes thousands of loans. Thus, an investor could face millions of 

dollars in losses from this liability on each bond. Furthermore, as trusts often have 

the ability to pay more than small originators, we believe that assignee liability 

could actually have the unintended consequence of weakening the liability of the 

originator, because plaintiffs’ attorneys will focus the lawsuits on the entity with the 

deepest pockets. 

Given this potential liability, assignee liability risk may already be affecting the 

PLS market, even in advance of the CFPB’s ability-to-repay requirements going into 

effect in January 2014. Institutional investors in this market are not close enough 

to the origination process to determine for themselves if all loans are exactly as advertised at the time of purchase, and so institutional investors are not willing to 

take on the risk that they could be sued for others’ actions. Further, although DoddFrank and the CFPB’s regulations include a safe harbor for a certain subset of 

qualified mortgages (QMs), this does not assuage our concerns because even if the 

safe harbor qualifications are met, asset managers will be forced to expend resources to establish the applicability of the safe harbor in every case where the borrower asserts that the ability-to-repay requirements were violated, regardless of the 

39 

merits of the claim. Unless legislative changes are made, we expect that the PLS 

market will deteriorate further once these rules go into effect in January. 

To address these concerns, we are supportive of any efforts to reduce the risk of 

assignee liability under Dodd-Frank and the CFPB regulations and to increase access to the ability-to-repay safe harbor. The best way to accomplish this goal would 

be by including language to eliminate assignee liability completely. Removing assignee liability would not reduce the protections afforded homeowners under the 

ability-to-repay provisions, but rather would ensure that only those that are responsible for generating the loans will be held accountable for the loans that they generate. Under such a system, incentives will be properly aligned and institutional investors would not be held responsible for the bad acts of other players. Alternatively, although less ideal, the legislation could include a provision that would ensure that the CFPB must expand its ability-to-repay regulations to allow more loans 

to meet the conclusive safe harbor standard. 

Eminent Domain 

It seems in every crisis, there are powerful and well-connected opportunists that 

prey again on the victims. Certain jurisdictions are considering implementing a program designed and aggressively marketed by a private fund whereby a city would 

rent out its local eminent domain power to seize performing high quality mortgage 

loans, held in interstate trusts, in order to restructure the mortgages at a profit for 

the city and the fund’s investors. This unprecedented and misguided use of local 

eminent domain power could hurt the retirement savings of workers and retirees 

from across the United States, who currently invest in mortgages that would be 

seized, and significantly damage the overall PLS market. 

Under the fund’s plan, cities would seize current performing mortgages that are 

in trusts held by pension plans, 401(k) plans and mutual funds across the United 

States and managed by our members. If mortgages are taken by eminent domain, 

we will take action to protect the assets of our clients. 

As fiduciaries, we have a duty to ensure that the investments we make on behalf 

of our clients are in their best interests. Therefore, after eminent domain is used, 

we will be forced to weigh the possibility that future mortgage contracts will not 

be upheld and our clients will lose value in their investments. Ultimately, we believe it will be difficult to continue investing in the mortgage markets if any local 

community uses eminent domain to seize assets out of interstate trusts. 

Given these concerns, the Association believes any GSE reform legislation should 

include language similar to the language in H.R. 2733, the Defending American 

Taxpayers from Abusive Government Takings Act of 2013, which was included in 

the PATH Act (H.R. 2767). These provisions would prohibit the GSEs from purchasing, the Federal Housing Administration from insuring, and the Department of 

Veterans Affairs from guaranteeing, making, or insuring, a mortgage that is secured 

by a residence or residential structure located in a jurisdiction where eminent domain has been used to take a residential mortgage. We are also in favor of expanding the Home Affordable Refinance Program (HARP) to homeowners whose mortgages are held in PLS trusts, to provide these homeowners with relief. 

Conclusion 

As the Committee continues to consider housing finance reform, we hope our perspectives support your efforts. Each of our suggestions is intended to help promote 

a vibrant secondary mortgage market, accomplish your goal of reducing the Government footprint in the mortgage market, and avoid adverse consequences that will 

ultimately affect the millions of American investors who rely on the continued vitality of these markets in order to save for their families’ needs. We thank the Committee for its continued work and for focusing on this difficult issue. As the Committee progresses in its work, we stand ready to provide information and assistance 

as a voice for the millions of Americans who rely on these markets. 

Thank you for the opportunity to participate in today’s hearing. 

40 

PREPARED STATEMENT OF ADAM J. LEVITIN 

PROFESSOR OF LAW, GEORGETOWN UNIVERSITY LAW CENTER

OCTOBER 1, 2013 


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RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK 

FROM MARTIN S. HUGHES 

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 

Mac have been in conservatorship to preserve the assets and protect the taxpayers. These steps include enhancing the underwriting, credit risk pricing, and reps and warrants contracts of 

counterparties with Fannie Mae and Freddie Mac. These actions 

ensure standards being used by the two Enterprises are more updated, comprehensive, transparent, and that they more accurately 

reflect the risks assumed by the two Enterprises. Had these reforms been implemented prefinancial crisis much of the fraud, poor 

risk-management, and losses to the taxpayers could have been 

avoided. Going forward, these actions are providing for a more attractive and transparent agency market for investors, which is essential to ensuring the U.S. housing market continues to be attractive for global investment. 

Can you tell me if the private label security (PLS) market is 

adopting the same stringent transparency and contractual standards as the agency market? If not, why not? 

A.1. Participants in the post crisis private label security (PLS) 

market have implemented increased transparency and contractual 

standards, but with variations among the PLS sponsors. For example, it is my understanding that most or all of the issuers have 

adopted the American Securitization Forum disclosure format, 

which contains approximately 150 fields of data per loan backing 

a PLS. This compares to approximately 35 data fields disclosed by 

the Enterprises. Therefore, I would say that the PLS market provides far more data and transparency about the loans backing private securities than is currently being offered by the Enterprises. 

The contractual standards have also improved in the private market, but with variation among PLS sponsors. For example, some 

current securitization sponsors, mainly banks, have ‘‘sunset’’ 

clauses in their representation and warranties that they make to 

the securitization trusts, which we believe undermines confidence 

among the triple-A investors to purchase PLS. The PLS issued by 

Redwood do not have sunset provisions as we believe the PLS market needs to be held to a higher standard. 

Q.2. What is holding back standardization of the PLS market? 

What is happening to PLS pools in the market today? 

A.2. Simply stated, the lack of a self-governing organization or regulatory directed standardization is contributing to the holdback in 

standardization. As a result, PLS issuance represents a growing 

but still very small market. For example, in 2012, only $3.5 billion 

out of $200 billion of jumbo mortgage originations were securitized, 

representing less than 2 percent of originations. For the first 6 

months of 2013, $8.3 billion of prime jumbo originations were 

securitized out of $113 billion of originations, representing 7 percent of the market. These percentages are much smaller than the 

period starting in 1995 through 2007 in which the percentage of 

jumbo loans securitized to total jumbo originations averaged 29 

percent. 

We believe that what is holding up the reemergence of prime 

PLS is a combination of structuring and monetary policy issues 

63 

that currently incent large banks to retain mortgages on their balance sheets. The structuring issues that are holding up the reemergence of PLS include: 

1. A need for standardized representations and warranties for all 

securitizations that protect investors from noncredit related 

losses. Any exceptions should have to be noted clearly on a 

schedule so that investors do not have to compare and contrast the rep’s and warranties from one deal to another 

against a standardized format. 

2. A need to have a standardized enforcement mechanism (such 

as binding arbitration) for rep and warranty breaches. 

3. A need to empower the trustee to proactively monitor and 

take appropriate actions for the benefit of the security holders. 

We suggest the concept of the ‘‘controlling holder’’ as is used 

in our Sequoia securitizations. 

4. A need for investors to have confidence that their collateral 

will not be unfairly taken from them through Government actions (such as through eminent domain) or by third-party 

mortgage servicers that do not have an economic stake in the 

securitizations they service by modifying loans to further their 

own interests. 

5. A need to protect investors from having their mortgage collateral diminished in value by allowing borrowers an unlimited 

ability to withdraw equity from their houses. We suggest that 

any lender who proposes to provide a subordinate financing on 

a property that would increase the combined loan-to-value 

ratio above 80 percent obtain the consent of the first mortgage 

holder, and if the consent is not granted, the new lender can 

provide a new first mortgage for the entire amount desired. 

We also believe that investors take comfort from issuers that 

have meaningful ‘‘skin in the game.’’ At Redwood, for 

securitizations we have sponsored post crisis, we hold 100 percent 

of the noninvestment grade securities that are first in line to incur 

losses, which we believe provides a high alignment of interest with 

the investors in the senior securities. We realize that this issue is 

far more complicated than just risk retention, but it is unfortunate 

that it appears most residential securitizations will not require 

sponsors to retain risk. We expect to continue to hold all of the 

noninvestment grade credit risk tranches on our securitizations. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN 

FROM MARTIN S. HUGHES 

Q.1. One component of the housing finance system that has much 

received significant discussion over the last year is the role of recourse available to the lender. Recourse is available to lenders on 

a State-by-State level. States where recourse is available to lenders 

have a significantly lower risk of default as comp, especially among 

those who may strategically default. One Federal Reserve analyst 

found that for a sample of loans originated between August 1997 

and December 2008, ‘‘the probability of default is 32 percent higher 

in nonrecourse States than in recourse States.’’ Borrowers who had 

a property value of $500,000–$750,000 at origination were over 100 

64 

percent more likely to default in nonrecourse States than in recourse States. In your view, would expanded availability of recourse strengthen our housing finance system? What is the impact 

of recourse availability on investors’ decision making in real estate 

and private-label mortgage-backed securities? 

A.1. On the subject of recourse lending, we are generally in favor 

of the concept and we understand that it has worked well in Canada and Australia. As a practical matter, when a lender has an option of using a nonjudicial foreclosure process that does not allow 

for a deficiency judgment, or a using a judicial foreclosure that provides the lender with a deficiency judgment, lenders overwhelming 

use the lower-cost nonjudicial foreclosure alternative. Borrowers 

that ‘‘strategically default,’’ despite having ample resources, inflict 

damage to the integrity of the mortgage market and ultimately 

force all borrowers to pay a higher price for a loan, since investors 

suffer additional losses. 

RMBS investors factor into their pricing models loss severities by 

loan, which is a function of where the property is located and the 

rules around the foreclosure processes in each State, which would 

take into account the ability to obtain a deficiency judgment. 

Q.2. In your written testimony you said we should ‘‘remove the uncertainty caused by unfinished regulations,’’ referring specifically to 

the Dodd-Frank Act. You said the incompleteness ‘‘has constrained 

the development and growth of the private MBS market.’’ As you 

know, some proposals for the future housing finance system would 

place a new Federal regulator in the system in the form of the Federal Mortgage Insurance Corporation. The Federal Reserve, Department of Housing and Urban Development, Securities and Exchange Commission, Office of the Comptroller of the Currency, and 

Consumer Financial Protection Bureau all already manage these 

regulations. In your view, what are the most significant outstanding regulations impeding the industry currently? Additionally, 

how do you believe the future complexity of navigating regulations 

by these different agencies will adversely impact innovation and 

flexibility in the marketplace? 

A.2. As of October 1, 2013, only 40 percent of the 398 rules required by Dodd-Frank have been finalized. Various unfinished 

rules have a greater impact on some parts of the market than others. For the mortgage securitization market, one of the key unfinished rules is the risk retention, or QRM, rule. My point is not to 

single out any one rule as most important, rather the weight of all 

the unfinished rules is stifling growth and innovation. Markets 

cannot grow if businesses cannot understand the rules under which 

they will be required to operate. Perhaps some of the rulemaking 

delay is the result of having such a fragmented financial regulatory 

system. The addition of yet another regulator should be reason 

enough to step back and assess the need to streamline the current 

regulatory infrastructure. 

65 

RESPONSES TO WRITTEN QUESTIONS OF 

CHAIRMAN JOHNSON FROM JOHN GIDMAN 

Q.1. Can Government guaranteed MBS with private capital first 

loss exposure (as described in S.1217) be structured to allow trading in the TBA market? If so, how? 

A.1. The Association believes that Government guaranteed MBS 

with private capital first loss exposure can be structured to allow 

trading in the TBA market. However, in order to do so, there must 

be increased transparency, a fiduciary duty for servicers and trustees, and loan level disclosures. 

This year, Freddie Mac successfully marketed a new product, the 

Freddie Mac Structured Agency Credit Risk (STACR) securities, 

which shows that there is an appetite and it is possible to sell firstloss pieces of certain Government guaranteed MBS into the private 

market. However, deals like STACR 2013-DN1 did not include any 

new originations, and investors were able to review the history to 

appropriately price the risk. 

Unlike STACR 2013-DN1, under S.1217 investors are assuming 

the first loss position without the ability to review historical data 

related to the underlying collateral. In this type of scenario, increased disclosures and a fiduciary duty are necessary to attract institutional investment advisers to consider investing in the deals. 

Assuming increased transparency and a fiduciary duty provides institutional investors with more comfort in the quality of these investments, the Association expects these deals would be as reasonably attractive as any other subordination investment. 

Also, the STACR deal had Freddie Mac taking first 0.3 percent 

of risk below investors, and ‘‘catastrophic’’ risk above the credit risk 

sold to investors. This created an alignment of interest between 

Freddie Mac and investors, with Freddie Mac having a strong economic interest to minimize losses—we think this is a very important credit consideration for investors. In a situation where all of 

the credit risk is sold to investors, this alignment of interests 

would not exist, and investors would likely demand a higher return 

for the increase in risk. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK 

FROM JOHN GIDMAN 

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 

Mac have been in conservatorship to preserve the assets and protect the taxpayers. These steps include enhancing the underwriting, credit risk pricing, and reps and warrants contracts of 

counterparties with Fannie Mae and Freddie Mac. These actions 

ensure standards being used by the two Enterprises are more updated, comprehensive, transparent, and that they more accurately 

reflect the risks assumed by the two Enterprises. Had these reforms been implemented prefinancial crisis much of the fraud, poor 

risk-management, and losses to the taxpayers could have been 

avoided. Going forward, these actions are providing for a more attractive and transparent agency market for investors, which is essential to ensuring the U.S. housing market continues to be attractive for global investment. 

66 

• Can you tell me if the private label security (PLS) market is 

adopting the same stringent transparency and contractual 

standards as the agency market? If not, why not? 

• What is holding back standardization of the PLS market? 

What is happening to PLS pools in the market today? 

I would love to see the conforming loan limits for agency mortgage backed securities to be lowered, as it is one of the more obvious ways to increase and incentivize the private market back into 

this market space. I am concerned however that if the standards 

in the PLS market are not the same as the agency market—including to provide for clear and updated reps and warranties agreements and greater transparency—that investors will be hesitant to 

move to the PLS space. 

• If the standards for risk-based pricing, reps and warranties 

and standardization of agency securities are improved for any 

‘‘agency-like’’ security that is developed post-housing finance 

reform, will investors begin demanding these enhanced standards for PLS investment? What more could be done to 

incentivize the private market to adopt such standards? 

• Do you think that the PLS market can truly be optimized if 

loan limits are lowered before greater transparency, contractual, and fiduciary changes/updates are adopted in the PLS 

market? 

A.1. Summary—The PLS market has not adopted the same stringent transparency and contractual standards as the agency market 

because institutional investors and their investment advisers are 

not parties to the agreements, unlike the Government-sponsored 

enterprises (GSEs). Without being parties to the agreements, investors have little leverage to ‘‘demand’’ these enhanced standards for 

PLS investment. Further, the parties to the agreements have no incentive to enhance the underwriting, credit risk pricing, and representations and warranties. 

We believe Congress should consider the agency market and the 

PLS market as part of one interconnected mortgage finance system. 

We believe that any regulation or legislation that reforms one market needs to consider the impact on the other market. 

S.1217 considers the establishment and operation of a Federal 

Mortgage Insurance Corporation (FMIC) as playing an important 

role in structural reforms designed to align interests appropriately 

for the various parties engaged in the housing finance markets. It 

may be helpful to explore ways to support expansion of this concept 

to the PLS market though implementation of an agency-like entity, 

perhaps titled the Private Mortgage Assurance Corporation, which 

could provide many of the structural elements we have highlighted 

as important components of housing reform in support of the PLS 

markets. 

This type of private mortgage agency entity, while not providing 

a Federal backstop, could promote a variety of services including 

standards for documentation covering PSAs, representations and 

warrantees, enforcement mechanisms, due diligence, and identification of baselines for risk managers and servicers. Such an entity 

could be party to the contracts, similar to the way the GSEs are 

party to their contracts, and would have the authority to enforce 

67 

these contracts on behalf of investors. We think this approach is 

better than the complex documentation and multiple levels of reunderwriting that is becoming prevalent in the PLS market, which 

increase costs without providing an enforcement mechanism. 

The Association’s members support further standardization of 

documentation in the PLS market, as well as efforts to increase 

transparency and enhance representations and warranties. These 

changes will ultimately help create a more level playing field. However, we do not believe standardization should be the ultimate goal. 

Even without standardization, if servicers and trustees had a fiduciary duty to act in the best interest of investors, the Association 

believes that communication and trust would increase among the 

parties and the market would be strengthened. 

The PLS market already had loan-level data transparency, riskbased pricing, and many of the contractual protections that have 

come into the agency market in the past several years. However, 

the crisis exposed the fact that trustees are not required to enforce 

the documentation, and servicers (often the same banks that originated the faulty loans) are unwilling to hand over borrower credit 

files to be examined for Reps and Warrants breaches. In the end, 

investors have had very little actual success in enforcing their 

rights. 

Rather than looking to incentivize the private market to adopt 

such standards, the Association believes it would be better to focus 

on ensuring that servicers and trustees act in the best interests of 

the investors. Trustees would act more rapidly and decisively to 

protect a trust’s assets if subjected to a fiduciary duty, and they 

would also better oversee the activities of servicers. Further, 

servicers would have the proper incentives to act transparently in 

their servicing duties. The Association believes the PLS market 

cannot be optimized if loan limits are lowered before a fiduciary 

duty is extended to these entities. 

Expanded Response—The fundamental issue across the PLS market is alignment of interests between the originator of the loans, 

the servicer, and the PLS investor. The simplest way to align interests (the way it is done in almost every other securitized market 

in the U.S., and also in most foreign mortgage markets) is for the 

originator to hold the subordinate position. Risk retention places 

the first-loss risk with the party that has the best information to 

evaluate that risk—the originator. It aligns the interests of the 

originator and PLS investor in the most straight-forward way. If 

risk retention is impossible, first-loss piece shifts to investors, who 

do not have the best information or control of the servicer. As a result, we think PLS investors need protections, such as very strict 

contractual protections and enforcement mechanisms. 

There is little homogeneity in ‘‘to-be-announced’’ (TBA) pools. 

The agency market is liquid because of the GSEs’ guarantee, not 

because the market or the pools have become more standardized. 

Therefore, the Association believes that standardization may not be 

the major obstacle for investors to return to the PLS market. The 

Association agrees that there is a marginal benefit to standardization, as it avoids fragmentation. However, despite this marginal 

benefit, investors would prefer that Congress focus on creating 

transparency and ensuring that investors’ interests are being proVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00071 Fmt 6602 Sfmt 6602 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
68 

tected, rather than focusing on standardizing documentation. As 

long as the market is transparent and investor rights are enforced, 

institutional investment advisers can appropriately price the risk 

and buy the assets. 

Transparency would be best created in a market where market 

participants are able to trust one another, rather than be concerned that each participant is only focused on their own best interests. To create such trust, it would also be helpful to have access 

to the actual loan files. Particularly when our clients are taking the 

first loss risk, the operational and borrower risk is documented in 

those loan files. Further, the Association recommends creating a fiduciary duty for trustees and servicers, which would better align 

interests among market participants. Such a change would best be 

achieved through amending the Trust Indenture Act, and specific 

language regarding such changes is detailed in the Association’s 

White Paper submitted to the Committee on October 11, 2013. 

The Association agrees with Senator Kirk that FHFA has been 

far more successful in enforcing representations and warranties 

than the private market. However, this is largely due to the ways 

in which the GSEs are able to identify, find, and enforce the repurchase of defects, rather than the difference in the underlying contracts. If PLS issuers were obligated to operate in the same fashion, investors would benefit, but it is unlikely PLS issuers will ever 

do so. The GSEs are able to operate as they do simply because of 

their market power, not because of increased standardization or 

better reps and warranties. If, for example, a major bank says they 

will not buy back loans, the GSEs could in theory shut them out 

of the market. Institutional investment advisers and their clients 

do not have this type of negotiating power. 

If the standards for risk-based pricing, representations and warranties and standardization of agency securities are improved for 

any ‘‘agency-like’’ security that is developed post-housing finance 

reform, investors would ask for these enhanced standards to also 

apply to PLS investments. However, just as these requests are 

going unheeded in today’s market, leading to a lack of new PLS 

pools, there would likely be no incentive for this to be created in 

the post-housing finance reform PLS market, unless a fiduciary 

duty is created for entities like trustees and servicers. 

As we mentioned above, we also believe it is worth exploring creating an organization that would standardize contracts and oversee 

that these contracts are enforced. The Association believes this concept could be built into the FMIC common securitization platform 

provisions of the Corker-Warner bill, if this is the base text of the 

Senate Banking Committee’s mortgage reform proposal. We view 

this proposal as additional and complementary to assigning fiduciary designation to the trustees. Such an organization could be a 

party to the contracts, similarly to the way the GSEs are party to 

their contracts, and would have the authority to enforce these contracts in the best interests of the trust. 

Over the course of the Financial Crisis, because of thousands of 

PLS trusts (each with its own documentation) and hundreds of PLS 

investors, investors have found it challenging to coordinate their efforts in order to enforce their contractual rights. Often it is difficult 

to even determine who other investors in each trust may be, in 

69 

order to reach minimum voting thresholds that would compel trustees to act. Existing trustees are typically themselves large banks, 

and have a multitude of relationships with the banks they are supposed to sue, causing conflicts of interest. Creating a central utility 

with standardized representations and warrants of underwriting 

quality and stringent enforcement mechanism would give all investors greater confidence to buy and give the originators the right incentives to securitize high-quality loans. This organization would 

also have the ability to set servicing standards and hold servicers 

accountable for acting legally and in the best interests of investors, 

something the GSEs do today but which is impossible in today’s 

PLS market. 

Originators and Wall Street firms would still originate loans, create the liability structure and control pricing execution—assets and 

liabilities would remain priced by the market. We think this approach is better than the complex documentation and multiple levels of re-underwriting that has become prevalent in the PLS market in the past 2 years, which increase costs without providing an 

enforcement mechanism. A standardized platform may also reduce 

pressure for banking consolidation, by making it easier for midsize 

investors to perform due diligence on PLS, and making it cheaper 

for smaller banks to sell loans into PLS trusts. If investors found 

such a framework attractive, they would chose to buy securities 

issued under these contracts, offering lower cost of funds than is 

available through the current structure of the PLS market. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN 

FROM JOHN GIDMAN 

Q.1. One component of the housing finance system that has received significant discussion over the last year is the role of recourse available to the lender. Recourse is available to lenders on 

a State-by-State level. States where recourse is available to lenders 

have a significantly lower risk of default as comp, especially among 

those who may strategically default. One Federal Reserve analyst 

found that for a sample of loans originated between August 1997 

and December 2008, ‘‘the probability of default is 32 percent higher 

in nonrecourse States than in recourse States.’’ Borrowers who had 

a property value of $500,000–$750,000 at origination were over 100 

percent more likely to default in nonrecourse States than in recourse States. In your view, would expanded availability of recourse strengthen our housing finance system? What is the impact 

of recourse availability on investors’ decision making in real estate 

and private-label mortgage-backed securities? 

A.1. Summary—The Association believes that to the extent that expanded availability of recourse lowers delinquencies and foreclosures, it would likely be helpful. However, in today’s market, recourse is not enforced in any State, including those States where 

recourse is available. The Association believes that transitioning 

the U.S. to a full-recourse system would be very difficult, and instead efforts should be focused on ensuring that servicers and 

trustees use legal tools available to them today to act in the best 

interests of the trusts. 

70 

1 In this discussion, the Association is defining ‘‘recourse’’ as laws that: (1) permit the lender 

to seize any assets that were used as collateral to secure the loan, and (2) if money is still owned 

after the collateral is seized and sold, then take the borrower’s other assets or sue to have his 

or her wages garnished. 

History of Recourse Provisions—To fully understand why the Association believes it would be nearly impossible to implement a 

Federal recourse 1 standard, it is helpful to consider some of the 

changes to the market that have been implemented since 2008, 

when the Federal Reserve’s study cited in the question concluded. 

The Association agrees that prior to the crisis, the probability of 

default was higher in nonrecourse States. However, since the financial crisis, the public policy trend has clearly been toward weakening recourse in all States. 

Much of this stems from Congress’ implementation of the Home 

Affordable Modification Program (HAMP), which was designed to 

assist struggling homeowners. In order to entice servicers to work 

under the program, it included a servicer safe harbor, which ensured that investors and others could not sue the servicer. The 

HAMP program subsequently emboldened State legislatures to implement and enforce investor-unfriendly regulations. Today, not 

only is recourse no longer practically (and politically) enforceable, 

but lenders are effectively required to both allow the borrower to 

keep their house and forgive debt. 

Given this history, any Federal deficiency regulation would have 

to supersede State regulations, and Federal regulators would have 

to ensure that each State was enforcing the requirements. Until 

the housing market fully recovers, we believe that this would be 

very difficult, and recourse provisions would likely not be enforced. 

Potential Unintended Consequences of Expanded Recourse Provisions—Additionally, it is important to also consider the potential 

macro impacts of expanded recourse that may be less helpful to the 

market. Other systems, such as the housing market in Japan, have 

full recourse available, and it has actually harmed the system because it places too great of a burden on consumers. In practice, creating a system where there is no ability to forgive debt has led to 

situations where bursting asset class bubbles cause consumers to 

find themselves with so much debt that consumer attitudes shift 

against any future investment in that asset class—in this case, 

housing. 

Impact of Recourse Availability on Investors’ Decision Making— 

Currently, since recourse provisions are almost never enforced, institutional investment advisers assign no value to the availability 

of recourse. Therefore, they currently have no impact on investors’ 

decision making. 

Alternative Solutions—The Association believes there are better 

ways to protect investor interests than expanding the availability 

of recourse provisions, including creating a fiduciary duty for trustees and servicers. For example, if a fiduciary duty were imposed 

upon trustees and servicers in a similar manner as mutual fund or 

ERISA pension plan trustees, investors would have more reason to 

have confidence that their assets are protected because the servicer 

and trustee would be required to act in the investors’ best interest. 

Additional information regarding how the Association would implement such a fiduciary duty is included in the Association’s testiVerDate Nov 24 2008 13:06 Oct 17, 2014 Jkt 046629 PO 00000 Frm 00074 Fmt 6602 Sfmt 6602 L:\HEARINGS 2013\10-01 ZDISTILLER\100113.TXT JASON
71 

mony, as well as the Association’s White Paper submitted to the 

Senate Banking Committee on October 11, 2013. 

RESPONSES TO WRITTEN QUESTIONS OF 

CHAIRMAN JOHNSON FROM ADAM J. LEVITIN 

Q.1. Please detail the potential size of the market for private label 

MBS based on historical levels. In addition, please provide a comparison to the size of other fixed income markets. 

A.1. At the peak of the PLS market in 2007, there were $2.2 trillion in PLS outstanding. Over 90 percent of those PLS were investment grade (usually AAA-rated), indicating that there has never 

been more than $220 billion of true credit risk investment in the 

PLS market. Annual PLS issuance peaked at less than $1.2 trillion 

in 2005. Based on this, I cannot imagine a PLS market supporting 

more than $500 billion in annual flows—slightly more than the annual issuance of PLS in 2002, before the housing bubble and PLS 

crazy took off. Correlations between flows and outstandings vary 

significantly, but a reasonable rule of thumb based on historical 

correlations is that outstandings are unlikely to be more than three 

times flows. Therefore, based on a peak possible flow of $500 billion, a PLS market could probably support no more than $1.5 trillion in housing finance needs. The current U.S. housing market has 

$11 trillion in financing needs. 

Relative to U.S. fixed income markets, the PLS market has always been relatively small. There were approximately $38.1 trillion 

in U.S. fixed income securities outstanding as of the end of 2012. 

Of this $38 trillion, approximately $36.6 trillion (96 percent) of 

these securities—involve zero or quite limited perceived credit risk: 

Treasury securities; the debt of Federal agencies and GSEs; GSE 

MBS; money market instruments; investment grade corporate debt; 

investment grade municipal debt; investment grade structured financial products. Investors in these classes of fixed-income securities are not credit risk investors. 

This means that there is only perhaps $1.5 trillion in deliberate 

credit risk investment in U.S. fixed-income markets: high-yield 

bonds plus junior tranches in structured financial products. There 

is another $1 trillion in speculative grade leveraged-loans. This indicates that the total pool of investors willing to assume real credit 

risk on any fixed-income security or the like in U.S. markets is 

around $2.5 trillion. 

The limited pool of investment for real credit risk in fixed-income 

securities suggests that PLS cannot support anything close to the 

$11 trillion U.S. housing finance market, even with tranched credit 

risk. Assuming—perhaps generously—that PLS could be tranched 

so that there was no real credit risk for 90 percent of investors, the 

market would still require $1.1 trillion in credit risk investment. It 

is hard to see that emerging given that most of the $2.5 trillion in 

credit risk investment is already committed to the high-yield loan 

and bond markets, with only a small part invested in PLS (around 

$100 billion outstanding now in junior tranches) and other assetbacked securities. 

72 

Q.2. How can variable or flexible LTV ratios (or other methods) improve countercyclicality in the PLS market? What can be drawn 

from methods used in other countries, e.g., Spain or Canada? 

A.2. In theory, authorizing a macroprudential regulator, such as 

the Federal Reserve Board or the Federal Open Markets Committee to impose maximum LTV ratios would provide a tool for 

countercyclical regulation that is focused solely on the housing 

market, as opposed to macroeconomic tools such as interest rates 

that affect more than the housing market. Such a tool would, of 

course, only be as useful as a regulator’s willingness to use it. 

Q.3. What are the risks of the different types of capital that could 

support bond guarantors, in particular, if capital was not limited 

to common equity? What is the most realistic mix of capital for 

guarantor entities taking first loss risk, or who should determine 

this and how should it be enforced? 

A.3. If capital in bond guarantors was not limited to common equity, there is a risk that bond guarantors could have an asset-liability duration mismatch: their funding might be of shorter duration than the bonds they guarantee, resulting in the bond guarantors facing a risk of frozen capital markets or runs. To put this in 

the most extreme example, a bond guarantor that finances its operations through overnight repo could find itself without funding the 

next day, making its guarantees worthless. 

I do not have an opinion on what is the most realistic mix of capital for guarantors entities taking first loss risk, but it is important 

that the capital requirements for bond guarantors not result in an 

arbitrage situation in which bond guarantors can hold less capital 

than competing methods of financing mortgages, such as depositories on balance-sheet operations. In general, any reform of the 

housing finance market should take care that there are similar 

capital requirements for all financing channels; if there is not, financing will flow to the channel with the lowest capitalization requirements, resulting in a less stable housing finance system. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK 

FROM ADAM J. LEVITIN 

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 

Mac have been in conservatorship to preserve the assets and protect the taxpayers. These steps include enhancing the underwriting, credit risk pricing, and reps and warrants contracts of 

counterparties with Fannie Mae and Freddie Mac. These actions 

ensure standards being used by the two Enterprises are more updated, comprehensive, transparent, and that they more accurately 

reflect the risks assumed by the two Enterprises. Had these reforms been implemented prefinancial crisis much of the fraud, poor 

risk-management, and losses to the taxpayers could have been 

avoided. Going forward, these actions are providing for a more attractive and transparent agency market for investors, which is essential to ensuring the U.S. housing market continues to be attractive for global investment. 

73 

Can you tell me if the private label security (PLS) market is 

adopting the same stringent transparency and contractual standards as the agency market? If not, why not? 

A.1. The PLS market is not adopting the same stringent transparency and contractual standards as the agency market. As an 

initial matter, the PLS market has been moribund since 2008, with 

less than 40 PLS securitizations done since then. This makes it 

hard to meaningfully talk about the PLS market adopting any particular standards. The post-2008 PLS deals have had pristine, 

ultra-prime credit quality, but representations and warranties and 

structures for their enforcement vary considerably among post-2008 

PLS deals. The PLS market appears to be experimenting with deal 

structures as it attempts to figure out what structures will strike 

the right balance between investor protection and seller/sponsor 

comfort. 

Q.2. What is holding back standardization of the PLS market? 

What is happening to PLS pools in the market today? 

A.2. There are no formal legal barriers to standardization of the 

PLS market. Instead, PLS continue to be nonstandardized because 

deal sponsors see no immediate benefit from standardizing. While 

standardizing PLS would help create a more robust and liquid market overall, currently there are only a small number of deals and 

the market is still trying to determine the optimal post-2008 deal 

structure. 

Q.3. I would love to see the conforming loan limits for agency mortgage backed securities to be lowered, as it is one of the more obvious ways to increase and incentivize the private market back into 

this market space. I am concerned however that if the standards 

in the PLS market are not the same as the agency market—including to provide for clear and updated reps and warranties agreements and greater transparency—that investors will be hesitant to 

move to the PLS space. 

If the standards for risk-based pricing, reps and warranties and 

standardization of agency securities are improved for any ‘‘agencylike’’ security that is developed post-housing finance reform, will investors begin demanding these enhanced standards for PLS investment? What more could be done to incentivize the private market 

to adopt such standards? 

A.3. It is possible that reforms of the ‘‘agency-like’’ market will 

begin to set standards for PLS as well; this is something that can 

be observed elsewhere in fixed-income securities as many securities 

that are not subject to the Trust Indenture Act, such as sovereign 

bonds, nonetheless include deal terms required by the Trust Indenture Act. The PLS market could be incentivized to adopt such 

standards through the provision of regulatory safe harbors. I would 

nonetheless urge Congress to consider certain nonwaiveable minimum standards for PLS, akin to those required by the Trust Indenture Act of 1939 provides for covered debt securities. 

Q.4. Do you think that the PLS market can truly be optimized if 

loan limits are lowered before greater transparency, contractual, 

and fiduciary changes/updates are adopted in the PLS market? 

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A.4. If conforming loan limits are lowered at this point, it is unlikely that the PLS market will expand rapidly to provide financing 

for homeowners with mortgage loans larger than the conforming 

loan limit. Instead, credit availability will likely significantly contract for these homeowners. Until and unless investors feel comfortable with PLS deal structures and have confidence that representations and warranties about the securitized loans will be enforced, I do not see the PLS market providing any meaningful level 

of financing for the U.S. housing market. Thus, I do not see lowering the conforming loan limits as precluding reforms in the PLS 

market so much as producing a decline in housing prices.