Politicians are still finding populist mileage in bashing the too-big-to-fail banks, and no one at the Department of Justice is going to get fired for adding another zero to a JPMorgan Chase legal settlement.
But the punches aimed at banks are often landing on the pension funds and retail investors who ultimately own US mortgages, and it has muddied the outlook for one of the most important asset classes.
After admitting last week that it created mortgage-backed securities out of loans that did not meet underwriting standards, JPMorgan’s $13bn settlement included $4bn of consumer relief, which will cut loan balances and other loan modifications for borrowers in danger of foreclosure.
That is good news for the at-risk borrowers, and may well be good social policy, but it is also the case that modifying mortgages has consequences for the value of the MBS into which they have been pooled.
BlackRock was among the big asset managers to point out the unfairness. The proximate victims of JPMorgan’s mis-selling of MBS were the investors who bought the dodgy securities, and now they are at risk of being hurt all over again.
Investors have extensive exposure to the $7.5tn MBS market through their core bond funds. Bill Gross’s Pimco Total Return Fund, the biggest bond fund in the world, has 34 per cent of its $250bn assets invested in mortgages, for example. Many more investors top up their portfolios with specialist mutual funds, and money is also flowing into the asset class through exchange traded funds and real estate investment trusts, which are highly leveraged mortgage investment vehicles listed on the stock market.
Mortgage-backed securities are a tricky enough beast at the best of times. An investor can only guess at how long he or she will be getting an income stream from the interest payments, before the underlying borrowers all move house or refinance.
Even guaranteed by the federally controlled mortgage finance agencies Fannie Mae and Freddie Mac, these securities are subject to complicated assumptions about future interest rates and about the characteristics of the underlying borrowers.
Securities without the government guarantee, of the kind backed by subprime mortgages before the credit crisis, are additionally subject to the risk that homeowners become unable – or unwilling – to pay their mortgage.
Now investors have to worry about the myriad ways in which, after a housing market downturn, government might intervene to modify the loans that underlie MBS.
The consumer relief clauses in the JPMorgan settlement are of a piece with other ad hoc interventions over the past five years. When it was discovered that mortgage servicers were routinely flouting the proper procedures for foreclosing on American homes, and “robosigning” repossession notices, federal agencies negotiated a deal with five banks to produce $17bn in loan modifications.
Such modifications are meant to be done in a way that does not financially harm MBS investors, but asset managers have complained about the lack of transparency.
Meanwhile, two additional headaches loom on the horizon for investors. Top of the list is the possibility that local governments will use “eminent domain” powers, normally reserved to buy land for urban regeneration or infrastructure projects, to compulsorily purchase mortgages in areas blighted by foreclosures.
The asset management industry has aimed a battery of lawyers at Richmond, the little California city that is furthest down the road to using eminent domain, and appears to be making politicians there think twice. But the risk of compulsory purchase has nonetheless started to turn up as a risk factor in prospectuses for new mortgage securitisation deals. Since the idea cannot be unthought, even if for now it remains unused, mortgage investors may want to push to have it explicitly outlawed by Congress.
More immediately, last week’s action by Senate Democrats to end the use of the filibuster to hold up judicial and other administration appointments means that the White House can finally replace Edward DeMarco as director of the Federal Housing Finance Agency, which regulates Fannie and Freddie. MBS prices fell on the news, because Mel Watt, the Obama administration’s nominee for the FHFA, is likely to extend policies that encourage loan modifications.
That MBS investors are still buffeted by these sporadic, unpredictable government interventions, five years after the credit crisis, is having a corrosive effect. What once seemed forgivable policy making on the hoof, now threatens to permanently lift the risk premium that MBS investors must demand and in turn raise borrowing costs for homeowners.
Any hope of kick-starting MBS issuance without Fannie and Freddie or other government guarantors seems as far away as ever. Unguaranteed MBS issuance this year has been just $17bn, compared with more than $700bn in the peak years of 2005 and 2006. That difference can no longer be explained away by the shock of discovering US house prices can go down as well as up.
Investors are reeling from punches thrown more recently, by federal and local government players who do not necessarily realise who they are bruising.