Unlocking the Asset-Backed Securities Market

Mortgage-backed and other securitized bonds may have helped cause the financial crisis, but their revival is critical to the recovery. William Gross, founder and co-CIO of Pacific Investment Management Co., the world’s largest bond investor, says his firm remains bullish on securitized debt.


JPMorgan Chase & Co. made a matter-of-fact announcement late last month that passed almost unnoticed in the financial world. The House of Jamie Dimon said it had sold a $1.1 billion securitized bond issue backed by a pool of commercial mortgages. Though the announcement of a ten-figure securitized bond was a weekly, if not daily, event just three years ago, that’s certainly not been the case since the financial crisis blew up the securitization market in 2008. Still, JPMorgan’s commercial-mortgage bond issue — two times oversubscribed — was a signal that one of the most crucial components of the capital markets is healing, albeit slowly.

“The commercial-mortgage securitization market is back up and running,” says Jeffrey Perlowitz, head of the securitization desk at Citigroup in New York. “The market is functioning terrifically. There is a huge demand for paper, all the way from below-investment-grade to triple-As.”

That’s a huge relief to a segment of the finance industry that was once a pillar supporting the American economy. As recently as 2007, when the market reached its zenith, there were $9.1 trillion in mortgage-related securities outstanding and an additional $2.4 trillion of bonds backed by such things as auto loans, credit card debt and student loans. That was equal to about two thirds of the market capitalization of all the stocks listed on the New York Stock Exchange.

But the securitization boom also inspired a flurry of dubious innovation: subprime mortgages, liar loans and collateralized debt obligations that bundled mortgages and other asset-backed securities together in the mistaken belief that diversification would lower risk. Then came even-more-exotic securities, known as synthetic CDOs and CDOs-squared, that sliced and diced other CDOs and combined them into packages that became time bombs on investors’ balance sheets.

“These deals didn’t exist because there were people out there who said, ‘I need to build a factory’ or ‘I want to liquefy my credit card portfolio so I can extend new credit,’” says Ronald Borod, Boston-based head of the securitization practice at law firm DLA Piper. “They existed because bankers were saying, ‘Look at the arbitrage we can make by bundling these assets together and selling them at a higher price than we bought them at.’”

The market began to crumble in 2007 when two Bear Stearns Cos. hedge funds heavily invested in subprime-mortgage-backed securities collapsed. Eighteen months later, after Lehman Brothers Holdings had failed and American International Group had barely escaped the same fate, the market for securitized debt was totally frozen, except for debt issued by government-backed agencies, which carries an implicit guarantee from Uncle Sam. To make matters worse, some now say securitized debt issued during the boom was the primary cause of the financial crisis.

“For me, it was very unfortunate to watch so many of the good things that structured finance had done for the marketplace being thrown out with some of the problems that took place,” says David Jacob, head of structured-finance ratings at Standard & Poor’s. He previously spent 14 years at Nomura Securities International, including several as head of U.S. fixed-income research. “We’re trying to figure out how to emerge from this so that structured finance will once again be a very important part of the capital markets,” Jacob says. “It’s probably not going to be as big as it was, but a significant component of it.”

Clearly, if there is going to be an economic recovery, securitization will have to play a major role. But one or two bond issues, even large ones like JPMorgan’s, or another a few weeks earlier by Citigroup and Goldman Sachs Group for $788 million of commercial mortgages, do not make a trend. The securitization markets are still way below the levels that were reached in the heady days of 2007, when $246 billion in commercial-mortgage securitizations were issued. This year only about $9 billion of new securities and refinancings were issued through September 30, according to figures compiled by Thompson Reuters.

It’s a similar story elsewhere in the asset-backed world: Auto loan securitization is a bright spot with $38.5 billion so far this year, but that’s still below the $82 billion issued in 2006. Securitized bonds backed by credit card receivables are down to just $5.1 billion, compared with $99 billion in 2007. But the real disappointment is private-sector-originated residential-mortgage-backed securities, known in the trade as private-label RMBSs. There has been just one new private-label RMBS issue, worth only $238 million, in the two years since the market imploded. That compares with $789 billion of new issuance in 2006 alone.

Will the asset-backed market ever fully recover? William Gross, founder and co-CIO of Pacific Investment Management Co., the world’s largest bond investor, says his firm remains bullish on securitized debt. Some $10 billion of its $250 billion Total Return Fund is in nonagency RMBSs, and Gross is investing in auto loans and credit card debt as well. “They represent attractive value with decent default assumptions,” he says.

But the market faces a lot of obstacles. For example, interest rates are now so low that some banks find it more profitable to keep loans on their balance sheets than to securitize them. The spread between what they pay depositors for their funds and what they earn by lending that money out to credit card borrowers far surpasses what they would earn on a securitization.

Another question mark is a rule change by the Financial Accounting Standards Board late last year that altered the way banks must consolidate assets, leaving many bankers wondering whether securitization is still an efficient solution for such things as credit card receivables.

Also putting a damper on new issuance is a sheaf of new regulations coming from Washington, which was chagrined and angered by the financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act contains an entire section putting limits on how securitizations can be carried out and on how the ratings agencies will be allowed to participate in the business. The Federal Deposit Insurance Corp. weighed in on September 27 with a new comprehensive securitization regulation that includes a requirement that banks retain a 5 percent slice of the credit risk of bonds issued after January 1 of next year. These regulatory changes may force banks to charge more for their services, or prompt them to exit segments of the market entirely.

Perhaps the greatest impediment of all is the fact that the federal government, thanks to its control of the Federal Housing Administration and its conservatorship of Fannie Mae and Freddie Mac, now oversees between 90 and 95 percent of new issuance in the $10 trillion RMBS market. The Obama administration has so far not made any proposals for reform of Fannie and Freddie that would create an opening for private capital to come back to the market in any significant amount. Even if reforms are adopted, it could be five to ten years before the private-label market for residential mortgages is revived. By contrast, in Europe, where there is no direct government involvement in housing finance, private-label securitization is flourishing once again (see sidebar, right).

And if all that is not bad enough, sloppy paperwork for 2005–’08 securitizations — which was revealed this fall when several U.S. banks temporarily halted foreclosures because of potentially faulty loan documentation — has called into question the legality of some of the RMBSs issued during the boom period. At the least, this could force banks to buy back tens of billions of dollars in loans; at worst, it could prompt investors to legally challenge entire bond issues.

FITTINGLY, SECURITIZATION WAS BORN FROM residential mortgages, in 1970, when the Government National Mortgage Association, also known as Ginnie Mae, guaranteed the first securities that pooled mortgages and passed the principal and interest payments through to investors.

In a typical securitization, the issuer sells loans to a special purpose vehicle, which then transfers the assets to a trust. The trust then trades the assets for cash from an underwriter, which sells bonds backed by the pool to investors. The investors receive the principal and interest payments monthly. The innovation of “pass-through” securitization allowed banks to get mortgages off their balance sheets, so they no longer had to face the risk that interest rates might shift suddenly, while investors such as insurance companies and pension funds had an investment that would not be affected by the bankruptcy of the lender and often had a higher credit rating than the financial institution that made the loans.

A later innovation carved the mortgage pools into slices known as tranches, with different repayment schedules and subordinate levels of risk. The top tranche, often up to 80 percent of the security, was rated triple-A and entitled to first payment of the principal and interest. Other tranches were rated from double-A to triple-B in a process known as a “waterfall,” with the bottom tranche taking the first loss if borrowers failed to repay. The lower-rated tranches offered higher yields and appealed to a different set of investors.

The mortgage-backed market grew steadily through the decades, especially after the savings and loan crisis of the early 1980s reduced that source of funding. In 1996, for example, there were $440.7 billion of mortgage-backed securities issued by agencies such as the Federal Housing Administration, Fannie Mae and Freddie Mac, according to the Securities Industry and Financial Markets Association. Private-label issuance was just $51 billion. By 2006 agency issuance had risen to $1.2 trillion and private-label issuance had ballooned to $789 billion.

Mortgages weren’t the only loans being packaged and resold. In 1985, Marine Midland Bank used the securitization process to issue a $6 million bond backed by auto loans; this type of instrument has since become a major part of the ABS industry. Banks began to use securitization for everything from credit card receivables to student loans and the memorable sale of a $55 million bond backed by David Bowie’s songs, the first use of securitization with intellectual property as collateral. Nonmortgage ABS issuance reached $753 billion in 2007.

The increase in private-label securitization was accompanied by a host of innovations, such as subprime loans, which went to borrowers with the lowest credit scores, and Alt-A mortgages for borrowers who were above subprime but still below prime. There was also a mushrooming variety of adjustable-rate mortgages, interest-only loans and negatively amortizing mortgage loans in which the repayment was less than the interest charged, so the loan amount kept growing ad infinitum.

According to Gary Gorton, a finance professor at the Yale School of Management, total outstanding subprime mortgages grew from $81 billion in 2000 to $731 billion in 2006 — 37 percent of private sector mortgage securitizations. Alt-A loans were an additional $765 billion.

The same period saw the rise of the collateralized debt obligation, which combined debt such as subprime loans with tranches of other asset-backed securities, like auction-rate securities and credit card debt. The total value of CDOs — which investor Warren Buffett says have so many permutations that “nobody knows what the hell they’re doing” — reached $1.3 trillion in 2007. Wall Street was making such huge fees creating these new securities that it branched out into even-more-esoteric instruments, such as CDOs-squared and -cubed, which were composed of tranches of other CDOs, and synthetic CDOs, which contained credit default swaps, a form of insurance on other debt.

When the two Bear Stearns hedge funds collapsed in the summer of 2007, it was an acknowledgement that subprime-backed mortgage bonds had been falling in value for some time. By October of that year, Merrill Lynch & Co. had reported $8 billion in losses in mainly subprime CDOs, with Stanley O’Neal resigning as CEO because of them. Lehman Brothers lost $3 billion on subprime-mortgage-backed securities it held on its balance sheet in the first half of 2008; it was never able to recover.

Academics are still debating the causes of the most recent financial crisis: Lax monetary policy, mispriced risk and improper incentives on Wall Street are just a few of the most frequently mentioned. But some prominent experts are now coming forward to blame the private market securitization process itself for the crash.

According to Susan Wachter, a real estate professor at the Wharton School of the University of Pennsylvania, and Adam Levitin, a law professor at Georgetown University in Washington, the housing bubble was the result of two simultaneous developments: the growth of private-label RMBS issuance in the late 1990s and early 2000s, and its expansion into new areas such as subprime, Alt-A loans and adjustable-rate mortgages.

According to Wachter and Levitin, the private-label market failed to take adequate account of credit risk — the danger that borrowers would not pay back the loans; this historically had not been a concern with mortgages backed by Fannie and Freddie because they were plain-vanilla fixed 30-year loans and carried an implicit government guarantee. “The process that delivered the information was broken,” Wachter says. “The first basic mistake was that diversification was all that was necessary, but that exposed you to concrete market risk. The second mistake was to rely on the ratings agencies. They were not tracking credit risk or systemic credit risk.”

In addition, the speed with which banks processed mortgage securitizations is now coming back to haunt the financial services industry. Loans were not always properly transferred to the trusts, and some did not live up to lenders’ declared criteria, such as income levels or FICO scores. In a research report last month, JPMorgan bond analysts said this problem could force originating banks to take $55 billion to $120 billion in losses on loans they have to repurchase from investors. Some analysts predicted that investors might now challenge the legality of entire securitization transactions and demand all their money back because of the shoddy documentation. The potentially sweeping scope of the crisis was illustrated when the Federal Reserve Bank of New York joined private investors like BlackRock, Neuberger Berman Group and Pimco in demanding that Bank of America Corp. buy back bad home loans that were part of $47 billion worth of mortgage debt securitized by the bank. BofA said it would oppose the demands.

When the housing bubble burst, it wasn’t just mortgage-backed bonds that took a beating. The market for all new asset-backed securities, even those that had no problems associated with their ratings, such as auto loans, fell off a cliff. Many traditional investors, sitting on huge mark-to-market losses in their ABS portfolios, ran for the hills.

“Basically, the whole securitization market was in the toilet,” says Guy Cecala, publisher of the closely studied newsletter “Inside Mortgage Finance.” He adds, “There was no confidence in the rating agencies. The market was frozen.”

At a hearing on the housing meltdown by the U.S. Senate’s permanent subcommittee on investigations earlier this year, evidence was introduced showing that nearly all of the subprime- and Alt-A-mortgage-backed securities sold during the housing boom had turned out to be worth much less than originally believed and had been downgraded from triple-A to junk status by the ratings agencies.

“For a while, everyone made money — banks and mortgage brokers got rich selling high-risk loans, Wall Street investment banks earned big fees creating and selling mortgage-based securities, and investors profited from the higher returns,” Michigan Democrat Carl Levin, the subcommittee chairman, told the hearing. “But those triple-A ratings created a false sense of security. High-risk RMBS and CDOs turned out not to be safe investments.”

Faced with the complete seizure of one of the core components of the capital markets, the government stepped in to try to get securitizations moving again. Its first effort was the Term Asset-backed Securities Loan Facility, or TALF, created in 2009.

TALF provided $71 billion in loans to investors that posted an asset-backed or commercial-mortgage-backed security as collateral. The New York Fed created a special purpose vehicle to buy collateral if the loans weren’t repaid, but the facility was never used. Although the program was criticized at the time as being too timid, there is no doubt that it jump-started the asset-backed market.
According to the Congressional Oversight Panel, TALF provided a hefty 39 percent of all auto loan, credit card and student loan securitizations between March and December 2009 — enough to break the logjam. Asset-backed issuance went from a low of $11.3 billion in April 2009 to $24.9 billion in June of this year.

Wall Street saw TALF as nothing short of a savior for securitization. “TALF was a hugely successful program,” says the head of securitized products at a large bank. “It was well crafted, targeted a lack of liquidity in the market and gave a backstop to the market that it could sort of spring off of. It became a positive, momentum-building cycle.”

In June 2009 the program was expanded to include commercial-mortgage-backed securities. Although only $12 billion in CMBS loans were handled, they too had an effect on the market. “TALF was an important piece to getting the commercial-mortgage-backed market going again,” says Mitchell Resnick, co-head of Goldman’s commercial real estate origination and securitization desk. “The Fed really did help thaw the market.” Goldman did the only new CMBS issuance under TALF — though there were later some refinancings — selling $400 million in securities for Developers Diversified Realty Corp., a real estate investment trust.

The other government initiative was the Public-Private Investment Program, which was announced in March 2009 and designed to bring private capital back to the market for residential- and commercial-mortgage-backed securities by buying legacy assets from banks. It worked like this: Private investment funds selected by the government received matching investments from the Treasury to buy RMBSs and CMBSs that were stuck on bank balance sheets. The idea was that as demand for these assets rose, even marginally, the market would become unfrozen and new issuance would take place.

By June of this year, the nine fund managers — AllianceBernstein; Angelo, Gordon & Co.; BlackRock; GE Capital Real Estate; Invesco; Marathon Asset Management; Oaktree Capital Management; RLJ Western Asset Management; and Wellington Management Co. — had raised $7.3 billion in private capital, which was matched by the government. Treasury also provided debt financing, for a total of $29 billion, of which $16 billion has been spent to buy securities.

Because of the program’s small size, it’s hard to determine whether PPIP actually did all that much to revive the market. There has been almost no new RMBS issuance. Aaron Bartley, who heads the PPIP program at the Treasury, says the ABX and CMBX derivatives indexes have risen 60 to 90 percent since the program was announced; he sees this as a sign that the secondary market for these securities has gained strength. “[The CMBS market] is beginning to come back, albeit in small steps,” Bartley says.
With all this government support, it should be no surprise that the commercial-mortgage-backed market has been one of the first to revive, led by JPMorgan’s $1.1 billion deal, which was the largest issuance since the crisis began in 2007.

Goldman’s Resnick estimates that there will be $10 billion of new commercial-mortgage-backed issuance this year, rising to $25 billion in 2011. But that still is a far cry from the $246 billion issued in 2007. “Investors tend to believe that the loans that they see now are safer than the loans that they saw over the past five to ten years,” Resnick says. “That’s because the amount of leverage that’s being offered is lower than what it was before. It was 80 to 85 percent before, and now you rarely see a lender going above 70 to 75 percent leverage.”

So bright do financial services firms see the future of commercial-mortgage-backed securitizations that some banks are once again scrambling to expand into the business. Wells Fargo & Co., for example, which had a CMBS origination business before but not the ability to underwrite the securities, has added a staff of 20 bankers and support personnel to launch an underwriting business. But Wells may be ahead of the curve. Most Wall Street banks laid off thousands of staff when the securitization markets froze and are just beginning to make hires because of the recent uptick in activity. Goldman and JPMorgan say they aren’t expanding their securitization staffs, which were heavily pruned in the past two years, but Citi is hiring on a small scale.

Commercial real estate is not all that’s flowing. The other bright spot in the asset-backed world is auto loan securitization. In September alone, Chrysler Financial issued a $2 billion auto-loan-backed bond and Nissan Motor Co. sold a $1.3 billion security, its first since March 2009, with record-low yields. There was also a $1 billion bond from Ford Motor Credit Co., a $750 million issuance from German automaker BMW and a $700 million deal by AmeriCredit Auto Receivables Trust.

Two types of ABSs have suffered since the financial crisis: bonds backed by credit card receivables and student loans. While the number of credit cards is up, card balances have declined sharply, so there is less product to finance. In addition, because major banks have huge deposits on which they pay little interest, they prefer to keep their credit card receivables on their balance sheets because they make a hefty profit on the interest rate spread. Nonetheless, on September 13, Deutsche Bank and JPMorgan managed to sell a $600 million bond backed by credit card receivables for the credit card issuer Discover.

One big concern, though, is the Financial Accounting Standards Board’s 2009 rulings known as FAS 166 and 167, which basically prohibit banks from taking off-balance-sheet treatment for securitizations. In the past, large banks used securitizations to get assets off their balance sheets and improve their capital ratios. That meant banks didn’t have to hold as much capital, because the loans were considered a risk to the investor. Now, however, banks can sell 70 to 80 percent of a transaction and still have to hold regulatory capital against the assets.

Under the new standards, if a bank has control over the assets, such as servicing the loans, or if it has retained some of the risk, it has to consolidate the assets. “I think it will fundamentally change a lot of how securitizations are done,” says Tom Deutsch, executive director of the American Securitization Forum, which represents both issuers and investors in asset-backed securities. Henceforth, he adds, Wall Street banks may opt to be servicers or owners of risk, but not both.

“Because the advantage of helping to improve your capital ratios is no longer there, there’s a question in many chief financial officers’ minds about whether the economic benefit of securitization is what it used to be,” explains Paul Jablansky, Stamford, Connecticut–based senior strategist for RBS Securities.

At a time when the cost of a college education is becoming prohibitive for many families, student loan securitizations have dropped dramatically — from $67 billion in 2006 to just $12 billion this year — but that is not because of the financial crisis. As part of the Obama health care package, Congress shut down the Federal Family Education Loan Program, in which commercial lenders lent to college students with a federal subsidy (a total of $55 billion in 2008), because of concerns that banks were making too much money on the deals. Over a 35-year period, as the cost of a four-year education skyrocketed, millions of students benefited from the program’s Stafford loans, but most new loans will now be made directly by the Department of Education, so there will be a much smaller market for private loan securitizations.

THE FINANCIAL CRISIS LEFT MANY in Washington feeling blindsided by Wall Street’s excesses; it should be no surprise that politicians and regulators alike have set out with a mixture of anger and missionary zeal to rein in what they see as irresponsible behavior. Barney Frank, the Democratic chairman of the House Financial Services Committee, predicts a “third age of American finance” in which the government slaps “restraints” on securitization much the same way it did on trusts and the stock market in earlier days.

The Dodd-Frank financial regulation bill, which was finally signed into law in July, has an entire section devoted to “improvements to the asset-backed securitization process.” In addition, other provisions of the law change the way that ratings agencies can work in the future; this will have a direct bearing on how ABSs are issued.

The Securities and Exchange Commission, perhaps the regulator most chastened by the huge investor losses in mortgage-backed securities during the financial crisis, is now writing regulations that will implement Dodd-Frank’s sweeping calls for reform. In addition, in April the SEC proposed its own substantial rewrite of Regulation AB, its rules for asset-backed securities, designed to increase the amount of information in investors’ hands. Both sets of rules aren’t expected to be finalized until the middle of next year.
Paula Dubberly, deputy director in the SEC’s division of corporation finance, says the government is trying to ensure that securitization doesn’t cause another crisis. “There is broad agreement that an ABS market is important for the country and the economy,” she explains. “That’s why the proposals were so sweeping.”

Among the biggest changes is a requirement that securitizers — meaning Wall Street underwriters — retain a 5 percent piece of the credit risk in any transaction. The government contends there were too many instances where securitizers sold investors pools of loans that turned out to be worth far less than originally thought. The belief is that by forcing the deal makers to hold a portion of the credit risk, they will be more careful about what they sell.

“Retention is a logical response and certainly makes sense,” says DLA Piper’s Borod. “What you are trying to do is make someone accountable where before they were packaging mortgages and selling them and not caring what was inside the packages. If you tell those people, ‘You’ve got to have skin in the game,’ then that should have some impact.”

The rule contains a number of exemptions, including bonds backed by qualified residential mortgages. The SEC may add other exemptions. The agency also has to decide if the 5 percent credit retention will be “horizontal,” meaning the underwriting firms must retain a slice of the lowest-rated tranche of a security, or “vertical,” which would entail forcing them to own a section of each of the many tranches in a deal: 5 percent of the senior triple-A-rated tranche, an equal portion of the double-A piece and so on.

The SEC is convinced that part of the reason for the financial crisis was that investors didn’t have enough information or time to study what was available. The new rules propose a five-day waiting period before an investor can buy a new bond issue. They also call for a huge increase in the amount of information disclosed about underlying loan pools. Auto loan ABSs, for example, would have to disclose details about every loan in the pool, even though a typical securitization might include 100,000 loans.

ABS issuers would also be required to review the bundled assets in the collateral to make sure the loans all meet the representations of the issuer, and to disclose to investors the results of that review, as well as any third-party due diligence.
Another, more controversial, rule proposed by the SEC would require the CEO of the securitizer to certify in writing that the pool of loans is able to pay out to investors as described in the prospectus. Critics maintain this would create a new and unnecessary legal liability for the securitizing firm.

Adding to the uncertainty, the FDIC on September 27 jumped the gun on the SEC and announced its own new securitization regulations, which are called Safe Harbor rules. In the past, the Safe Harbor rule guaranteed that if a bank became insolvent, the FDIC would not seize the collateral in the firm’s securitization pools to protect the depositors. Now, however, the FDIC says that under the Safe Harbor rule it can take control of the collateral. This may make securitizations by deposit-taking banks less attractive to investors.

“Basically, Safe Harbor creates an uneven playing field between U.S. banks and non-U.S. banks,” says the ASF’s Deutsch. In addition, the new rule requires U.S. banks to retain a 5 percent vertical slice of the credit risk, which may put it at odds with the SEC’s own rule on credit risk retention under Dodd-Frank. The FDIC’s ruling takes effect on January 1, well before the SEC even finishes drafting its regulations.

Predictably, Wall Street is not enthusiastic about all the changes, though no one will say so on the record. One investment banker moans privately: “I don’t think they realize that some of the things they are proposing will have a negative effect quite opposite to what they wanted to take place. If they make the rules too difficult to be involved in the business, you won’t be involved in the business, which means there is one less lender out there, rates will go up, and borrowers won’t have as much access to credit.” For example, on the question of retaining skin in the game, the banker says that holding credit risk indefinitely is expensive and that some firms may exit the business rather than submit to the new rule.

Of all the actors in the housing crisis, few came in for more criticism than the ratings agencies, which were widely accused of issuing favorable ratings on subprime mortgage debt solely in hopes of drumming up new business from the issuers. In response, Washington is trying to rein them in on several fronts, and the agencies themselves are taking steps to rehabilitate their image before a final regulatory decision is made.

“The commission has been clear, and the government as a whole is trying to get rid of the reliance on ratings,” says the SEC’s Dubberly. The Dodd-Frank bill, for example, removes all requirements for investment-grade ratings from all sections of U.S. law. It also calls on the SEC to create, after a two-year study, an oversight board to choose which ratings agencies will grade each bond.
One regulatory innovation adopted earlier this year requires issuers of asset-backed securities to set up a web site for each new issuance, with complete details of the transaction. The web site is then open to all ratings agencies, even those not hired to rate the deal, in an effort to spur competition in the ratings market, now dominated by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.

For their part, the ratings agencies have made substantial changes in the way they evaluate securities, particularly mortgages, even though there is virtually no private-label RMBS issuance taking place at the moment.

Moody’s has beefed up three parts of its analysis: an originator assessment that reviews the lender’s policies and procedures; a third-party review that requires a due-diligence firm to look at every loan in the pool to see if it is consistent with the lender’s guidelines; and an examination to make sure each loan is consistent with federal and state regulations about such things as truth in lending — this should reduce the problem of no-doc loans that was so prevalent before the crisis.

Linda Stesney, head of the primary RMBS ratings group at Moody’s, says the agency is also looking at the “representations and warrants” an originator makes when securitizing a loan, such as whether all the loans in the pool are current and meet regulatory guidelines. “Although we have reviewed R&Ws as part of our overall evaluation of transactions in the past, our updated review criteria more specifically address the aspects of R&Ws that we believe improve transparency, data integrity and accountability,” she says.

At Standard & Poor’s, a AAA rating now reflects economic stress on a level with the conditions of the 1929 Depression, according to structured ratings chief Jacob. Securitizations are compared against an “archetypical” loan pool so that investors can see how new issues might differ from the norm. In deliberating whether to bestow a AAA rating, S&P assesses whether bonds backed by an archetypical prime pool have a paper cushion equal to 7.5 percent of the total loan pool that can be exhausted before investors take losses — this is double the size of the previous cushion.“The level of credit enhancement to achieve various ratings categories has been increased, transactions are less levered, and loss assumptions are more severe,” Jacob says. In addition, if a so-called scenario analysis shows that the rating might shift quickly, the security can’t receive a AAA rating.

“Taking stuff through the ratings agencies is a very challenging process right now,” says one investment banker. “The response time is much slower, their staffing levels are a lot lower, and the whole thing just takes a lot longer than it used to.”

The change in attitude was evident in how the agencies approached the only new residential mortgage issue of the year, the $238 million Sequoia deal issued by Redwood Trust, a California real estate investment company. Moody’s gave Sequoia a Aaa rating, but S&P, while it issued a lengthy analysis of the deal, did not give it a rating, presumably because the credit cushion was below the new 7.5 percent AAA requirement.

That difference of opinion didn’t deter investors: The Sequoia deal was five times oversubscribed, despite the poisoned reputation of RMBSs these days. What made the difference? According to Redwood COO and CIO Brett Nicholas, the fact that the originator and servicer of the loans were separate from the sponsor was part of the allure. Also, Redwood kept the bottom 6.5 percent tranche, meaning it would take the first losses if any of the loans were not repaid.

One effect of the crisis is that more firms are doing their own due diligence and relying less on the opinions of the big ratings agencies. Karen Weaver, who as an analyst at Deutsche Bank was one of the first to recognize the calamity emerging in the subprime market, says investors have become more savvy and need the ratings agencies less. “Historically, the securitization product attracted investors looking for very high-quality assets, who in many cases didn’t feel it was necessary to do a lot of their own independent analysis,” says Weaver, who is now head of market strategy and research at Seer Capital Management, a New York investment firm with $300 million under management. “Having gone through the wrenching of the past few years, we now have a different investor base, which doesn’t rely on the ratings agencies as much. There are a lot of investors who are now doing a fair amount of their own due diligence.”

This has led to a concentration of investors in asset-backed securities at large fixed-income investment firms with budgets big enough to include dedicated research staffs. “Oh God, no, we don’t rely on the ratings agencies,” says Pimco’s Gross. “The obvious fact is that our common sense has proven much more valuable than their computers, so we match our common sense and computers against their computers, and it comes out to the plus side.”

There is also a growing business niche for companies that can assess the risk of securitized assets in better ways. Durham, North Carolina–based asset manager Smith Breeden Associates, for example, has developed sophisticated computer models of mortgage-backed securities that it uses to advise pension funds and other investors on which securitized bonds make good investments. “We’ve had a lot of inquiries from investors who quite frankly didn’t know what they owned, and we’ve been able to provide advice on valuation and risk and even helped investors work out their positions,” says Jeffrey Wheeler, a Smith Breeden portfolio manager who focuses on asset-backed securities.

IN AUGUST, Pimco’s BILL GROSS traveled to Washington in a role that was a departure for the outspoken bond guru. Treasury Secretary Timothy Geithner had invited him to a White House conference to discuss the future of Fannie Mae and Freddie Mac. Geithner himself called for weaning the markets away from government programs and letting the private sector get back in the business of financing mortgages, from which it is now almost entirely excluded.

Although Gross might have been expected to call for a quick return to private sector financing of mortgages — after all, he says he is a staunch Republican, and private-label securitizations offer a much higher interest rate for the benefit of Pimco’s many bond funds — he confounded his listeners by calling for the government to basically take over the residential mortgage market. His reason? Private sector mortgages, by requiring large down payments, are priced beyond the means of most home buyers and would have disastrous consequences for the housing market.

“We need the government until it becomes obvious the public begins to believe that housing has a decent foundation,” Gross says. “We need a number of years in which the confidence can begin to come back.”

There has been a vast variety of suggestions for reforming Fannie and Freddie, ranging from combining them into a new agency with an explicit government guarantee (even though the once-semiprivate firms were taken over by the government in 2008, there is still no promise that their bonds have the full faith and credit of the U.S. behind them) to eliminating them and putting mortgage securitizations entirely in private hands. Even the sharpest critics of Fannie and Freddie, however, concede that there is no quick fix.

Raphael Bostic, assistant secretary for policy development and research at the Department of Housing and Urban Development, says the Obama administration is still kicking around ideas on how to keep the housing market vibrant if Fannie and Freddie’s role changes. That includes whether to continue some sort of government guarantee for housing loans.

“It’s important that private capital be engaged in the marketplace, and some of that may come through private-label securities and some may come through public,” Bostic says. “But at the current stage, we haven’t ruled anything out as a possibility.”

Even if Fannie and Freddie are successfully reformed, Seer Capital’s Weaver doubts there will ever be a return to the kind of private-label securitization that took place in the past decade. “We’re never going to have that volume of raw material, and we’re never going to have that total risk transfer that begets more origination,” she says.

One idea for restarting the private mortgage market is to force Fannie and Freddie to reduce the limits on so-called conforming loans. During the financial crisis the limit was raised from $417,000 to $729,000 in expensive areas of the country, crowding out the private sector for all but the biggest loans. “Lowering the conforming maximum would sure help,” says Lawrence White, a professor of economics at New York University’s Leonard N. Stern School of Business. “That opens the market to the private sector more and is one of the necessary steps in reforming Fannie and Freddie.”

A proposal to make the private-label mortgage market less risky comes from Wharton’s Wachter, who suggests the creation of standardized mortgage products that would convey more information to the investor. “There has to be more standardization of information,” she says. “Without standardization, it’s impossible to interpret the information — you simply can’t do statistical analysis.” She proposes that residential mortgages be limited to just three flavors: a “Neapolitan” concoction of plain-vanilla 30-year fixed-, plain-chocolate 15-year fixed- and two types of strawberry short-term adjustable-rate loans.

Whatever new methods and innovations are adopted, the new securitization market is sure to be smaller in scale than it was just three years ago. “It’s going to be smaller bite sizes,” says attorney Borod, who also teaches securitization at Boston University. “The market is going to have to grow back brick by brick by issuing more smaller deals, maybe $200 million to $300 million instead of $1 billion to $2 billion. Let the investors take the time to understand the deals, and grow it back gradually.”

Though innovation will be a crucial and necessary part of the effort to restore the economy’s vigor, the market has learned the hard way that some financial breakthroughs are as dangerous as they are clever. Such innovations as CDOs-squared and synthetic CDOs are probably never going to be revived and won’t be missed by anyone.

The rule changes proposed by the SEC and the new regulations required by Dodd-Frank are steps in the right direction of reassuring investors that the excesses of the past will not be allowed to be repeated. The danger, of course, is that the rules will become so burdensome that the costs of securitization won’t be competitive with those of other forms of financing. That would be unfortunate, because with more than $5 trillion in private debt outstanding, securitization has a proven track record as one of the most efficient methods of raising capital.