The residential mortgage market has been plagued by uncertainty as the industry waits for guidance on risk retention, new disclosure requirements, and some kind of resolution of Fannie Mae and Freddie Mac.
One of the areas which had been left relatively untouched by Congress and regulators were mortgage real-estate investment trusts, vehicles used to originate and acquire mortgage loans and residential mortgage-backed securities. Mortgage REITs generally acquire assets on a levered basis, more than regular closed-end funds, but much less than banks or other financial institutions involved in the residential mortgage business.
Unlike banks, mortgage REITs mark their assets to market, so investors have a clear picture of the current value of the assets held by these REITs.
Mortgage REITs rely on a special exemption in Section 3(c)(5)(C) of the Investment Company Act of 1940. Since the dawn of mortgage REITs, the SEC has not questioned their ability to rely on this exemption, although they have provided some guidance on some issues through no-action letters.
In late August, however, the SEC issued a release and a request for comment on Section 3(c)(5)(C), which pointedly questioned many long-standing features of mortgage REITs, such as the use of leverage and the use of an independent manager. The release has added considerable uncertainty to the market, resulting in the delay of mortgage REIT initial public offerings and capital raising efforts by existing mortgage REITs.
Prior to the release, it was clear that, under the current proposed guidance on risk retention, mortgage REITs were going to play a major role in taking on credit risk with respect to residential mortgages, particularly with respect to those mortgages that were outside the definition of "qualified residential mortgages" for risk retention purposes. Mortgage REITs are generally small, segregated financial institutions, and the tax rules governing REITS require that their shares be widely held.
In light of what occurred during the financial crisis, shifting mortgage credit risk away from the U.S. government and from financial institutions that could be considered "too big to fail" should be viewed as a positive development. Though many mortgage REITs failed during the financial crisis, their failures did not pose any systematic risk to the financial markets. Several mortgage REITs also served certain niche markets of lending in specific areas, and the performance of the RMBS issued by some mortgage REITs has in many cases been better than that of the larger financial institutions originating similar product.
There were several public mortgage REITs created to invest in the Public-Private Investment Program established in 2009, so they have also played an important role in assisting with the unloading of mortgage assets acquired by the government. It should be noted that the exemption provided by Section 3(c)(5)(C) was essential to permit the participation by the public in PPIP, which was a stated objective of the government in setting up the program.
The SEC release is an unfortunate development for the residential mortgage market at this particular time, and may result in extended uncertainty for the future residential mortgage market. Until a set of rules governing the origination and sale of residential mortgage loans is put into place, those who wish to be a part of the new residential mortgage market will remain on the sidelines.
Once the rules are set, we will have a market again, and if something clearly does not work, we can tinker with it until it does. Until such time, we can only hope that regulators see value in the existence of mortgage REITs and the important role they will play in fostering a private secondary market for residential mortgage loans.
Richard D. Simonds Jr. is partner with law firm SNR Denton. He represents issuers and underwriters of mortgage- and asset-backed pass-through and debt securities
