© 2013, Adam J. Levitin
PLS can only provide the financing for at most an eighth of the US housing market’s peak annual financing needs
. There is a role for PLS within the US housing finance system, but itis not realistic to expect PLS to provide a significant share of the housing finance system because there is insufficient capital markets demand for credit risk on US mortgages. At best, PLS will be able to support no more than $500 billion of annual housing finance; theUS housing finance market needs anywhere between $1.5 trillion and $4 trillion in annualfinancing, depending on interest rate conditions.
PLS is a “lemons” market in which investors cannot adequately gauge the quality of theunderlying mortgages.
The institutional structure of the PLS market frustrates investors’ability to make sure that securitized mortgages conform to the represented underwritingquality. Standard market discipline mechanisms such as specialized subordinated debtinvestors and reputational sanctions did not work in the PLS market, and it is unlikely thatinvestors will rapidly return to this market.
The “Resurrected” PLS market consists of a very small number of deals involving ultra- prime mortgages
. PLS has provided financing for only around 17,000 mortgages since2008—fewer mortgages than originated in the District of Columbia alone last year. Themortgages financed through PLS averaged 65% LTV on properties valued at $1.26 million,and the average borrower FICO score was 723.
The PLS market will not produce widely available, affordable 30-year fixed rate mortgagesor provide pre-closing rate-locks
. Private mortgage markets have never produced widelyavailable long-term, fixed-rate mortgages or pre-closing rate locks anywhere in thedeveloped world. To the extent that 30-year fixed rate mortgages are available in the private-label jumbo mortgage market it is not on the same terms as in the Agency market. Similarly pre-closing rate-locks are available on jumbo mortgages only because the jumbo market canhedge the risk in the Agency MBS forward contract market.
A PLS-based housing finance market poses serious systemic risk
. PLS will result ingeographic price discrimination as investors attempt to price credit risk. Geographic pricediscrimination can result in self-fulfilling predictions of housing price bubbles, and theflightiness of capital from PLS markets means that capital will not be available precisely atthe times it is most needed.
There are several steps that can be taken to improve the PLS market, but PLS will never beable to support more than a small fraction of the US housing market.
Investor trust in thePLS market can be improved through reforms regarding securitization contractstandardization, the duties and compensation of trustees and servicers, representations andwarranties, ratings agencies, and the diligence process.