Weaknesses in securitization processes for mortgage loans contributed to the financial crisis of 2007 – 2008 and have led to a decade-long stagnation in the private-label residential mortgage-backed securities (PLS) market.
Although market participants have attempted to improve known weaknesses, lack of demand for private-label RMBS reflects investors’ reluctance to re-enter the market and the need for continued improvements to securitization processes to re-establish market activity. While significant issues still need to be addressed, promising advances have been made in the PLS market that improve information provided to investors as well as checks and balances designed to boost transaction performance.
Specifically, we are beginning to see significant improvements in the following securitization processes:
- Due Diligence
- Rating Agency Assessment
- Representation and Warranty Framework and Enforcement
- Loan Quality Standards
- Risk Retention
- Bondholder Communication
Enhancements to these processes in the post-crisis PLS market improve transparency; align incentives between issuers, sponsors, and investors; and may lead to increased investor trust in this market segment.
The due diligence process is intended to provide the purchaser of an asset with an opportunity to assess the asset’s quality. Prior to the financial crisis, investors relied on the underwriter of the securitization (i.e., an investment bank) to perform loan-level due diligence on their behalf and assess the quality of the underlying loans. Limited information about these reviews was made available to investors. The process was opaque and did not provide investors a clear view of the quality of loans underlying a securitization.
Prior to the financial crisis, due diligence was performed on between 5% and 10% of the loans in a securitization. (Slightly larger samples were selected for Alt-A and subprime transactions.) The criteria for selecting the specific loans in the sample was generally not communicated to investors and rating agencies. Even more odd, the due diligence results were not communicated to key transaction parties (rating agencies and investors) and issuers did not disclose the results in disclosure documents.
Since the crisis, the following improvements to the due diligence process have made it more transparent:
- While specific due diligence sample sizes have not been mandated, securitizations issued since the financial crisis have significantly increased the percentage of loans being reviewed—in many transactions, issuers have even included all loans. In two recent Prime Jumbo securitizations, Flagstar and JPMorgan Chase performed 100% due diligence on the underlying loans.
- Rating Agencies have defined requirements for the firms that perform due diligence activities. Market participants have recommended standards for the scope of the due diligence performed. For example, the Structured Finance Industry Group (“SFIG”) has outlined general criteria for the review of credit, property valuation and regulatory compliance on loans reviewed during the due diligence.
- Due diligence results are provided to all rating agencies under SEC Rule 17g-10. These reports detail the number of loans reviewed, due diligence findings, the number of loans dropped during the due diligence process, and the rationale behind dropping them. The reports summarize grades assigned to each loan based on rating agency criteria and are made available on the Securities and Exchange Commission (“SEC”)’s EDGAR site as well as in securitization disclosure documents.
- If a transaction is rated, issuers are required to file detailed reports of due diligence results with the SEC (Rule 17-Ga2 filings) at least five business days prior to first sale of an offered security. Examples of summary reports for both the Flagstar and JPMorgan Chase securitizations show the additional information on due diligence results provided to investors. For those investors interested in more detail, loan-level reporting of the due diligence findings is also available on EDGAR.
This increased transparency enables investors to independently assess the quality of mortgage loans in a private-label RMBS transaction and factor the results of the due diligence process into their investment decision.
Rating Agency Assessment Process
Over-reliance on rating agencies and the conflict of interest caused by the “issuer pay” model for credit ratings is a frequently cited problem with pre-crisis private-label RMBS transactions. Passage of the Dodd-Frank Act is expected to help reduce the blind reliance by investors and regulators on the ratings process by eliminating the use of credit ratings within the regulatory framework and increasing independent due diligence by investors. Despite tremendous criticism of the “issuer pay” model, the system remains intact almost a decade after the financial crisis across multiple asset classes, including corporate bonds and municipal bonds. The Dodd-Frank Act, however, now requires rating agencies to establish “firewalls” between their business development processes and their ratings processes.
With the criticism levied on the performance and opacity of the rating agency assessment process, the SEC Rule 17g-7 requires public disclosures from rating agencies whenever they provide a credit rating. With these new disclosures, rating agencies have increased the transparency of the ratings process by making public the following changes to their assessment process:
- Assumptions, methodologies, and processes used to rate transactions
- Pre-Sale Reports that outline how a rating agency reviews the specific transaction, including areas such as the capital structure, cash flow triggers, pool characteristics, loan underwriting criteria, representations and warranties, and origination and servicing practices
While many market participants criticize the pre-crisis methodologies used by rating agencies to establish credit enhancement levels, pre-sale reports detail reviews performed on each rated private-label RMBS transaction and the assessments made by rating agencies to compute the expected credit enhancement requirements to support the securitization ratings.
In response to a weak pre-crisis representation and warranty framework (discussed in greater detail in the following section), rating agencies now publish “market standard” representations and warranties for each asset class and compare the representations and warranties in each private-label RMBS transaction being evaluated against the standard. The rating agencies also assess a transaction’s processes for enforcing representations and warranties (including repurchases) when a breach occurs.
Rating agencies typically publish the pre-sale report and their assessment of the representations and warranties a few days before a new private-label RMBS issuance is priced. Together with the preliminary offering documents, these items provide post-crisis PLS market investors a comprehensive view of the transaction’s risk prior to making a pricing / investment decision.
Finally, in another step to reduce the risk of issuers “shopping” for favorable ratings, SEC Rule 17g-5 requires rating agencies to make information provided to them by an issuer available to all other rating agencies. This allows other rating agencies to assess transactions on an equal basis and reach independent conclusions – using the same data – on credit enhancement requirements.
One measure of whether the rating agency process has changed since the crisis is the credit enhancement levels themselves. Higher credit enhancement levels would tend to suggest more stringent ratings. Credit enhancement levels on prime jumbo private-label RMBS can be observed in the tables below.
Post-Crisis Transaction Summary:
Pre-Crisis Transaction Summary:
In general, post-crisis AAA credit enhancement levels are higher today compared to pre-crisis AAA credit enhancement levels, which generally ranged between 3.50% - 4.00%. The rating agency assessment process has become more transparent since the crisis, and credit enhancement levels have increased. The future performance of these transactions will determine whether these changes are sufficient.
Representation and Warranty Framework and Enforcement
Representations and warranties are designed to allocate risks associated with a securitization’s underlying loans between issuers and investors. Basic principles of an effective process for allocating risks associated with underwriting standards, collateral value, or regulatory compliance include:
- Clear rules (i.e., representations and warranties) defining when loans must be repurchased out of the security
- Transparent and robust methods for identifying loans that may cause losses
- Financial stability of the entity responsible for funding required loan repurchases
One criticism of the pre-crisis PLS market was the lack of an independent party tasked with identifying rep and warrant breaches. In many cases, the issuers or sponsors themselves were the only transaction parties capable of conducting the type of forensic loan review necessary to discover breaches. However, because these very parties would be on the hook to fund any repurchases required by their analyses, investors had reason to question the thoroughness of these reviews.
In response, the post-crisis PLS market has generally adapted a rules-based approach that relies on delinquency and other objective “triggers” to review loans and identify potential representation and warranty breaches. Once triggered, reviews are often performed by either 1) an independent third-party with forensic review capabilities, or 2) the holder of the most subordinate outstanding security. Reviews are no longer performed or controlled by issuers whose incentive to identify a breach could be questioned.
These process improvements are meant to increase the likelihood that potential representation and warranty breaches are identified and their terms enforced. If a loan meets the contractual requirements for a repurchase, it is critical that the entity responsible for repurchasing it has the financial ability to do so. New SEC disclosure requirements (Rule 15-Ga1) help track and assess an issuer’s ability to comply with repurchase requests.
Changes in the representation and warranty framework have improved methods for breach identification, evaluation, and enforcement. These changes have increased transparency, clarified the allocation of risk, contractually established roles for identifying and evaluating potential breaches, and brought about more effective enforcement mechanisms.
Loan Quality Standards
The Dodd-Frank Act requires lenders to make a good faith effort to determine borrowers’ ability to repay (ATR) their mortgage obligations. The ATR rule seeks to discourage some of the practices used to originate pre-crisis mortgage loans and requires lenders to consider certain underwriting criteria, such as the borrower’s assets or income, debt load, and credit history, to determine whether a loan can be repaid.
Lenders are presumed to comply with the ATR rule when they originate a “qualified mortgage” (QM) which meets the requirements of the ATR rule and additional underwriting and pricing standards. These requirements generally include a limit on points and fees, along with various restrictions on loan terms and features.2
The risk retention requirements added by Section 15G of the Securities Exchange Act of 1934 generally require the issuer of securities backed by non-QM loans to retain at least 5 percent of the credit risk of the mortgage loans collateralizing the securities. This rule change helps align the interests of issuers and sponsors with those of investors by requiring issuers and sponsors to retain an economic interest in the credit risk of the assets they securitize. The rule allows issuers and sponsors to retain risk as either a horizontal interest (i.e., retaining the most subordinate 5% of the securitization), a vertical interest (i.e., retaining a “slice” of each security issued), an “L-shaped” interest (i.e., a combination of horizontal and vertical), or a cash reserve account.
For most non-QM securitizations, the issuers and sponsors have migrated towards the vertical interest, which performs like whole loan exposure and avoids the comprehensive fair value disclosures required for retained horizontal interests. At the margin, this change will create “skin in the game” for non-QM issuers and sponsors and better align their incentives with those of investors.
To address concerns expressed by investors in locating other investors to enforce contractual rights, recent private-label RMBS transactions have incorporated mechanisms for investors to communicate with each other. Many transactions have incorporated methods for investors who wish to communicate to be included in a transaction registry, which may allow them to reach the required percentage of security holders necessary to provide specific direction to the trustee.
The PLS market has experienced a decade of stagnation since the financial crisis of 2007 – 2008. Notwithstanding new entrants to this market, a persistent lack of investor trust in and demand for private-label RMBS remains a challenge. While opportunities for improvement remain, major improvements to the securitization process are beginning to take hold. These changes in post-crisis private-label RMBS transactions improve transparency, align the incentives of issuers and sponsors with those of investors, and hold the key to attracting investors back to this once-thriving market segment.
 Include loans with original term less than 20 years.
 Unpermitted features include negative amortization, interest-only payments, loan terms of more than 30 years, and "back-end" debt-to-income ratios above 43%. (The back-end debt-to-income ratio limit does not apply to 1) loans guaranteed by the Federal Housing Administration and Veterans Administration, 2) loans eligible for purchase by Fannie Mae and Freddie Mac, and 3) portfolio loans made by "small creditors.")