Credit Risk Transfer and Financial Crises

photo by Dean Hochman

Susan Wachter posted Credit Risk Transfer, Informed Markets, and Securitization to SSRN. It opens,

Across countries and over time, credit expansions have led to episodes of real estate booms and busts. Ten years ago, the Global Financial Crisis (GFC), the most recent of these, began with the Panic of 2007. The pricing of MBS had given no indication of rising credit risk. Nor had market indicators such as early payment default or delinquency – higher house prices censored the growing underlying credit risk. Myopic lenders, who believed that house prices would continue to increase, underpriced credit risk.

In the aftermath of the crisis, under the Dodd Frank Act, Congress put into place a new financial regulatory architecture with increased capital requirements and stress tests to limit the banking sector’s role in the amplification of real estate price bubbles. There remains, however, a major piece of unfinished business: the reform of the US housing finance system whose failure was central to the GFC. Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), put into conservatorship under the Housing and Economic Recovery Act (HERA) of 2008, await a mandate for a new securitization structure. The future state of the housing finance system in the US is still not resolved.

Currently, US taxpayers back almost all securitized mortgages through the GSEs and Ginnie Mae. While pre-crisis, private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.

The appropriate pricing of mortgage backed securities can discourage lending if risk rises, and, potentially, can limit housing bubbles that are enabled by excess credit. Securitization markets, including the over the counter market for residential mortgage backed securities (RMBS) and the ABX securitization index, failed to do this in the housing bubble years 2003-2007.

GSEs have recently developed Credit Risk Transfers (CRTs) to trade and price credit risk. The objective is to bring private market discipline to bear on risk taking in securitized lending. For the CRT market to accomplish this, it must avoid the failures of financial assets to price risk. Are prerequisites for this in place? (2, references omitted)

Wachter partially answers this question in her conclusion:

CRT markets, if appropriately structured, can signal a heightened likelihood of systemic risk. Capital markets failed to do this in the run-up to the financial crisis, due to misaligned incentives and shrouded information. With sufficiently informed and appropriately structured markets, CRTs can provide market based discovery of the pricing of risk, and, with appropriate regulatory and guarantor response, can advance the stability of mortgage finance markets. (10)

Credit risk transfer has not yet been tested by a serious financial crisis. Wachter is right to bring a spotlight on it now, before events in the mortgage market overtake us.

Mortgage Servicing Since The Financial Crisis

photo by Dan Brown

Standard & Poors issued a report, A Decade After The Financial Crisis, What’s The New Normal For Residential Mortgage Servicing? It provides a good overview of how this hidden infrastructure of the mortgage market is functioning after it emerged from the crucible of the subprime and foreclosure crises. It reads, in part,

Ten years after the start of the financial crisis, residential mortgage servicing is finally settling into a new sense of normal. Before the crisis, mortgage servicing was a fairly static business. Traditional prime servicers had low delinquency rates, regulatory requirements rarely changed, and servicing systems were focused on core functions such as payment processing, investor accounting, escrow management, and customer service. Subprime was a specific market with specialty servicers, which used high-touch collection practices rather than the low-touch model prime servicers used. Workout options for delinquent borrowers mainly included repayment plans or extensions. And though servicers completed some modifications, short sales, and deeds in lieu of foreclosure, these were exceptions to the normal course of business.

Today, residential mortgage servicing involves complex regulation, increased mandatory workout options, and multiple layers of internal control functions. Over the past 10 years servicers have had to not only modify their processes, but also hire more employees and enhance their technology infrastructure and internal controls to support those new processes. As a result, servicing mortgage loans has become less profitable, which has caused loan servicers to consolidate and has created a barrier to entry for new servicers. While the industry expects reduced regulatory requirements under the Trump administration and delinquency rates to continue to fall, we do not foresee servicers reverting to pre-crisis operational processes. Instead, we expect states to maintain, and in some cases enhance, their regulatory requirements to fill the gap for any lifted or reduced at the federal level. Additionally, most mortgage loan servicers have already invested in new processes and technology, and despite the cost to support these and adapt to any additional requirements, we do not expect them to strip back the controls that have become their new normal. (2/10, citation omitted)

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As The Economy Improves, Delinquency Rates Have Become More Stable

Total delinquency rates have only just begun returning to around pre-crisis levels as the economy–and borrowers’ abilities to make their mortgage payments–has improved (see charts 1 and 2). Lower delinquency rates can also be attributed to delinquent accounts moving through the default management process, either becoming reperforming loans after modifications or through liquidation. New regulatory requirements have also extended workout timelines for delinquent accounts. In 2010, one year after 90-plus delinquency rates hit a high point, the percentage of prime and subprime loans in foreclosure actually surpassed the percentage that were more than 90 days delinquent–a trend that continued until 2013 for prime loans and 2014 for subprime loans. But since the end of 2014, all delinquency buckets have remained fairly stable, with overall delinquency rates for prime loans down to slightly over 4% for 2016 from a peak of just over 8% in 2009. Overall delinquency rates for subprime loans have fluctuated more since the peak at 29% in 2009. (2/10)

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Modifications Now Make Up About Half Of Loan Workout Strategies

Government agencies and government-sponsored enterprises (Fannie Mae and Freddie Mac) developed new formal modification programs beginning in 2008 to address the rising delinquency and foreclosure rates. The largest of these programs was HAMP, launched in March 2009. While HAMP was required for banks accepting funds from the Troubled Asset Relief Program (TARP), all servicers were allowed to participate. These programs required that servicers exhaust all loss mitigation options before completing foreclosure. This requirement, and the fact that servicers started receiving incentives to complete modifications, spurred the increase in modifications. (4/10)

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Foreclosure Timelines Have Become Longer

As the number of loans in foreclosure rose during the financial crisis, the requirements associated with the foreclosure process grew. As a result, the time it took to complete the foreclosure process increased to almost 475 days in 2016 from more than 160 days in 2007–an increase of almost 200%. While this is not a weighted average and therefore not adjusted for states with smaller or larger foreclosure portfolios, which could skew the average, the data show longer timelines across all states. And even though the percentage of loans in foreclosure has decreased in recent years (to 1% and 9% by the end of 2016 for prime and subprime, respectively, from peaks of 3% in 2010 and 13% in 2011) the time it takes to complete a foreclosure has still not lessened (6/10)

Treasury’s Overreach on Securitization Reform

Treasury Secretary Mnuchin Being Sworn in by Vice President Pence

The Department of the Treasury released its report, A Financial System That Creates Economic Opportunities Capital Markets. I will leave it to others to dissect the broader implications of this important document and will just highlight what it has to say about the future of securitization:

Problems related to certain types of securitized products, primarily those backed by subprime mortgage loans, contributed to the financial crisis that precipitated the Great Recession. As a result, the securitization market has acquired a popular reputation as an inherently high-risk asset class and has been regulated as such through numerous post-crisis statutory and rulemaking changes. Such treatment of this market is counterproductive, as securitization, when undertaken in an appropriate manner, can be a vital financial tool to facilitate growth in our domestic economy. Securitization has the potential to help financial intermediaries better manage risk, enhance access to credit, and lower funding costs for both American businesses and consumers. Rather than restrict securitization through regulations, policymakers and regulators should view this component of our capital markets as a byproduct of, and safeguard to, America’s global financial leadership. (91-92, citations omitted)

This analysis of securitization veers toward the incoherent. It acknowledges that relatively unregulated subprime MBS contributed to the Great Recession but it argues that stripping away the regulations that were implemented in response to the financial crisis will safeguard our global financial leadership. How’s that? A full deregulatory push would return us to the pre-crisis environment where mortgage market players will act in their short-term interests, while exposing counter-parties and consumers to greater risks.

Notwithstanding that overreach, the report has some specific recommendations that could make securitization more attractive. These include aligning U.S. regulations with the Basel recommendations that govern the global securitization market; fine-tuning risk retention requirements; and rationalizing the multi-agency rulemaking process.

But it is disturbing when a government report contains a passage like the following, without evaluating whether it is true or not:  “issuers have stated that the increased cost and compliance burdens, lack of standardized definitions, and sometimes ambiguous regulatory guidance has had a negative impact on the issuance of new public securitizations.” (104) The report segues from these complaints right to a set of recommendations to reduce the disclosure requirements for securitizers. It is incumbent on Treasury to evaluate whether those complaints are valid are not, before making recommendations based upon them.

Securitization is here to stay and can meaningfully lower borrowing costs. But the financial crisis has demonstrated that it must be regulated to protect the financial system and the public. There is certainly room to revise the regulations that govern the securitization sector, but a wholesale push to deregulate would be foolish given the events of the 2000s.

Subprime v. Non-Prime

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The Kroll Bond Rating Agency has issued an RMBS Research report, Credit Evolution: Non-Prime Isn’t Yesterday’s Subprime. It opens,

Following the private label RMBS market’s peak in 2007 and the ensuing credit crisis, non-agency securitizations of newly originated collateral have focused almost exclusively on prime jumbo loans. This is not surprising given the poor performance of loosely underwritten residential mortgage loans that characterized certain vintages leading up to the crisis. While legacy prime, in absolute terms, performed better than Alt-A and subprime collateral, it was apparent that origination practices had a significant impact on subsequent loan performance across product types.

Many consumers were caught in the ensuing waves of defaults, which marred their borrowing records in a manner that has either barred them from accessing housing credit, or at best made it extremely challenging to obtain a home loan. Others that managed to meet their obligations have been unable to qualify for new loans in the post-crisis era due to tighter credit standards that have been influenced by regulation.

The private label securitization market has not met the needs of these consumers for a number of reasons, including, but not limited to, reputational concerns in the aftermath of the crisis, regulatory costs, investor appetite, and the time needed for borrowers to repair their credit. The tide appears to be turning quickly, however, and Kroll Bond Rating Agency (KBRA) has observed the re-emergence of more than a dozen non-prime mortgage origination programs that intend to use securitization as a funding source. Of these, KBRA is aware of at least four securitization sponsors that have accessed the PLS market across nine issuances, two of which include rated offerings.

Thus far, KBRA has observed that today’s non-prime programs are not a simple rebranding of pre-crisis subprime origination, nor do they signal a return to the documentation excesses associated with “liar loans”. While the asset class is meant to serve those with less pristine credit, and can even have characteristics reminiscent of legacy Alt-A, it is expansive, and underwriting practices have been heavily influenced by today’s consumer-focused regulatory environment and government-sponsored entity (GSE) origination guidelines. In evaluating these new non-prime programs, KBRA believes market participants should consider the following factors:

■ Loans originated under sound compliance with Ability-To-Repay (ATR) rules should outperform 2005-2007 vintage loans with similar credit parameters, including LTV and borrower FICO scores. The ATR rules have resulted in strengthened underwriting, which should bode well for originations across the MBS space. This is particularly true of non-prime loans, where differences in origination practices can have a greater influence on future loan performance.

■ Loans that fail to adhere to GSE guidelines regarding the seasoning of credit dispositions (e.g. bankruptcy, foreclosure, etc.) on a borrower’s credit history should be viewed as having increased credit risk relative to those with similar credit profiles that lack recent disposition activity. This relationship likely depends on, among other things, equity position, current FICO score, and the likelihood that any life events relating to the prior credit issue remain unresolved.

■ Alternative documentation programs need to viewed with skepticism as they relate to the ATR rules, particularly those that serve borrowers with sub-prime credit histories. Although many programs will meet technical requirements for income verification, it is also important to demonstrate good faith in determining a borrower’s ability-to-repay. Failure to do so may not only result in poor credit performance, but increased risk of assignee liability.

■ Investor programs underwritten with reliance on expected rental income and limited documentation may pose more risk relative to fully documented investor loans where the borrower’s income and debt profile are considered, all else equal. (1, footnotes omitted)

I think KBRS is documenting a positive trend: looser credit for those with less-than-prime credit is overdue. I also think that KBRS’ concerns about the development of the non-prime market should be heeded — ensuring that borrowers have the ability to repay their mortgages should be job No. 1 for originators (although it seems ridiculous that one would have to say that). We want a mortgage market that serves everyone who is capable of making their mortgage payments for the long term. These developments in the non-prime market are most welcome and a bit overdue.