Credit rating agencies are sparring over a new feature in a private-label residential mortgage securitization from Galton Funding, a unit of Mariner Investment Group, that upends the relationship between senior and subordinate bondholders.
No surprise, the debate spilled out into the public after Fitch Ratings, one of the most prolific publishers of unsolicited rating commentary, issued a report critical of the ratings of three of its rivals.
This feature, known as stop-loss advancing, limits the number of months that mortgage servicers will advance funds to bondholders when borrowers get behind on payments. It is designed to overcome a pitfall that cost mortgage bondholders dearly after the credit crisis, when servicers advanced interest payments on distressed loans for extended periods. Servicers eventually recovered these advances from the sales proceeds of repossessed homes, reducing the funds available to repay bondholders’ principal.
Galton is not alone in employing this feature; it is becoming increasingly common for servicing agreements on mortgage bonds to limit advances on interest payments to four months; after that there are fewer funds available each month to pay bondholder interest. What’s unusual about Galton’s latest deal is a related provision that determines how the interest shortfall affects different classes of bondholders: It is incurred concurrently by all classes of notes. This is achieved by removing unpaid loan interest from the definition of bond interest that is due to all investors. Doing so means that unpaid loan interest is treated as a non-credit cost to be shared by all bond classes.
This is a big change. Historically, losses from unpaid loan interest on U.S. residential mortgage bonds have been allocated first to the most junior class of bondholders, and then to more senior classes.
Redwood Trust, one of the most active issuers of residential mortgage bonds since the financial crisis, introduced a similar treatment of unpaid interest in a 2015 transaction. Like Galton’s, it has an atypical definition of an interest shortfall that effectively reduces bond coupons based on unpaid interest from delinquent loans. But unlike Galton’s deal, the Redwood structure allocates the bond coupon reduction in reverse sequential order beginning with the most subordinate class.
This didn’t stop three rating agencies, S&P Global Ratings, Kroll Bond Rating Agency and DBRS, from assigning triple-A ratings to the most senior tranches of securities to be issued in the $452.7 million deal, Galton Funding Mortgage Trust 2018-2, which launched Tuesday.
In their presale reports, all three explained that other factors, most notably the high quality of the collateral, helped offset the increased risk to senior noteholders introduced by the unusual treatment of unpaid loan interest. Essentially they believe that the risk of borrowers in the collateral pool missing more than four payments is so remote that senior bondholders are unlikely to be significantly impacted.
Fitch Ratings takes a different view, however. In a report published this week, it said that it would not assign ratings to any transaction with this feature.
Fitch’s objections are twofold.
First, it is concerned that the structure is “inconsistent with a traditional allocation of credit risk in structured finance and results in meaningfully higher credit risk for senior classes,” the report states. The rating agency believes that the triple-A ratings assigned by its peers “do not fully reflect the higher risk based on the transaction's unique definition of shortfall,” and that this “reduces the clarity and consistency of ratings across transactions for investors.”
Fitch is also concerned that the feature is so unusual that it may not be well understood by investors. It acknowledges that there have been other transactions with similar features. Most notably, unpaid interest related to loan modifications is typically shared across all classes of U.S. residential mortgage bondholders. But this feature has been standard for several decades in the sector and is well understood by investors, according to the rating agency.
“Conversely, the GFMT structure is uncommon and poses greater risk of misinterpretation by investors of the risks considered in the ratings,” the report states.
S&P, DBRS and Kroll all agree that the unusual treatment of unpaid loan interest in Galton’s deal increases the risk to senior noteholders, and all three highlight this risk in their presale reports. However, all three believe that this risk is mitigated by the high quality of the collateral, among other things.
Quincy Tang, managing director and head of U.S. RMBS at DBRS, declined to comment on Fitch's report. But in an email, he said that DBRS' disclosure on the deal "notes considerable compensating factors in the GFMT 2018-2 trust, such as strong underwriting standards, prime quality collateral, 100% third-party due diligence and satisfactory loan performance of the Galton Funding conduit to date.
Tang also noted that the AAA ratings assigned by DBRS in this transaction have 20% credit enhancement levels.
Though many of the loans do not meet the definition of a qualified mortgage or are exempt from the rules because they finance investment properties, they have many features that are similar to prime jumbo loans, such as relatively high FICO scores (754 on a weighted average basis) and low original combined loan to values (68.8%).
In addition, a third-party due diligence provider, AMC Diligence, reviewed every single loan in the collateral pool. This is unusual, as many collateral pools only undergo a representative sampling. AMC Diligence’s review encompassed regulatory compliance, underwriting compliance, property valuation and data quality, according to the presale reports.
The deal’s representation and warranty framework is also unusually strong.
“New and innovative deals are a feature of the structured finance market, and our role is to bring clarity and informed insights to investors,” Sujoy Saha, S&P’s director, U.S. structured finance and the rating agency’s lead analyst on the deal, said in an email.
“We conducted robust analysis of all aspects of the GFMT 2018-2 transaction, including the potential decline in interest paid to each class of rated certificates, and took into account the high-quality collateral in the pool. Our stress scenarios showed the potential risks were commensurate with our assigned ratings, as set out in our published criteria and detailed extensively in our presale report.”
Kroll did not comment on Fitch’s report. However, in its own report on stop-loss advancing published in February, the rating agency noted that such provisions are increasingly accompanied by a number of structural nuances
“When employing these provisions, it is our observation that sponsors strive to strike a balance between using the feature to mitigate losses and advancing timeline ambiguity while still maintaining liquidity for high investment grade,” the report states.
Fitch acknowledges that the treatment of unpaid interest in Galton’s deal is “transparent and direct for investors willing to closely read the transaction documents and to quantify the risk on their own.” It also acknowledged that the risk is disproportionately concentrated in the interest-only classes and that, “in more moderate stress scenarios, non-interest-only classes may be unaffected by the feature.”
In fact, investors in subordinate classes of bonds may favor the structure over standard structures due to the reallocation of a portion of credit risk to more senior classes, the rating agency said.
