After having gone through an enormous disruption characterized by unexpected deterioration and massive losses, investors in residential mortgage-backed securities have a number of reasons to feel unsettled. Regulatory uncertainty clouds the market's future and mortgage originations remain at historically low levels despite housing affordability reaching its highest level since the National Association of Realtors began keeping records in 1970.
As the industry works through these issues, participants can actually look forward to a beacon of light. The bright spot is a valuable new tool: the ability to more easily track loan level data at the borrower level, while shielding the borrower's identity.
Up until recently, it was problematic and costly to match mortgage loan-level data at the borrower level, but breakthroughs in technology now allow market participants to track the borrower's credit score performance and other risk indicators throughout a loan's lifecycle. The benefits to this breakthrough include the ability to benchmark deals, monitor changes in collateral and borrower health, and even determine the impact of strategic defaults.
Taking a major step forward recently was Fannie Mae, who will now provide issuance loan-level data for its newly issued single-family MBS as part of its loan-level disclosures initiative.
Difficult as it is for those outside the industry to understand, previously there was little information available to gauge a borrower's ability to repay a mortgage loan post-origination. It's logical that two borrowers may both be current on a loan, but over time evolve into different risk profiles. This is one of the reasons periodic valuations were difficult and subjective.
Yet, as powerful as the development of loan-level data solutions may be, market participants must understand a number of dynamic factors, particularly as they relate to credit scores.
First, and somewhat obviously, consumers' credit scores can migrate — meaning that a consumer's probability of default may be very different from one time period to the next based on changes with their own debt management behavior. Less understood is that as overall systemic risk increases or decreases, the default probabilities for each credit score value can also change. In fact, default rates at all score intervals rose dramatically as the economic crisis hit. As the economy improves, the probability of default decreases, which is presently occurring.
For example, the default risk behind a VantageScore credit score of 700, which is generally considered prime based on VantageScore's scale of 501 to 990, was less than 2% in 2005. Over the next four years, the default rate for the same score skyrocketed more than 60%. As the history books show, the seismic shift in risk manifested itself through huge losses for RMBS investors.
The good news is that while the mortgage and RMBS industries face down their challenges, increasingly consumer risk is becoming less of an issue, particularly for new originations because the probability of default is decreasing.
The default rate behind a VantageScore of 700 is now nearing pre-recession levels. As of 2011, a 700 VantageScore equated to a 2.5% default rate compared with 2009 when a 700 VantageScore equated to a 7% default rate. With roughly 90% of new mortgage originations going to consumers scoring 700 or higher, there is less risk in the system along with a large pool of potential new lower-risk origination opportunities.
From an investor's standpoint, this is also good news. The new availability of loan-level data to track score and risk fluctuation enables secondary market investors to measure, leverage and properly price default risk as it moves up and down. Post origination, the value of RMBS securities will be much better understood.
Users of loan-level data must also understand how credit score migration trends can affect a portfolio. Naturally, consumers can move upwards and downwards along a credit score model's distribution range. Those shifts can be influenced by a number of factors and occur differently from year to year, affecting loan issuances of different vintages.
Illustrating the significance of this issue is a study from Equifax, one of the three national credit reporting companies. The study examined “current” mortgages from 900 deals issued in 2006 and found that in 55% the average VantageScore dropped 10 points or more since origination. For 17% of those deals, the average VantageScore dropped between 30 and 50 points, which means that the likelihood of those borrowers becoming severely delinquent increased by at least 15% and potentially over 30% since their loan was originated. Of course, this works both ways. A material percentage of deals increased in terms of their average credit scores, opening up potentially actionable arbitrage scenarios.
New solutions to tracking loan-level data may have a profound impact on the securitization market, but it is not a panacea. Peeling back the onion, and understanding what is contributing to borrower behaviors is the best path forward when utilizing this new tool.
Indeed, with more understanding of loan-level risk, many of the misfortunes of the past can be avoided on the downside and many investment opportunities can be reaped on the upside.
