As new deal volume in the private label RMBS market continues to ramp up, so do questions from investors about how these deals will evolve over time. Already this year, the volume of new issuance exceeds that of all of 2012. Additionally, big banks are stepping back into the private label space, with more likely to join them in the coming months.
Most of the discussion centers on three areas: the credit quality of the collateral, the level of due diligence, and the strength of the representations and warranty framework.
Fitch Ratings took an in-depth look at the composition of each deal it has rated so far in 2013 based on these three areas. The primary goal of this exercise was to try and ascertain what deals may look like in the coming months as market participants search for the “new normal” in private-label RMBS.
A review of the loan collateral is the primary focus of Fitch’s analysis. This is an area where Fitch and other market participants generally agree that quality remains high. All private label RMBS 2.0 transactions rated by Fitch have been comprised of collateral characterized by strong credit quality borrowers (770 average FICO), with low LTVs (less than 69%) and underwritten with full documentation.
High-quality collateral, however, often comes with some corresponding risks. Most recent private label RMBS pools are comprised of loans with high average balances (more than $800,000), large state concentrations (40-50% in California) and low loan counts (300-to-400 loans). Fitch accounts for these risks by increasing its lifetime default and loss severity expectations. In concentrated pools, these adjustments can increase Fitch’s loan default frequency expectation by 30% or more. Default probability and loss severity will be further increased in cases where pools are concentrated in geographic regions that Fitch believes are significantly overvalued using its “Sustainable Home Price” model.
Nonetheless, the market seems to be largely in agreement that overall collateral quality is very strong and will likely remain so for the foreseeable future.
The quality and transparency of loan level due diligence has improved dramatically with the advent of the private label RMBS 2.0 market and represents another key area of Fitch’s analysis. Loan level due diligence has been conducted on nearly 100% of a pool with all loans contributed from new or smaller originators subject to reviews. Diligence results continue to indicate that sound underwriting controls are in place.
Due diligence results are shared directly with Fitch; this is an important differentiator that was not seen in pre-crisis transactions. It allows Fitch to make default and loss severity adjustments on a loan-by-loan or pool basis when the due diligence analysis indicates weaknesses or uncertainties. Fitch views this as a very positive attribute of RMBS 2.0 transactions and does not envision significant changes in this trend anytime soon.
Reps & Warranties
This area is precipitating the most debate among market participants as balancing lender liability concerns with the interests of investors is proving to be challenging for some private label issuers.
The model rep and warranty framework developed soon after the crisis (and replicated in Fitch’s criteria) is the most robust and provides the most assurances about the quality of the collateral. The enforcement mechanisms, which include loan file reviews for loans that go 120 days delinquent and provisions for automatic arbitration to resolve disputes, are key protections that offer greater confidence that an originator will maintain sound origination standards.
The Redwood and EverBank transactions adhere to this standard. However, some recent transactions have sharply deviated from Fitch criteria and contain a substantially diluted framework. Many reps included sunset provisions, and the enforcement mechanisms contained proximate cause provisions and materiality clauses. Further, the scope of the review of defaulted loans for possible breaches was prescriptive and narrow.
It is the variability in the constructs and the financial condition of the entities responsible for repurchasing loans that has prompted Fitch to take a holistic approach toward evaluating each transaction’s rep and warranty framework. Transactions in which the rep and warranty framework, as well as the entity providing the reps, meet Fitch’s criteria will see no increase in credit enhancement, all else being equal.
Conversely, Fitch expects higher ‘AAA’ credit enhancement where the reps and warranties are dilutive and the enforcement mechanisms contain hurdles that make it more difficult for investors to put back a loan. Similarly, a financially weak counterparty limits the protections provided. This is irrespective of the quality and substance of the reps as such an institution may be unable to honor its repurchase obligation. In this case higher loss protection is needed to account for the possibility of higher defaults and losses due to breaches.
For example, the JPMorgan Chase transaction contained strong counterparties, but a significantly diluted rep and warranty framework. The inclusion of qualifying and conditional language that substantially reduced lender loan breach liability, and numerous “sunsets” for some provisions, including fraud were noted by Fitch as key risks.
While the high quality of the loans and clean due diligence mitigated these concerns, Fitch’s loss expectations were increased to account for the potential operational risks that are not accounted for in the due diligence review. Thus, the transaction’s ‘AAA’ credit enhancement was much higher than that indicated by the very strong loan quality.
What Will the ‘New Normal’ Look Like?
Going forward, Fitch expects to see these three factors evolve and transition from the current standard as private label RMBS issuance picks up and more issuers enter the market. While not likely to occur in the short term, changes are on the horizon.
Foremost, while Fitch does not expect collateral quality to deteriorate, we are likely to see a credit drift as current pool compositions remain at the very high end of the credit spectrum. Originators with solid origination platforms and proven track records may also be subject to less than 100% diligence reviews.
Finally, in part because of ongoing litigation concerns, Fitch believes that the market will continue to see new rep and warranty frameworks that attempt to balance issuer liability concerns with adequate investor protections. Frameworks that are significantly weaker than Fitch’s criteria and expose the transaction to additional risks will result in Fitch seeking higher credit enhancement levels or applying a rating cap.
Rui Pereira is head of Fitch’s U.S. RMBS group; Kevin Duignan is Global Head of Structured Finance and
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