Wall Street thinks it has a found a solution to jumpstart the dormant market for private-label mortgage-backed securities: bring a third-party reviewer to determine who is on the hook for bad loans.
One reason investors are reluctant to buy private-label securities is that they don't trust the trustees to look out for their interests. The result is that investors are only buying mortgage bonds that are backed by Fannie Mae, Freddie Mac and the Federal Housing Administration.
The idea of a third-party reviewer has been around for several years but only now is making its way into private-label jumbo securitizations in anticipation of an eventual transition away from government-backed loans.
Issuers are adding this layer of protection at a time when lawmakers are examining how to wind down Fannie Mae and Freddie Mac and bring private capital back into the mortgage market.
Last month, JPMorgan Chase issued $412 million of jumbo private-label mortgage bonds and upfront it named Pentalpha Surveillance of Greenwich, Conn., as the independent reviewer with sole authority to determine if a delinquent loan has violated a test related to loan quality representations and warranties.
Pentalpha will review all loans that are 120 days delinquent, that liquidate at a loss, and where the servicer has stopped advancing principal and interest payments to investors. Pentalpha will run through a series of tests to determine if a loan's failure is material and will provide the results and recommend actions to the securities administrator.
Banks that serve as bond trustees have glommed on to the concept as a way to limit their legal liability. After the financial crisis, trustees were hit with billions of dollars in lawsuits for allegedly hiding defects in their own recordkeeping or not bothering to transfer essential documents for the loans that were packaged and sold to investors.
The added governance seeks to address concerns that trustees and custodians had little contractual ability to oversee mortgage servicers, to identify and return problem loan to originators, and to properly secure documents.
If a lender disputed a buyback request, "the demand often just sat there and there was no mechanism to resolve the dispute," says Jay Knight, a real estate capital markets attorney at Bass, Berry & Sims in Nashville, who formerly was a special counsel at the Securities and Exchange Commission's office of structured finance.
A third-party reviewer could also give bondholders confidence that securitized trusts will not again become dumping grounds for bad loans.
"There was a vacuum that the financial crisis revealed," says Knight. "If a loan performs poorly, there needs to be a party that has the independence to make decisions related to whether to put the loan back to the lender."
The SEC has endorsed the idea of a third-party reviewer and included it in a 2010 proposal on Reg AB, which sets requirements for the registration, disclosure and reporting of all publicly registered asset-backed securities including mortgage-backed securities. That proposal is still pending.
Still, it remains to be seen whether the added oversight will quell investors' frustrations at being unable to force lenders to repurchase poorly underwritten loans, which has been the crux of most of the outstanding litigation.
Critical to the new testing structure is that the independent third-party reviewer will have access to loan files, a major concession on the part of many banks that in the past have refused to give investors access to loan data.
Analysts say the new structure could even prevent repurchases of risky loans if the originating lender can show that the borrower suffered a life event such as a job loss, divorce, serious illness or death—something banks have long argued they should not be responsible for.
"The reviewer has neither the obligation nor the incentive to dig deeper or analyze new sources of information when reviewing defaulted loans," Moody's wrote in a recent report about the JPMorgan Chase deal.
In a report last month, Fitch called the inclusion of a third-party reviewer a "positive from the standpoint of independence and clarity."
Kroll Bond Ratings said the specificity of the review process "provides a straightforward and transparent mechanism for breach reviews," but also found that limiting the scope of the review process means "potential breaches may be less likely to be discovered."
Tom Deutsch, executive director of the American Securitization Forum, an industry trade group that has endorsed the third-party reviewer concept, says it will be "omnipresent in future private label securitization deals."
"One of the things investors have a strong view of coming out of the crisis is there needs to be some form of watchdog to oversee rep and warranty violations," he says. "It's a very big deal."
The volume of private label securitizations has plummeted from a peak of $2.2 trillion in 2007. Deutsch says issuance will be between $10 billion to $20 billion this year.
Even with a third-party reviewer, some industry experts say incentives in securitizations still are not aligned because servicers are stuck advancing principal and interest payments to bondholders when a loan goes delinquent.
As a result, servicers bear the brunt of delinquencies and have an incentive to push borrows into foreclosure in order to get repaid. Some industry experts say investors should be taking the hit by sustaining losses when loans are 120 days or more past due.
And while a third-party reviewer may solve some issues, the structure of recent deals may turn off investors. Most of the credit rating agencies lambasted the recent JPMorgan jumbo deal for allowing important representation and warranty provisions, including those covering fraud, to expire after three years, which would expose investors to defects that appear later in the life of the loan.
Peak defaults typically occur in the fourth or fifth year of a loan, so having such sunset provisions would appear to undermine investors'—though not lenders'—interests.
In contrast, Redwood Trust, the real estate investment trust that has been the most active jumbo loan securitizer, structures its deals differently: the holder of the first loss tranche is responsible for and has an incentive to vigorously pursue defective loans in order to avoid losses.
How such structures change and play out will be part of the debate around reforming the government-sponsored enterprises. "Even though the bills related to GSE reform speak to first-loss position, having improved trust governance similar to what's being adopted in private label space could help the transition from a fully GSE model to a private sector mitigation of credit risk," says Knight.