The two prevalent forms of private-label RMBS representation and warranty frameworks that became popular following the financial crisis do a good job of detecting defective loans, according to a report from Moody's Investor Service released Wednesday.

While both open-ended and prescriptive R&W frameworks can detect and remedy defective loans, each type possesses its own set of strengths and weaknesses, the report noted.

Open-ended frameworks give reviewers more liberty to determine how they will detect loans that breach representations and warranties. Prescriptive frameworks, on the other hand, rely on specific sets of tests to review a loan. For both frameworks, it is their structure that can make review as problematic as it is useful.

Open-ended frameworks are employed by Redwood Trust- and WinWater-sponsored transactions, for instance, whereas prescriptive frameworks are more common with JPMorgan- and Goldman Sachs-sponsored transactions.

For open-ended frameworks, the discretion given to reviewers can spell out trouble if the controlling holder considers interests other than loan losses, the Moody's analysts who wrote the report found. This could lead them to overlook breaches or agree to settle them in a way other than forcing the originator to repurchase.

Another issue inherent in the open-ended framework is the controlling holder's importance to the process, since the holder could be lost in the transaction, meaning that the trust would have difficulty in enforcing the remedy.

At the same time, open-ended frameworks give reviewers the freedom to look beyond specific parameters. Therefore, the reviewer has no limit on what it can review, allowing reviewers to use their judgment more easily in discerning possible breaches.

Prescriptive frameworks, given their simple test-based nature, allow for more uniformity in the review process, which in turn makes it much more cost-effective, according to the Moody's analysts. The tests are done on a pass-fail basis, wherein a loan's failure means it has breached R&W, making reviews very easy to perform and more objective.

Where this second type of framework hits a pothole is in the limits of the tests themselves. If a reviewer employs a test that is more narrow than the representations and warranties. As an example, the report cites a possible situation in which the R&W covering fraud focuses primarily on borrower fraud, meaning the test does so as well. In this case, that framework could then overlook systemic originator fraud.

Nevertheless, the article emphasizes that both frameworks are likely to catch defective loans, making them useful tools for parties to these transactions.

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