The residential mortgage backed securities market is the securitized sector that has arguably taken the longest to emerge from the ashes of the financial crisis over 10 years ago. A vital component from those first post-crisis RMBS deals at the start of this decade needs to reassert its importance again today: Mortgage reps and warranties.
This is an area of RMBS that has never wavered in its importance as far as we at Fitch are concerned since we first brought attention to it five years ago. So we felt it was important to take a look back to fully ascertain how mortgage rep and warranty frameworks have evolved since then, and more importantly, how we feel they need to evolve going forward.
Project Restart was put in place by the industry in 2008 to help achieve a balance between protecting both lenders and investors in new RMBS deals by promoting transparency and incentivizing sound underwriting in new securitizations. As part of Project Restart, a rep and warranty model was introduced containing strong and effective safeguards for the investor and perhaps most importantly, reduced ambiguity. Fitch quickly adopted these principles into our formal criteria with the expectation that issuers would also follow the model.
In 2013, we began to notice and express concerns that some of the rep and warranty proposals in new deals coming to market could leave investors exposed to higher losses from weak underwriting and defective mortgage loans. For instance, one framework contained sunset provisions that relieved lenders from their repurchase obligations after less than three years. Others contained proximate cause language and materiality factors for determining if a breach had occurred. These provisions were beginning to introduce subjectivity and limitations that we were concerned would burden mortgage investors with additional risks and expenses.
Since proposed RMBS representation warranty and enforcement frameworks varied so widely, we approached each one holistically. Those deals with significant third party due diligence and strong credit quality borrowers would provide greater confidence that any future default risk would be driven by credit events and not operational weaknesses. And deals with weaker rep and warranty frameworks had higher credit enhancement levels to help shield investors from elevated risk of higher losses and defaults.
Fitch’s analysis for new RMBS includes a detailed review of the following:
• Does the proposed framework meet Fitch criteria and industry standards?
• Do deviations weaken the deal structure and/or dilute investor protection?
• Are the rep, warranty and enforcemen risks quantifiable?
Rep, warranty and enforcement constructs that incorporate industry best practices receive no incremental adjustment in our RMBS analysis. However, if the answers to the above questions raise concerns, Fitch may adjust its loss expectations, apply a rating cap or may decline to rate the transaction.
So what has changed over the last five years?
The private-label RMBS market is certainly more active than it was back in 2013. While issuance still remains well below the high-water marks we were seeing pre-crisis, originators are certainly warming to securitizing in greater numbers. Whereas super-prime quality deals were the go-to credit profile five years ago, the pendulum is swinging back to deals using collateral that it not as pristine.
While rep and warranty frameworks established post-crisis have features intended to protect investors from the operational risks that were prevalent in pre-crisis RMBS, some new RMBS deals and issuers coming to market of late have rep and warranty frameworks that are showing signs of slippage at a time when they should be taking on greater importance since we’re at the end of a very positive (and unprecedented) credit cycle.
Of late, there is a more concerted push among RMBS issuers towards providing only sample due diligence. While most rep and warranty frameworks have safeguards to protect investors from misrepresentation risk on the non-reviewed portion of loans, some frameworks are not conducive to a sample due diligence review. This is particularly true in the non-QM space, where 100% due diligence is viewed as a key offset to the weaknesses in the rep and warranty frameworks. As diligence review sample sizes and scopes weaken, more RMBS investors will be exposed to rep and warranty weaknesses that could become evident if mortgage defaults increase. In short, some of the rep and warranty frameworks evident in select RMBS deals leave room for improvement.
An initiative by the Structured Finance Industry Group called RMBS 3.0, which established consistency among various issuers’ loan level reps, was a step in the right direction. Importantly, the working group advanced a “best practices” approach with standardization and ways to easily identify differences as well as clawback provisions for loan level reps with knowledge qualifiers, which helped address issuer liability concerns without diluting investor protections. Though the initiative was never fully implemented, Fitch viewed it as a positive and constructive change. Other improvements that have been discussed widely by market participants but have not yet to be implemented include adding a deal agent, which should address weaknesses Fitch believes still exist with regards to investor reporting and communication.
Fitch’s focus and assessment of each rep and warranty framework for RMBS deals it is asked to rate is a core component of its rating analysis. Increased loss protection has been one way Fitch has worked to address weaknesses. These credit enhancement adjustments, together with loan loss model assumptions should help protect investors against misrepresentation risk greater than that observed historically.
Here’s what needs to change in reps and warranties going forward.
• Materiality clauses need to be more clearly defined. Some materiality clauses contain a testing construct, where the defaulted loan reviewer determines if the breach test passes or fails. We at Fitch view this as a weakness due to reviewer subjectivity. Clarity around what constitutes “materiality”, while subjective, can add certainty and help with the administration of the trust.
• Reporting needs to become more standardized. Some transaction documents do not precisely define the reporting or investor disclosure and in some cases investors are only provided limited information through trustee reports. A standardized and more robust template can make it less difficult for investors to easily assess the breach reviewer’s conclusion.
• More bondholder communication is needed. Despite being developed post-crisis, few transactions include bondholder communication provisions for RW&E. The inclusion of a deal agent in new RMBS could help to serve as a central point of contact for facilitating investor communication.
• Reduced controlling holder sway in certain transactions. Some issuers function as controlling holders within the RMBS transaction and the potential exists for them to make loan review decisions which may not be always be beneficial for all investors. This could prove detrimental to some deals over time.
• Underwriting exception and guideline tracking needs to be clearer. Some issuers do not provide a loan-level mapping to specific underwriting guidelines, potentially making it difficult for breach reviewers to accurately reference. Also, items listed as compensating factors for underwriting exceptions need to more directly address the exceptions.
Rep and warranty frameworks have by and large improved since the crisis. However, there remains an ongoing lack of consistency and some recurring weaknesses that are keeping some traditional U.S. RMBS investors on the sidelines. Going forward, we at Fitch will continue to work to make distinctions in rep and warranty frameworks between RMBS issuers, account for weaknesses through higher credit enhancement, and provide issuers with transparent guidance on each RMBS deals rep and warranty risk.
Rui Pereira is head of structured finance for the Americas at Fitch Ratings.