Is RMBS credit more insulated from originator woes this time around?

Investors have been watching the mortgage industry closely as it has downsized amid the sudden uptick in interest rates this year, which begs the question: To what extent will the bankruptcy-remote trusts used in private securitization protect loan performance from originator struggles?

With the private-label residential mortgage-backed securities market’s crash during the Great Recession looming large for many in that context, Kroll Bond Rating Agency recently looked into how the credit implications of the lull in origination volume compares, and concluded in a report released this week that investors are a lot better protected from credit risk now.

“We just wanted to point out that it’s not like the old crisis days where there were essentially no underwriting standards or very loosely adhered-to underwriting standards,” said Ed DeVito, senior managing director at KBRA, and one of the report’s three primary authors.

The conclusion is generally in line with credit availability indexes that the Mortgage Bankers Association and Urban Institute’s Housing Policy Finance Center separately publish.

The first, the MBA’s Mortgage Credit Availability Index, on a monthly basis compares industry underwriting to the period when it was at its tightest following the Great Recession (March 31, 2012). Compared to that benchmark, which gets assigned a value of 100, overall underwriting was at 108.8 in July, and it has been tightening this year.

While private label RMBS constitute only a small subset of the larger housing finance market today, the association has confirmed that its monthly analysis of ICE Mortgage Technology data shows that credit parameters for private originations like jumbo and other non-QM loans also generally have been tightening.

The second measure of underwriting, the Housing Credit Availability Index, found overall purchase-loan default risk in the first quarter was at a series-record low of 4.9% based on an analysis of data from Home Mortgage Disclosure Act reports, IMF, eMBS and CoreLogic. Portfolio and private-label securities risk has been at more of a plateau, but also generally was still historically low at 2.9% in the first quarter.

KBRA’s conclusion is based on the current underwriting tightness, which is reinforced by rules requiring lenders to ensure borrowers have the ability to repay and a relatively more consistent secondary-market approach to third-party reviews. Both of these were lacking in the loosely underwritten, securitized loans that massively underperformed during the Great Recession, DeVito noted.

“Now you’ve got the ATR rule, which essentially makes it illegal to originate a loan where you don’t verify income, assets, employment and the ability to repay; and then while third party diligence has always been around, with the advent of the crisis, there became more of a standardized diligence scope that all the rating agencies are are using,” he said.

Without the ability-to-repay rule in place, loose underwriting during the Great Recession contributed to total default risk above 20% for portfolio and PLS, and above 16% for the market as a whole, according to the institute. 

To be sure, today’s investors could still be exposed to some risks from originator hardships with monetary policy and interest rate direction remaining moving targets, slower loan volumes contributing to reduced issuance. Certain circumstances exist that could combine with these to create credit concerns for RMBS.

One is a situation where a mortgage company’s origination operations have flaws that affect loan quality.

“I think one big caveat to [the report’s conclusion] that we say right up front is that it’s assuming that any given lender’s loan manufacturing process isn’t suspect for some reason,” said DeVito.

However, such circumstances currently look more likely to be the exception than the rule.

“Because of ATR, and all the things we’ve been talking about, there haven’t been many originators that I could point to post-crisis that either were rogue…or had such poor internal controls and systems that those things were happening and management wasn’t aware about it. I think that’s pretty rare,” DeVito said.

If a troubled originator had a servicing arm with flaws, that could be a concern as well, DeVito added.

“The vast majority of [PL RMBS] loans are third-party serviced, but if you did have an originator retaining servicing, and if they had financial difficulties, those loans might not perform well,” he said.

Overall, the report concludes that while originators under stress due to rate volatility are likely to see more layoffs and potentially closures and bankruptcies like those at Sprout and First Guaranty, private-label securities have a good chance to bear up with tight underwriting in place.

“Because of rising interest rates, a lot of issuers got stuck with a pipeline of underpriced loans and warehouse lines started getting called and so on, so there is sort of an exogenous shock to the system, but there’s no reason to suspect that leading up to that point, that there was that there was a problem with most originators,” DeVito said.

The most routine layoffs seen since then in the market involving sales and related support staff are unlikely to affect operational integrity in ways that could affect the PL RMBS market but certain other types of large-scale cuts could.

“A lot of these layoffs we’ve been seeing [involve] origination personnel and that, unfortunately, makes sense, because that’s the variable cost part of the business,” DeVito. “What you wouldn’t want to see is companies let go [excessive numbers] of their underwriters or…appraisal review people.”

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