Mortgage investors still in the dark about risk details

The American Banker ran an article where the headline tells you everything you need to know about mortgage-backed securities:  Mortgage investors still in the dark about risk details.

As your humble blogger has repeated a countless number of times, until there is observable event based reporting, there are no mortgage-backed securities investors, but rather there are gamblers blindly betting.

With observable event based reporting, every activity like a payment or default on the underlying collateral is reported before the beginning of the next business day.

It is only with this level of reporting that investors have current information on the performance of the underlying collateral.

It is only with current information that investors can assess the risk of and therefore value each mortgage-backed security.

Nearly a half decade after the start of the mortgage crisis, portions of borrower vetting for securitized mortgages are still being done primarily by loan originators. 

This causes a potential risk management gap, particularly for non-Fannie Mae and Freddie Mac-backed mortgages that are bundled and sold as mortgage-backed securities. 

The buy-side recognizes this risk management gap and has responded by going on strike until such time as observable event based reporting is made available and the risk management gap is closed.

"The bond market needs to focus more on the front-end origination of mortgages. For certain, they have to do the same type of due diligence review as lenders. It can be an automated review to look at a whole portfolio to see which loans were good and which were bad. I don't see that tech on the buy side," says Christine Pratt, a senior analyst at Aite Group who specializes in lending and credit risk....

The buy-side could easily do an automated review of all the loans IF there was observable event based reporting.

However, there isn't.

The non-agency mortgage market, which has traditionally referred to subprime loans, Alt-A loans, and jumbo loans, has been relatively stagnant for the past few years, with yearly issuance of non-agency mortgage-backed securities falling from a high of $1.2 trillion in 2005 to less than $100 billion in early issuance following the 2008 collapse. 

But as the residential mortgage market starts to recover, there are some signs of a resurgence, and Pratt says there need to be more "checks and balances." 

After the crisis, there was an expansion of credit risk tech that was designed to speed mortgage processing while performing better due diligence on borrowers. This new tech included broader information such as regional price changes, behavioral tendencies to gauge a borrower's propensity to pay, automated employment and income verification, and even some early use of social network analysis to get a sense of a borrower's overall financial health....

However, at the end of the day, this new tech is insufficient.  What is required is observable event based reporting.

Two of the largest providers of mortgage risk technology, LPS Applied Analytics (LPS) and CoreLogic(CLGX), both say the tech being used by the buy side and sell side are different.

The reason for this difference is that until recently, the sell-side (aka, Wall Street) owned mortgage servicers.  The sell-side could tap the mortgage servicers for the equivalent of observable event based reporting.  No need to turn to an outside data vendor.

LPS Applied Analytics' buy-side tech leverages models that focus on gauging prepayment risk, and also determine the potential impact on a pool of mortgages resulting from the evolution of government mortgage programs, refinancing market changes and event risk such as pressures on MBS pools resulting from the European debt crisis. 

Raj Dosaj, a vice president at LPS Applied Analytics, says its sell side tech collects data from servicers and "they don't require all of the information that originators have. It's not a nefarious plan. There's no incentive to change how it's being done currently." Dosaj says there's been some policy talk about increasing disclosure thresholds for originators. 

Fascinating.  The sell-side looks at loan level data and the buy side looks at models.

What could account for this?

The buy side knows that observable event based reporting is not available so therefore it only focuses on government backed securities where they don't have to worry about credit risk.

"Origination guidelines are tighter now, but there is still a murky world to understand now things are being processed. It's not transparent. We have large data servers and can glean what's going on, but the detail of why people are rejected for loans and what the pricing is, is not fully transparent," Dosaj says. 

Dosaj stresses that for agency mortgage-backed securities, Fannie Mae and Freddie Mac are taking on all of the credit risk, so the "thing you focus on as an investor is prepayment risk, so having that information is helpful for prepayment, but it's not the same risk as when you are exposed to credit [risk]."...

Dosaj explanation confirms why the buy-side is on strike when it comes to non-agency backed mortgage-backed securities.

On the investor side, Bradley says most investors do due diligence on a sample of the loans to make sure the pool's quality matches what is being represented by the seller. "They aren't [checking loans] one by one, it's too burdensome and costly. It would definitely be prudent to get involved with some quality control."

If observable event based reporting existed in would be easy for investors to do due diligence on all the loans as due diligence could be automated.

This way investors could see all the loans in the pool that do not match what is represented by the seller.

Mortgage credit vetting has been back in the news recently, following the suit filed by the Justice Department against Bear Stearns, which is now a unit of JPMorgan Chase (JPM). That suit alleges that EMC Mortgage, a unit of Bear Streans, defrauded investors in mortgage-backed securities by misrepresenting the quality of the loans, and ignored defects among the loans that were pooled and sold to investors.... 

But what lingers, says Pratt, is the breadth of vetting of the borrowers that are in the pools of mortgages. "I would think that the [buyers of MBS] would have some better controls and I'm not sure if that's true," Pratt says.

Since they are on strike, there is no need for buyers of MBS to vet the borrowers in non-agency mortgage-backed security deals.  The buyers are not buying these securities.

There is no reason for the buyers to vet the borrowers in agency mortgage-backed security deals because the agencies absorb the credit risk.

It is only when there is observable event based reporting that buyers will a) vet the borrowers and b) return to the non-agency mortgage-backed security market.

This is a critically important step if we are to reduce the presence of and need for Fannie Mae and Freddie Mac and the government guarantee in the mortgage market.

Finally, one of the commenters on this article made a series of points that need to be addressed.

the whole point of RMBS is sound, i.e. to turn mortgages into liquid securities with dynamic cashflows so that lenders can actually extend credit to consumers and home buyers. 

Clearly incentives for good underwriting were lacking and good mortgage origination is the fundamental building block of good RMBS - otherwise it's rubbish in, rubbish out... 

From Principia's research, major investors (e.g. banks or investment management firms with exposure to sometimes hundreds of senior or AAA equivalent tranches) today wont have the operational ability to go down to the enhanced loan level/borrower credit, property or loan information unless they really need to - monitoring key performance measures of the collateral pools first will give indications of sectors that require deeper dive analysis. 

It's not practicable for investors to look at every loan in every bond and continually asses the dynamic creditworthiness or property values of every line item. 

The information is available to investors for sure, but operationally managing this level of data across a large investment portfolio remains an ongoing challenge - and that's just in the US.

The author throws out a bunch of factually inaccurate statements.

First, observable event based data is not available.  If it were, the buy-side could access it through any number of data vendors like Bloomberg or Reuters.

Second, nobody looks at every loan in every bond.  Instead, they use information technology to flag for them the loans that need their attention.  Again, this is something that could easily be provided by data vendors like Bloomberg or Reuters.

Whether the flags are set at a market level, pool level or individual loan level is the analyst's choice.

Third, it is completely reasonable to use computers to look at every loan in every bond.  Computers don't get tired and the cost to process this data is insubstantial relative to what investors lost on subprime mortgage-backed securities by not having the data and using computers to analyze the data.

The EU MBS market, where collateral on the whole has actually performed very well (better underwriting standards??), is still working on getting consistent and publicly available loan level data into the market, let alone the more dynamic credit information about the borrowers or properties.

As I have said on many occasions, what is needed is observable event based reporting.  The European data warehouse initiatives are focused on providing data updates less frequently.  As a result, the data in these data warehouses is effectively worthless.

If you're a sophisticated investor delving into a smaller number of securities to assess the intrinsic value of a mezz or equity tranche of course, you're going to want to really understand all that granular detail because you're so much closer to the risk.

Having said this in the past, naturally I agree with this observation.

For a larger investor looking at a portfolio of this stuff, you need to have to ability to dive down on the occasions you need to, but more importantly you need a consolidated way to look at all your exposures, to automate the warning signals on certain pools or tranches and to really have a single window on risk across your structured finance business.

Having said this in the past, I agree with this observation also.

And that should mean, consider a portfolio and risk management system dedicated to those requirements, not complex, operationally risky and intensive spreadsheets. 

The portfolio and risk management system follows naturally from observable event based reporting.  Observable event based reporting provides the standardized data this system would need.