[u]REQUIRED READING:[/u][/i] New legislation that would overhaul the nation's financial regulatory structure has caught the attention of just about everyone in the nation's financial sector. [/b] The secondary markets have a particular interest in the legislative details put forth by Sen. Chris Dodd, D-Conn., and his Senate Banking Committee, especially in its calls for the creation of a consumer agency that could sanction nonbank financial companies – including mortgage originators and servicers. Ongoing financial uncertainties in the domestic and international economies, which began more than 18 months ago, continue to be prolonged by a series of thorny conditions, including sclerotic loan channels, shifting borrower characteristics and – perhaps most of all – by continuing concerns about the underpinnings of private-label residential mortgage-backed securities. As a result, the investment community waits and watches, wondering whether enough improvement will materialize – driven either by government dictate or natural market currents – to recharge the secondary markets and, with it, the broader housing market, which itself fuels so much of the general economy. The most-frequently asked questions we hear begin with the words ‘When’ and ‘What?’ For instance, ‘When will the markets rebound?’ and ‘What will be securitized and what will it take for investors to make that happen?’ The smart answer to the ‘when’ question is that it looks like just about every significant investment bank will be back this year in the newly originated securitization flow. It will come no later than the fourth quarter of this year. The obstacle to securitization of newly originated product is a matter of math. At current credit qualities (high), interest rates (low) and spreads (widening, at least for now), the best execution for prime jumbo is the balance sheet. As rates climb and balance-sheet capacity declines, the financial viability of securitizing jumbo prime loans will increase. The wild card is how much credit enhancement the rating agencies will require for the credit quality. The data exist to help the rating agencies understand and deal with the extreme downside scenarios that are currently requiring outsized credit enhancement. A supply of leverage would help, as well. [i][b]Trust in us[/b][/i] To regain investors' confidence, it will take greater accountability in financial transactions, at the heart of which will be more stringent due diligence. No longer will a sample review of a securitization's contents be acceptable as representation of the whole pool. Rather, a full analysis will be expected, at least until enough confidence has returned to warrant something less. This tighter scrutiny will be demanded by the ratings agencies, which were subjected to some criticism in the past for being too-casual ‘cops on the beat’ when it came to their central role as intermediaries in the quality-assurance process. Standard & Poor's is the leader in this area and has already has gone on the record against rating future deals unless due diligence is performed by an approved firm. Fitch and Moody's have determined their own criteria for the greater due diligence they will expect and require going forward. (Fitch has said it expects heightened standards and increased transparency of new transactions will help restore confidence in the sector.) Many Wall Street firms have dedicated groups of their brightest people studying how to do these new deals correctly – to make money, of course, but also to ensure it is done in such a way as to minimize the shortcomings that have dogged the industry with many negative consequences, ranging from doubting investors to doubtful regulators and redoubtable courts. Issuers are also reconsidering stronger support from master servicers and credit risk managers. One of the loudest complaints involving these two groups has been that these gatekeepers were insufficiently empowered to rigorously represent investors' interests, in order to get ‘action’ even on some of their own recommendations. In blunt terms, credit risk managers traditionally submitted reports that many servicers promptly sent to the ’round file.’ What issuers hear from investors is usually summed up in one word: ‘accountability.’ This includes the accountability from servicers, issuers and mortgage insurance companies – especially the latter, in view of a current 30% rate of denial on claims that, frankly, leave the investor holding the proverbial bag. In more mathematical terms, the industry failed to follow its long-standing ’80-20 rule,’ which holds that when the right 20% of a file is properly scrutinized (appraisal, debt and borrower income), 80% of the problems can be avoided. It's interesting to note that in the aforementioned Dodd bill, an effort by Sen. Bob Corker, R-Tenn., to add underwriting requirements, reinforcing this 80-20 rule, failed to see the light of day – an unfortunate consequence of internal politics. Indeed, if regulations had mandated that just those three components be thoroughly and credibly verified by a qualified and objective third party, it is likely we would have had much different and better results overall. The casualties from this failed diligence around debt-to-income and loan-to-value can be seen on a daily basis. Investors are digging deeper into the root causes of why pricing has not been as transparent as it needs to be. Centralized appraisal practices mandated by Fannie Mae are believed to be addressing the collateral valuation issue (specifically, the asset valuation of the property). Lenders have also tightened guidelines and are demanding more document disclosures. All of this will serve to re-open the flow of financing to borrowers to buy homes or refinance their existing mortgages. [i]Alex Santos is president of Digital Risk LLC, based in New York. He can be reached at asantos@digitalrisk.c
