REQUIRED READING: For the past two years, the question on everyone's mind has been, what will it take to restart the non-agency securitization market? There is a simple answer: confidence!
The three leading rating agencies and the Securities and Exchange Commission (SEC) have all mandated significant changes in the due-diligence process for pre-securitization reviews and for warehouse-line securitizations. These new industry requirements are designed to ensure the independence, transparency and reliability of due-diligence firms and processes that they follow.
These changes may be specific to each transaction and may differ based on many factors including the SEC's final rules, asset type and seasoning, as well as the rating agency guidelines for the third party review (TPR).
Moody's, Standard & Poor's (S&P) and Fitch have also published comprehensive securitization requirements. Although they may take different views on certain aspects of the review, they are fundamentally similar, with the goal of ensuring an independent and qualified TPR of data and findings.
Based on the transaction, the rating agency and client must discuss and agree upon the TPR scope and process. New requirements will most likely include the following:
- Sampling methodology,
- Review scope determination,
- Loan-level review process,
- TPR results reporting, and
- TPR qualifications assessment and attestation letter submission.
Let's consider a high-level overview of each of these requirements.
In sampling methodology, several questions are asked. For instance, does the sample selected for a review adequately represent the characteristics of the entire pool of loans being securitized? Who should select the sample? Let's start with the sampling methodologies.
Adverse sampling. Under this approach, loans are targeted for inclusion in the sample by meeting (or not meeting) set thresholds that distinguish them as being higher-risk. This methodology will most often be seen on reviews where pools are not expected to be rated or as an additional sample on top of a statistical sample.
Percentage sampling. Loans are selected randomly from the entire pool until a certain percentage (e.g., 5%, 10% or more) has been selected. This methodology will most often be used to select loans within a sample for a specific purpose, such as selecting 20% of the sample to run automated valuation models (AVMs). At this time, however, among the big three rating agencies, only Fitch requires this methodology.
Statistical sampling. Loans are selected randomly from the entire pool until enough have been selected into the sample to statistically represent the entire pool. The number of loans required to meet this criterion is based on factors set by the parties involved. Typically, these factors include setting a confidence level, a precision amount (i.e., interval or "margin of error") and an error rate.Â
It has been noted by some of the rating agencies that the individual loans for the sample to be reviewed should be selected by the TPR firm. This would be further evidence of the independence of the review.
Scope it out
We now come to the review scope determination. Determining the components of the review is critical and should be confirmed by all parties: the issuer client, any rating agencies involved and the reviewer. The rating agencies indicate that certain third-party due-diligence findings may be less applicable to seasoned loans than to newly originated loans. The following is an overview of the possible due-diligence scope requirements, broken down by newly originated loans and seasoned loans.Â
For newly originated loans, we are concerned with data quality, compliance with underwriting guidelines, property valuation review and regulatory compliance. With seasoned loans (including nonperforming loans), we are interested in updated data quality (i.e., recent credit score, occupancy based on current servicing records, modification information), regulatory compliance, current value, payment history, payment velocity, a collection comment review and a loan modification review.
Seasoned loan definitions vary by rating agency. Generally, S&P classifies seasoned loans as having had at least 12 payments prior to securitization; Moody's defines a seasoned loan as a currently performing loan that is at least 18 months from its first scheduled payment date. Generally, all loans in the pool must be seasoned to be eligible for the seasoned loan TPR; however, nonperforming loans less than 18 months seasoned that are included in seasoned pools will be eligible for the seasoned-loan criteria.
Review components may also vary based on loan type. Pre-securitization reviews can be performed on loan types including residential mortgages, reverse mortgages and manufactured housing. Specific data reports may be required for each loan type.
The rating agencies and the SEC stress the importance of data quality in their analysis of the credit risk of a loan. The capture and reporting of specific data fields may be required by rating agencies and/or the SEC. Originator data tapes received from issuers should be reviewed in order to ensure that all critical data fields are accurately included in the setup of the due diligence system. The TPR should highlight when the data value provided by the originator is unreasonable or unsubstantiated.
A closer look
Next up is the loan-level preview process. In addition to the analysis of data quality, the rating agencies typically look for the TPR to include an assessment of each loan in the sample, including the following components: credit, regulatory compliance and property valuation. As part of the process, the loan files are examined to confirm the presence, accuracy and reasonableness of relevant documents and information.Â
On newly originated loans, the credit review should include a determination that the loan met the originator's underwriting guidelines or, if not, note any exceptions and/or compensating factors. In addition, TPRs must also verify borrowers' willingness and ability to repay their mortgage. For seasoned loans, a review of borrowers' payment history on the loan will typically replace the origination credit review.
The TPR should confirm that each loan in the regulatory compliance sample was originated in compliance with all applicable federal, state and local laws, as well as predatory lending and high-cost Truth in Lending and Regulation Z laws and regulations. Any exceptions (i.e., violations) to these regulations should be noted during the review process. In the event that any loan fails the compliance test, the number of loans in the TPR for compliance may be expanded.
The property valuation review by the TPR should consider the quality of the appraisal and the property. The accuracy of property valuation is key to determining how much equity the borrower has in the property, and the TPR should indicate whether the value is reasonably supported. The rating agencies have established procedures regarding the ordering and utilization of AVM and broker-price-opinion valuations.
A grade is to be assigned to each loan based on the findings of each component (credit, regulatory compliance, property valuation) of the review. The overall loan grade will be reflected as the lowest of any component grade. Tracking and reporting of exceptions, issue resolution and loan grades by the TPR is a critical part of the review process.
The results are in
The next requirement involves TPR results reporting. New requirements include that the rating agencies receive reports regarding the scope, procedure and findings of the TPR review. The reports may include a narrative or summary of the review and a findings report.Â
The narrative or summary may require detail on such specifics as an account of how the loan sample was chosen, a summary of the overall loan grade and each component grade of the loans reviewed, and a description of any tools that may have been used as part of their independent verification of income, occupancy or property value. The TPR findings report should present details on the overall loan grade and each component grade. Explanations should be included on any exceptions or missing documents noted during the credit, regulatory compliance and property valuation reviews, and the report content and file format should be discussed with each rating agency in order to ensure that their requirements are met.
Finally, there are the TPR qualifications assessment and attestation letter submission. As a part of their credit analysis, the rating agencies say they will be taking into account the independence, competency and quality of the TPR firm doing the diligence. For this reason, issuers should select TPR firms that meet TPR standards set by the various agencies.
S&P sends an annual due-diligence firm questionnaire for the assessment and approval of the firm; sometimes, the questionnaire is sent more frequently, as it deems appropriate. Moody's established a checklist of general criteria for assessing an independent TPR provider. While Moody's does not approve TPR firms annually, it does approve on a deal-by-deal basis.
As part of the ratings process for each transaction, Moody's and S&P have requested that the due-diligence firm submit an attestation letter.
The attestation letter submitted at the conclusion of a review may include the following items:
- The TPR and its staff are independent and have no direct affiliation with the loan originator, the security underwriter or the issuer.
- The TPR acknowledges that there was no coercion or duress by any party to the transaction that limited the scope of the review or limited the firm's ability to conduct an independent and thorough review.
- The firm acknowledges that the review was completed in accordance with the rating agency's sampling requirements and loan-level review standards for credit, property valuation and legal/regulatory compliance.
- The firm acknowledges that the individual reviewer(s) and project manager(s) met the rating agency's underwriting or loan review experience criteria.
- The firm acknowledges that the rating agency will rely on the attestation and that any omissions, misrepresentations or inaccuracies may be a basis for the rating agency to refuse to rate and/or to withdraw any rating of the securities issued in connection with the transaction.
- The firm agrees to promptly notify the rating agency if it discovers that the attestation was not true when made.
The forms must be signed by an officer of the company. Going forward, due diligence will take on greater significance, and TPRs will have to meet increased requirements and scrutiny.
Vicki Beal is senior vice president of Clayton Holdings, based in Shelton, Conn. She can be reached at vbeal@clayton.com.
