It is no secret that a lack of investor confidence in mortgage-backed securities (MBS) has all but brought the secondary market to a standstill for everything except government-guaranteed products. Rightly or wrongly, investors don't trust securities and the loans backing them, and they certainly don't trust ratings from the three traditional credit rating agencies.
The question is, how do we bring back liquidity and restore investor trust? The answer is through an audit of mortgage-backed securities and the loans backing them. A mortgage audit that provides an independent, objective assessment of risk can restore confidence and liquidity to the industry. That, in turn, will get the economy going again.
The method used by the major rating agencies has a fatal flaw: Although rating agencies create ratings based on the quality of the issuer's mortgage, agencies do not check the loan quality. They simply take the issuer's word that the loans meet lending guidelines. Instead of verifying the borrower's income, employment history, debt amounts and other factors, the agency simply accepts the provided figures.
However, auditing a security could reveal where loans fail to meet lending guidelines and uncover missing, incorrect and otherwise unacceptable items by using independent validation tools. Such third-party tools could check property ownership history, find what other properties the borrower may own, and catch fraudulent loans by verifying the borrower's name, Social Security number and employer.
A mortgage audit can provide securities ratings of good, fair or poor in the six critical areas: assets, property, income, credit, closing documents and the mortgage application. The more unacceptable or serious quality issues that are discovered, the lower the quality score will be.
Unacceptable quality issues in one or more of these six critical areas can indicate the presence of a mediocre loan, while serious quality issues in one or more areas indicate serious issues that should not be overlooked. In addition, grouping loans by quality score can provide investors a streamlined way to review a portfolio and find problem loans.
Mortgage-pool information should be arranged to show the average weighted yield, the proportion of alternative to full-doc loans and the overall portfolio. A mortgage audit will be able to show the portfolio's weighted average for documentation type, credit scores, loan-to-value range, note rate, property type, and other key considerations.
To gauge housing affordability, an audit can compare the borrower's annual income to the loan amount. That affordability can be expressed by the number of times annual income must be multiplied to reach the mortgage amount. For instance, if a borrower with a yearly income of $80,000 takes out a mortgage of $300,000, the mortgage is 3.75 times the annual income (TAI).
According to the renowned economist Robert Shiller, a Yale University professor and co-developer of the Shiller-Case Housing Index, borrowers begin having troubling meeting housing payments when the multiple exceeds 3.5. Grouping the TAI ranges provides insight into the housing affordability of the portfolio. For instance, 28% of the loans in the mortgage pool might have a TAI less than or equal to 1.99, while 29% are between 2.0 and 3.9.
Analyzing originators
The types of originators are another important factor that should be analyzed. An audit can reveal the number and proportion of third-party originators, or brokers and correspondents, compared to loans originated by the lender itself, while listing how long each originator has been in business. Investors who believe the type of originator can influence the quality of loans would be particularly interested in this data.
By ‘slicing and dicing’ data, the audit can report the credit-score average, documentation types, LTV ranges and other factors for each type of originator, helping to rate their overall quality. In addition, an audit can drill down to particular originators, underwriters, processors and appraisers to reveal the quality of the loans or properties they are producing and reviewing.
Data should be revealed in a way that is easily and quickly understood. It should be presented in a tabulated and graphic form, giving management a clear picture of loans reviewed. For instance, a pie chart could show the percentage of conforming and nonconforming loans in a pool, which would outline the risk factor. A graph could show the number and current dollar amount and appraisal value ranges of loan values by loan category, credit and lien position. Graphs could outline the current dollar amount and percentage of loan amounts, current and original appraisal value, combined LTV and net equity.
Being able to categorize loans by credit-score range is a critical function for a mortgage audit. A good audit can report the volume of credit scores below 600, scores between 600 and 639, and so forth, up to scores over 720. By finding loans with lower credit scores, in addition to lower documentation – so called layered risk – an audit will spot especially risky loans – those with the increased likelihood of defaulting.
Knowing the life of the loans, including the weighted average remaining months, how many loans in a pool have approaching rate resets or balloon payments, and the appraisal values and net equity involved, will help investors adjust their bids for securities, and will help investors and their servicers plan loan modification strategies. Investors will have a better idea of how much income – before taxes and expenses – they will derive from their investment.
For negative amortization loans, an audit could show the number, percentage and dollar amount of loans with outstanding balances over the initial loan amount due to insufficient payments.
An audit could also show data for each particular loan, including basic information such as loan amount, rate and term, but also documentation type, credit score, borrower income, the amount of negative amortization – if any – as well as more details. A loan quality score will provide a quick summary of overall characteristics.
Document quality is another characteristic that can be analyzed and revealed through an audit. Documentation from addendums to hazard insurance to Regulation Z can be verified, with space for comments and exceptions.
Evidence of history
History has proven that investors must perform their own due diligence and cannot rely on rating agencies to do their work for them. The traditional rating agencies – Standard & Poor's, Moody's Rating Service and Fitch Ratings – have taken substantial criticism for their role in the subprime mortgage debacle, the ensuing credit crunch and the economic meltdown. The rating agencies gave AAA ratings to securities that turned out to be toxic, and then were slow to downgrade failing securities. In some cases, they continued to back top ratings even while loans were defaulting in droves.
Investors who purchased mortgage securities believing they were safe because of their AAA ratings are justifiable angry. The chances of default were supposed to be remote, yet they defaulted in droves – sometimes before making a single payment.
Losing trust in the rating agencies, investors have refused to buy any security without an explicit government guarantee. Liquidity came to a standstill, and the economy went into a tailspin, as consumers and business could not get loans.
Investors have yet to regain faith. According to a recent survey by the CFA Institute Centre for Financial Market Integrity, 60% of the 1,100 members polled believe that rating agency assessments are not valid and are not helpful in making investment decisions. Most – 79% – said more needs to be done to regulate the agencies.
What went wrong? Many observers blame the agencies' issuer pay method. The issuers who made, aggregated, packaged and sold the mortgages paid the agencies to rate their product, creating an obvious and inherent conflict of interest. If an agency did not give the securities a good rating, the issuer could shop elsewhere for an agency that would.
Meanwhile, non-government mortgage securities remain stuck in neutral as investors remain leery of their quality. To bring them back to the market and restore their confidence in MBS, the industry needs a comprehensive mortgage quality review that can both perform due diligence and grade the quality of the loans. A risk management tool like that could help investors predict the probability of continued strong loan performance, compare the loan quality of different securities or whole-loan portfolios and complete their loan modification strategies.
Kenneth Dwyer is CEO of Kemdy Inc., a provider of mortgage due diligence services based in Mount Vernon, N.Y. He can be reached at (914) 667-2200 or kmdwyer@kemdy.com.
