The concept of “skin in the game” for residential mortgage-backed securities took on new meaning in the wake of the nation’s financial crisis and has important implications in today’s secondary market as we begin to see a nascent return to private-label securitization.
The recently rated Caliber Home Loans COLT 2016-2 Mortgage Loan Trust — the first rating of a nonprime mortgage-backed securitization since the housing crisis — holds special interest for the mortgage industry. It securitizes what some would consider to be risky loans yet it differentiates itself from subprime securitized in the frothy housing market of the mid-2000s because the sponsor and securitizer are retaining a portion of the risk.
Securitization ushered in the “originate-to-distribute” model that transferred risk from the originator to the investor. Under the historical “originate-to-hold” process, banks held loans on their balance books, which gave them an incentive to make loans to highly qualified individuals because their balance sheets could suffer if they didn’t. While originate-to-distribute has many advantages, including providing liquidity to the housing market, the lack of risk retention proved to be a major weakness.
Last year, the nation’s largest credit ratings agency, Standard & Poor’s, agreed to pay $1.5 billion to settle lawsuits that it inflated ratings on risky subprime mortgages although it admitted no criminal wrongdoing. Moody’s, meanwhile, remains under a federal government probe and may be headed to court. Of course, we all know the big banks along with Wall Street investment banks also settled with the government in recent years for their role in the housing meltdown.
Will risk retention do what it was intended to do?
The ability to transfer all risk changed after the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which forced lenders to retain 5% of the credit risk for a loan sold into the secondary market that wasn’t classified as a “qualified residential mortgage (QRM).” The rule ties the definition of a QRM to the Consumer Financial Protection Bureau’s definition of Qualified Mortgage (QM) – a loan that has met certain requirements that make it more likely that the borrower will be able to repay it.
It’s been about two years since regulators issued the risk-retention rule and about a year since the market has had to comply. On December 24, risk-retention rules will become effective for all classes of asset-backed securities not just RMBS.
To be sure, it is still too soon to determine if risk retention will have the desired effect of curbing abuses or if it will get the blame for putting the brakes on private-label RMBS. Others question if, with the crisis now far in the rearview mirror, whether the mortgage market will resume its bad behavior.
Bloomberg recently reported that an analysis it performed on credit ratings for mergers-and-acquisitions (not RMBS deals) showed S&P and Moody’s bumped up their ratings by two, three or even six levels on a majority of the biggest deals. While the agencies didn’t dispute the bumps, they said human judgment not just a company’s finances, plays into their ratings. Bloomberg also reports that some underwriters of CMBS are favoring upstarts for their ratings over Fitch, S&P and Moody’s in order to obtain the highest ratings, a process known as ratings shopping.
No one to my knowledge has suggested rate bumping or rate shopping for RMBS deals post-crisis, but we only have one rated nonprime deal in the market to even talk about.
Retaining risk in a post-crisis RMBS world
Most mortgage industry players would likely agree that some risk retention is a good idea in our post-crisis environment even as they cringe under the weight and cost of new federal regulations. Certainly the market needs investors to place their trust back into the market in a bigger way if private-label securitization is to return to any significant degree.
But whether the current regulation will have the stated effect of curbing lending, ratings and securitization abuses uncovered after the crisis remains to be seen.
Unlike RMBS pre-crisis, the recent COLT 2016-2 Mortgage Loan Trust securitization benefits from an alignment of interests between the issuer and the investor, a positive ratings driver, according to Fitch. The sponsor, securitizer or an affiliate is retaining a horizontal interest equal to at least a 5% aggregate interest of the fair market value of all certificates in the transaction. LSRMF Acquisition I LLC, or an affiliate, is also retaining all the M-2 certificates, which represent 8.45% of the transaction.
Fitch also notes in its presale report that representations and warranties on 435 Caliber loans are provided by Caliber, which is owned by LSRMF affiliates and therefore aligns the interest of investors with those of LSRMF to maintain high origination standards and sound performance.
Investors’ appetite for risk returns
Over the past year or so, we have seen some evidence that the appetite for riskier RMBS is returning. COLT 2016-2 comes on the heels the non-rated COLT 2016-1 issued earlier in 2016 as well as two other non-rated nonprime securitizations that Caliber and its parent, Lone Star Funds, issued in 2015.
The fact that Caliber’s sponsor and securitizer retained the riskiest portion as well as 5% of the value of all certificates may provide comfort to wary investors who desire better yields but who don’t want a repeat of the 2007 subprime meltdown.
This article was written exclusively for GoRion.