The new ability-to-repay rule is designed to remove credit risk from the mortgage market, but investors in residential mortgage-backed securities should brace for higher potential losses in new private-label RMBS issuance backed with this kind of collateral.
A new report from Moody’s Investors Service (MCO) is clear and daunting on this point.
It concludes that mortgage bonds supported by loans outside the ability-to-repay rule’s (ATR) qualified mortgage standard "will incur higher loss severities on defaulted loans" when compared to those supported by qualified mortgages (QM).
The litigation risk alone poses the greatest threat to the investor bottom line. If a borrower defaults and sues under the ATR claiming they had no ability to re-pay the loan, RMBS pools will feel the pinch of associated legal costs and penalties.
The ability-to-repay rule and corresponding QM definition, which was outlined by the Consumer Financial Protection Bureau earlier this year, officially take effect on Jan. 10.
Under these standards, a lender can be held accountable if it’s determined the originator issued a loan that failed to meet the qualified mortgage standard as defined by the CFPB.
"In non-QM transactions, a defaulted borrower can more easily sue a securitization trust on the grounds that the loan violated the ATR rule," said Moody’s Senior Vice President Kruti Muni, the report’s co-author.
Yet, the risk varies. There is no clear answer as to when a non-QM loan poses the greatest risk to RMBS investors.
The overall risk depends greatly on the quality of the underwriting, the strength of the reps and warranties agreement and whether the deals include indemnification plans that prevent the securitizations from feeling the sting of borrower lawsuits.
The end result is likely to be a sliding scale approach, where the degree to which RMBS transactions tack on credit enhancements hinges on what agreements are in place to prevent lawsuits and the quality of the original underwriting, Muni pointed out.
As the market tries to address some of the new risks facing investors, the private-label market is preparing for a slow comeback in 201.
Moody’s is also forecasting a potential relaxation in underwriting standards as refi volumes ease. This in itself may lead to further deterioration of the credit quality tied to the loans backing RMBS pools. Ashley Gam, an analyst with the Royal Bank of Scotland (RBS) also called out refi risk in assessing the 2014 market.
That is likely to be an issue for some time considering investor protections are still not in place, and issuers of private-label RMBS are still working on how they will build the right reps and warranty agreements to account for all the risk.
"Institutional investors and RMBS issuers have not yet reached a consensus on the appropriate balance of liability and protection," noted Muni. "Investors will have to decide which R&W framework will provide a level of credit protection they deem acceptable."
