HW Focus: Secondary Markets & Securitization

S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / S P E C I A L E D I T I O N O F H O U S I N G W I R E M A G A Z I N E / 2 0 1 1

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contents Volume 2, Issue 1

SECURITIZATION & SECONDARY MARKETS

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Reducing CRA reliance

Transition rates on RMBS

Investors need clarity on HPIs

Investor due diligence takes a larger role in managing risk

Gauging the potential for future loan defaults

Home Price Indices are only as useful if completely accurate

plus 2 Editor’s note

5 Secondary markets, at a glance

perspectives 07 SUE ALLON

08 TOM DONATACCIE

25 RUTH LEE

14 PATRICK BARBER

24 ERNIE DURBIN

06 JENNIFER MILLER

15 LARRY BARNETT

16 BRENDAN KEANE

ad index A LA MODE BLACKBOX LOGIC

IBC 17

CLAYTON

03

CORELOGIC

BC

LENDER PROCESSING SERVICES, INC.

IFC

R R DONNELLEY GLOBAL REAL ESTATE SERVICES

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SWBC

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Why focus on securitization?

When I approached a potential contributor to the latest HousingWire supplement and said we would be covering securitization, the answer was immediate and biting: “Why? The private market is dead.”

I can understand the reticence. Being one of only a handful of journalists who covered securitization before the Great Recession, I can understand the shell-shocked response. But the focus should not simply reflect the timing. And relevance was not always measured in the now.

S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / E D I T O R ’ S N O T E /

EDITORIAL PUBLISHER & EDITOR IN CHIEF Paul Jackson ASSOCIATE PUBLISHER Richard Bitner EXECUTIVE EDITOR Kerry Curry EDITOR Jacob Gaffney

From a forward-looking perspective, housing finance is on the lookout for changes in the way mortgages in America are funded. That means privatelabel securitization will come back.

COPY EDITOR Eduardo Rocha

Admittedly, hope for a short-term solution does not seem likely to materialize, and substantial reform of Fannie Mae and Freddie Mac remains one or two years away according to a conference call hosted by the Securities Industry and Financial Markets Association.

ART DIRECTOR Polly d’Avignon

The reason is mainly logistics. Reform of the government-sponsored enterprises will need to wait while the rest of the financial services industry begins to put forth its interpretation of the wide-reaching Dodd-Frank Act. In the meantime, “financial services remain frustrated by the inability to effectively jump-start the (private-label) securitization business,” said SIFMA President Tim Ryan.

Attendees at the American Securitization Forum’s ASF 2011 in Orlando will have several challenges ahead. The largest securitization conference will be covering all of the major issues facing the securitization markets, including regulatory reform, risk-based capital requirements, loan servicing and government-sponsored housing reform.

The pages of this Focus also address many of those issues and examine not just the private-label market, but also the challenges facing the government-sponsored enterprises, Fannie Mae and Freddie Mac. Only by working together, can we make securitization work again.

CREATIVE

DESIGNER Jessica Fung

ADVERTISING & BUSINESS ACCOUNT EXECUTIVES Christi Lingard clingard@theLTVgroup.com

Lauren Border lborder@ theLTVgroup.com MARKETING DIRECTOR Sally Powell Schall WEB EVENTS & CIRCULATION Christina Vick

THE LTV GROUP EXECUTIVE CREATIVE DIRECTOR Greg Lakloufi DIRECTOR OF INTERACTIVE SERVICES Jason Clemens DIGITAL DEVELOPERS Ron Ferguson, Jody Thigpen UX DESIGNER Joe Hair

ABOUT

Jacob Gaffney, Editor

HW Focus is published by The LTV Group, 2701 Dallas Parkway, Suite 200, Plano, TX 75093; 469.893.1480 The information contained within should not be construed as a recommendation for any course of action regarding legal, financial or accounting matters. All written materials are disseminated with the understanding that the publisher is not engaged in rendering legal advice or other professional services. The LTV Group does not guarantee the accuracy of information provided, and is not liable for any damages, losses, or other detriment that may result from the use of these materials.

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VOLUME 2, ISSUE 1 FEBRUARY 2011

© 2011 by The LTV Group • All rights reserved

Answers are why clients come to Clayton for Due Diligence.

It’s just their questions that are different.

“What’s the current LTV on these loans?”

“Are these loans “How much RESPA compliant?” has the

“Were these loans credit underwritten deteriorated properly?” on this

pool?”

877.291.5301 www.clayton.com RESIDENTIAL & COMMERCIAL DUE DILIGENCE ASSET PRICING S TA F F I N G SPECIAL SERVICING SURVEILLANCE C O N S U LT I N G I N T E R N AT I O N A L

© 2011 Clayton Holdings LLC All Rights Reserved

Bring your business into focus.

2011 TOPICS MAY: REO MANAGEMENT

ADVERTISING DEADLINE: APRIL 6

AUGUST: ORIGINATION

ADVERTISING DEADLINE: JULY 6

NOVEMBER: DEFAULT SEVICING ADVERTISING DEADLINE: OCTOBER 5

TO ADVERTISE, CONTACT: Christi Lingard 469.893.1492 clingard@theLTVgroup.com Lauren Border 469.893.1500 lborder@theLTVgroup.com

WWW.HWFOCUS.COM

The state of the secondary Secondary markets outlook is in with predictions for 2011, and a fond farewell to 2010 MOODY’S Investors Service sees incentives for private resecuritized RMBS deals will lessen in 2011 “Higher disclosure standards mandated by the FDIC safe harbor rule over the coming year will weigh on the issuance of resecuritizations,” according to analysts at the rating agency.

“As a percentage of original balance, cumulative losses from December 2009 to November 2010 for 2005-2008 vintage deals grew to 14.9% from 11.8% for subprime pools, to 9.5% from 5.7% for Option ARM pools, to 7.9% from 5.2% for Alt-A pools, and to 1.4% from 0.6% for Jumbo pools.”

THIS IS GOOD NEWS considering three points from Amherst: 1. Borrowers who are nonperforming have a low probability of permanently curing.

2. Borrowers who are re-performing have a relatively high probability of eventually re-defaulting.

3. Borrowers who are “always current” and in a negative equity position have a reasonable probability of going delinquent and eventually defaulting.

MEANWHILE agency mortgage-backed securities issuance hit an all-time high in 2010, though FTN Financial expects this number to fall in 2011.

But it’s going to be a rocky transition as three of six major upcoming investigations by the House Oversight and Government Reform Committee involve housing finance issues.

New House Oversight and Government Reform Committee Chairman Darrell Issa (R-Calif.) will lead six major investigations over the next three months. They include the role of Fannie Mae and Freddie Mac in the foreclosure crisis, the effect of business regulations such as the new Dodd-Frank Act on the economy and the Financial Crisis Inquiry Commission’s failure to identify the origins of the meltdown.

BRIGHT IDEA Read more about securitization and the secondary markets at HousingWire.com

Appeasing the GSEs Providing appraisals to the GSE will get a whole new look in two years

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By Jennifer Miller The government-sponsored enterprises have announced their implementation dates for the XML requirement for new appraisals. It looks like, for any loan originated starting Dec. 1, 2011, lenders will need the entire appraisal in XML and first-generation PDF formats if the lender intends to sell the loan to Fannie Mae or Freddie Mac. Lenders can also send reports to the GSEs in first-generation PDF format only, but the indication is that there will be a fee per report sent as a PDF. The appraisal will have to be submitted pre-funding and pass review rules. These rules will start out fairly non-specific, but as the GSEs get comfortable with the appraisal data, they will increase the scope of the rules.

We’ve polled many lenders to find out how they anticipate meeting the new standards. Many are responding with phrases like, “My vendor will handle it for me.” My response is “Really? How do you know?”

Make no mistake: This is a game changer, and it’s not exactly an easy requirement for vendors like appraisal management companies to fulfill. Some management companies out there do receive native XML today from the appraiser, but most do not.

An appraisal report can easily be 30 pages, and each individual field of data will need to be represented in a data file.

As a lender, you need to start asking some hard questions of vendors to make sure everyone’s covered, and to ensure that you are not faced with making a vendor switch without having the time to plan it.

WHAT TO ASK YOUR VENDOR Are you delivering native XML? How is your vendor receiving the XML from the appraiser? Many vendors think they have a solution for you because they use technology that attempts to extract data from a PDF file.

As you can probably guess, this process is error-prone.

It’s like trying to scan a picture and figure out what’s contained in it.

Sure, it works sometimes, but do the math: The URAR form alone has over 1,000 fields. Even at 98% field-level accuracy, 20 or more fields will be corrupted.

Some of those will be critical, and your pipeline will stop due to bad data. But there is technology out there that gets the XML data directly from the appraiser’s source file rather than trying to pull data out of an image. The XML file is actually part of the source file itself — the data from it is used to fill out the completed report. You probably

want to stick with vendors that use this technology.

Will you deliver 100% of your appraisals in XML format? A vendor may tell you they support XML, but only send it to you 80% of the time, leaving you to cover the cost of submitting only a PDF to the GSE. Demand from your vendor that they deliver XML 100% of the time. Get it in writing. If they can only submit XML 80% of the time, at least you can budget the cost of delivering only PDFs. The key here is to know what you’re getting into ahead of time. If your vendor answers “I don’t know” to whether 100% of appraisals will be in XML format, sirens should be going off in your head.

Have you verified that every piece of data in the XML file matches what is on the printed PDF? As I mentioned, the GSEs will be launching with a pretty narrow rule set initially that probably only covers a few fields. But they plan to phase in updates to that rule set.

Once GSEs make XML mandatory, it will be very easy for them to simply turn on a rule with little or no notice.

You need to make sure that your vendor has every piece of data covered, and that they’ve actually looked at it and verified it. If not, new rules could cost you considerable delays in closing.

Are you running rules against the report on the appraiser’s desktop prior to delivery? This new mandate could increase appraisal turn times — especially if the GSEs kick back an appraisal because it doesn’t pass their rules. The most effective way to ensure that the appraisal will pass the GSE rules is to check the report against those rules before the appraiser delivers the report, and to require that the appraisal pass the GSE rules before the appraiser can deliver the report as complete.

Will you have a direct connection to the GSE UCDP platform? How does your vendor plan to deliver the appraisal to the GSEs? GSEs will have a portal called the Uniform Collateral Data Portal through which all the appraisals have to come in. Is your vendor going to handle this for you, or will you be stuck to figure out a way to deliver your appraisals through the portal?

Are you supporting MISMO XML? Initially, the GSEs may support a few other XML formats in addition to MISMO. But, in the long run, the GSEs will require that MISMO be submitted and will most likely drop support for those other formats.

MISMO is the way to go, because the GSEs are committed to supporting this format. Is your vendor delivering MISMO today? They should be. That way, you won’t be faced with an uncertain future when those other file formats are dropped.

Miller is EVP of products at a la mode. a la mode is a provider of real estate software and web solutions for appraisers, agents, mortgage professionals, inspectors.

Setting a new RMBS due diligence standard For securitization, a stitch in time saves nine

By Sue Allon Despite commentary to the contrary, residential mortgagebacked markets are far from dead. Issuers have been quietly preparing deals while awaiting the Securities and Exchange Commission’s interim rules on securitizations, which were released last month.

In the run-up to the rule changes, the industry took some important steps toward putting itself on better footing for when the markets fully come back to life. Significant improvements in the due diligence process have been one highlight.

For the past two years, rating agencies have worked to comply with new mandates set by former New York Attorney General Andrew Cuomo in 2008. We worked with the major rating agencies to implement these new standards and so far have found that two of the four rating agencies issued somewhat detailed requirements that result in independent data on transactions, produced by qualified thirdparty review firms.

While these standards have some areas that need to be developed in more detail — such as what happens when there are discrepancies in compliance or valuations reviews — it’s a promising start.

Issuers also have worked to improve the due-diligence process. Over the past two years, Allonhill has worked with several major banks to develop a new standard for reviews that comply with new SEC and rating agency requirements.

Due diligence on individual loans is happening pre-securitization, an important development that may help pre-

vent loans with signs of fraud or poor underwriting from getting into securitization in the first place.

By having loans reviewed earlier in the process, prospective issuers expect these reviews will be robust enough that they only need to be refreshed, should a loan be included in a securitization later. Investors will benefit, ultimately, from a more timely scrutiny of loans that can keep them from ever being funded.

Issuers also are offering disclosures for publication to investors that were not made in the past. At this point, we’ve seen mostly summary-level statistics.

While this is a notable improvement over past disclosures, the process should be further refined as securitizations come to market over the next few months.

Issuers should work toward more standardization of disclosure documents to provide investors with useable information about the performance of individual loans in deals, so they can make fair comparisons and accumulate meaningful, comparable data.

As markets come back to life, more standardization in the due-diligence process is needed.

Third-party review firms like Allonhill need to be able to clearly say what we looked for when we reviewed a loan and to conclude objectively that what we saw was what was represented to be in the loan that was securitized — and do it in a consistent manner for every deal. Any subjectivity in these reviews needs to be removed. That will take some time.

It is important that industry partners work together to build on these important developments as we set new standards for securitizations and work to protect investors’ interests.

Allon is founder and CEO of Allonhill. Allonhill’s core business provides due diligence and risk management that support clients in meeting goals on quality, accuracy, transparency, and risk reduction.

Unlocking nonagency securitization Better upfront diligence and life of the asset surveillance are key

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By Tom Donatacci Nonagency securitizations peaked in 2005 at $1.2 trillion.

By 2010, that flow has been reduced to basically one public deal, Redwood Trust’s, valued at $238 million.

While it is unrealistic to think that we will see 2005 levels again, in the near future it is fair to ask, when will nonagency securitization return? What will the deals look like? And what safeguards will issuers have to put in place to entice investors and appease rating agencies and regulators?

Let’s start with “when.” In all likelihood, 2011 will probably not be the year that the nonagency market again becomes the primary source of liquidity for nonconforming loans.

Too many questions remain unresolved for this to occur. As an industry, we will be in a holding pattern until we see the fine details of the Dodd-Frank Act and the final rules from the Securities and Exchange Commission, and until we get a better sense of the administration’s (and Congress’) long-term plan for the GSEs. Once we know the ground rules, the next questions that will need to be answered are: Will investors accept securities backed by less-than-perfect, but still prime, collateral? Can issuers assemble and structure these deals in a way that balances risk retained and profitability? Lastly, will there be enough product available to securitize?

The outlook for the real estate recovery is another big unknown. Recently, Fitch predicted an additional 10% decline in housing prices nationally in 2011.

As 2011 progresses, there will be greater visibility and extensive debate on these issues, which will lay the groundwork for a more productive, flowing market in 2012.

Initially, future RMBS deals will most likely closely resemble the securities issued in the early days of securitization than those in recent years: basically, more traditional prime jumbo loans.

Credit scores are apt to be in the 720 to 780 range, versus the 560 to 620 scores of the past and may not be at the pristine level of the Redwood deal, which had a weighted average credit score of 768.

Eventually, these deals will be expanded to include the traditional Alt-A borrowers, such as self-employed and professional borrowers, with high credit scores and significant assets and equity.

NEW GUIDANCE ON DUE DILIGENCE In 2010, the three leading ratings agencies and the SEC all released new guidelines on what they will require in the due-diligence process for pre-securitization reviews.

These changes are designed to guarantee independence, transparency and reliability of due diligence firms and the processes that are used.

While requirements will vary based upon the transaction, asset type and seasoning, the rating agencies will expect significantly more transparency from the issuer and the third-party reviewers (TPR), including details on: • Sampling methodology • Review scope determination • TPR results reporting

• Loan-level review process • TPR qualifications assessment

For the first time, due diligence results will now be reported directly to the agencies and shared among investors in prospectuses.

The agencies also intend to review the qualifications of TPRs and will expect the chief executive officers of due diligence firms to sign letters of attestation. These letters acknowledge that the review was truly independent, that it was conducted in accordance with agency rules, and that the reviewers and their supervisors had the appropriate level of experience.

While this may create new liabilities for due diligence firms, it will help assure competence, independence and will create a high level of confidence in the diligence process.

The SEC has proposed similar rules that will seek to increase transparency and give investors a greater sense of confidence. However, one of their proposed new rules can

potentially create significantly more liability for both the rating agencies and due-diligence providers by changing their status to “experts.”

Clayton and other due-diligence providers have commented on the proposed rule suggesting that the training and work product of TPRs should not be held to the same standard as professionals, such as accountants, engineers and lawyers.

If left unchanged, we believe “expert liability” may have unintended consequences. In addition to higher due-diligence costs, it may shift reviewers from larger, more established firms to smaller startups without deep pockets or the quality control processes found in the larger firms.

It might also mean that more due-diligence work would be performed by in-house issuers, which, of course, would undermine the objective of third-party independence.

While the SEC has recently extended a “no action” letter to omit requiring ratings in registration statements, this issue has not yet been definitively resolved.

SURVEILLANCE TO IDENTIFY FUTURE PROBLEMS While improved due diligence should give investors a better sense of what is backing their bonds, it doesn’t protect them from fraud, nor does it protect them from servicing or transaction errors on a go-forward basis. For these reasons, we expect to see a greater use of surveillance on nonagency and perhaps even agency MBS. Credit risk management, or surveillance as it is more commonly known, was becoming a more important safeguard for private label MBS just prior to the market meltdown.

Historically, deals that had a CRM protected the interests of investors over the life of the bond, and reduced losses as evidenced by documented recoveries. In fact, for every dollar spent on surveillance, more than four times those dollars were typically recovered or not lost for investors in the first place.

Dodd-Frank and Moody’s have both highlighted the value of surveillance in future transactions.

For example, Moody’s, in its ratings methodology report, noted that post-securitization forensic reviews provide greater servicer accountability and can identify and remedy rep and warrant issues.

Even though we think credit scores will be higher, initially, for loans in new securitizations, servicers, master servicers and trustees are being asked to do more with less regardless of credit quality.

The regulatory environment continues to change and more servicing complications are introduced with every new government program. System limitations and the high number of manual processes in each of these organizations increase the opportunity for error. Surveillance provides oversight and assurance that all parties are performing as required in transactions and evolving industry best practices.

Additionally, if vertical risk-retention guidelines become required practice, proper surveillance will be a critical factor for interested parties to maximize cash flow, an area where Clayton has seen errors with increasing complexity and bond impact.

And lastly, surveillance firms will have database infrastructure and reporting solutions developed to house and manage the large volume of new data required as part of the financial reforms.

By centralizing these data capabilities with a surveillance provider, interested parties will experience reduced financial and resource investment to maximize the benefits of new data.

As we enter 2011, the nonagency securitization market remains in a state of suspended animation. New rules will be formalized, investors will become more comfortable with products and their respective yields, and housing will begin to right itself. This sequence of events should lead to signs of life for nonagency securitization in late 2011 and into 2012.

Clayton Holdings is a leading provider of customized risk analysis, loss mitigation and operational solutions for the secondary market.

Reducing reliance on credit rating agencies

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Investor due diligence takes on larger role in managing securities portfolios

BY DOUGLAS LONG

THE NATION’S CREDIT-RATING AGENCIES HAVE BEEN GIVEN SOME REPRIEVE. Uncertainty surrounding the repeal of Rule 436(g) in the Dodd-Frank Act froze new issuance activity temporarily as rating agencies refused to allow inclusion of their ratings in registration documentation. The rule exempted rating agencies from “expert” designation, preventing them from being held liable for the ratings they attach to securities. Its potential to detrimentally affect 2011 new issuance was effectively eliminated with the indefinite extension, or at least hold up, of the SEC’s no-action position back in November. However, the vilification of the major ratings agencies seems to have abated somewhat as the rational view that they are, in fact, systemically important to a fully functioning securitization market takes hold.

The agencies have done a lot of soul-searching. They have taken huge strides to improve the integrity of ratings methodologies and their public perception.

But the shifting sands are yet to define a new, consistently applied role for these third-party independent evaluators — or what the legislators are trying to label “experts.” Dodd-Frank recognizes that credit ratings played a role in the mismanagement of risk by large financial institutions and investors. But the cycle of incentive misalignment, the originate-to-distribute model and, fundamentally, investor propensity to not question the validity of ratings was as much, if not more, to

blame. Just because the ratings houses were seen to be the experts, at no stage should that ever have suggested they knew it all. A rating is an expert opinion on creditworthiness, incorporating a view of future performance.

It’s not a fact imparted by an oracle. How often would you trust an opinion as fact without the counterpoint of independent understanding to make an informed and confident decision?

There is some divergence in U.S. reform with regard to the use of ratings, which makes it difficult to actively enforce investor due-diligence guidelines. Dodd-Frank aims to improve the quality and reliability of agencies’ ratings by implementing internal and external control structures, increasing their liability exposure and promoting a more transparent rating process. However, at the same time, it seeks to eliminate almost any kind of reliance on external ratings by investors and regulators.

These efforts pull in opposite directions, attempting to strengthen the ratings process while undermining the future importance of external ratings to the system.

LET BANKS RATE THEIR OWN One solution under consideration by U.S. regulators in December was to let banks devise their own ratings for the securities they own, only loosely based on exter-

nal ratings. Focus is now shifting to investors as they are advised not to rely solely on ratings to know their investments, but are also pushed toward performing their own ongoing and independent understanding of asset creditworthiness and portfolio performance.

Meanwhile, European Union rules implemented on Dec. 7 mandate that all rating agencies promoting their evaluations for use in the region must apply for registration. As in the U.S., they, too, address conflicts of interest in the issuer-pays model and demand greater transparency in the disclosure of methodologies, internal models and key rating assumptions. The aim, as with new securities regulation at almost every level, is to give investors all the tools to perform better due diligence.

In Europe, the drivers for ratings quality and credit rating agencies’ oversight are slightly different. External ratings are fundamental to the implementation of the Basel 2 enhancements. Getting the ratings process right is a must for the regulators in order to get the regulation back on track as a credible rulebook for capital measurement and bank capital standards.

The use of ratings is already more interwoven with the EU banking system than it is with the U.S. system. Ratings there are a standard measure to allocate bank capital for securitization and a basis for collateral eligibility in major funding tools such as the European Central Bank’s Repo Facility and the Bank of England’s Discount Window Fa-

cility. In the U.S., rating agency reform is actually preventing swift implementation of Basel 2-type rules on investors or mandating them to “know what they own.”

The bottom line is that international reform all aims to improve the core aspects of investor due diligence. In Europe, the Basel 2 Securitization Framework Enhancements in particular will penalize bank investors that don’t perform sufficient, ongoing due diligence in the analysis and stress testing of their structured finance portfolios.

So while ratings have been given the green light, any overreliance on these by an investor or rather, an insufficient understanding of the assumptions that form those judgments will now result in big capital charges.

DISCLOSURE AND TRANSPARENCY In the U.S., the Dodd-Frank Act and the SEC’s Reg AB show more of a drive toward enforcing issuer disclosure and transparency. While there is no legislation forcing investors to perform a standard level of due diligence, the lack of full rating agency backing, or commitment to use ratings within the regulatory framework, are a clear sign that investors must perform their own credit analysis to truly understand the securities in which they invest.

Anyone buying into securitizations from 2011 — even triple-A investors — will want to have a thorough understanding of the cash flows related to any tranche

S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / F E AT U R E : R E D U C I N G R E L I A N C E O N C R E D I T R AT I N G A G E N C I E S / HW FOCUS / 12

The BOTTOM LINE is that international reform all aims to improve the core aspects of investor due diligence.

they invest in. This will be vital to satisfy the regulators and to have the conviction and confidence to be decisive in either investment or divestment.

Investors will need to understand the historical, current and forecasted performance of collateral and its effects on payments through the waterfall. If there is a concern about a pool of mortgages, investors need to be able to drill down to see loan performance at a more granular level. The U.S. is more mature than the EU in terms of the loan data, full cash-flow models and collateral performance information available.

According to a recent Principia survey, more than 60% of U.S. and U.K. investors plan to increase their activity in the asset-backed securities and mortgagebacked securities markets in the next 12 months.

More than two-thirds of those stated that, with their current infrastructure, they were less than effective at accessing and physically managing the universe of information required to effectively and confidently analyze, manage and report on their structured finance portfolio.

With increasing disclosure and more standardized data available in the U.S. and Europe, investors are now

looking to implement better ways to manage their operations, derive real meaning from the data available and consistently use it as a basis to inform their assumptions about the performance of assets.

As systemically important as ratings are, whatever the final model for their use, investors will not be able to place the same level of reliance on them.

Investors here and abroad are confronted with the challenges the new paradigm presents: How to bring all the new information from issuers, rating agencies and data vendors together in a single operational framework for their structured finance portfolios; how to do this in a way that ensures they can prove they know all of their investments at every stage of the lifecycle; how to manage their entire portfolio of ABS and MBS assets in a scalable way, now and in the future.

Only then can investors feel that they have truly reduced their reliance on ratings.

Ratings will however remain a valuable source of independent analysis and expert opinion — a benchmark from which to verify or disprove investors own analysis and assumptions.

Doug Long is executive vice president of business development and product strategy at Principia, a technology provider that builds and integrates ABS/MBS instruments and structured credit derivatives capabilities into software solutions.

Credit rating agency reform: Why the best action is no action

BY JACOB GAFFNEY In a strange turn of events, the Securities and Exchange Commission recently extended its no-action position against the credit-rating agencies.

It’s strange, because it seems regulators are struck with an acute case of amnesia. And honestly, it’s not such a bad affliction.

The SEC is currently reinventing itself as a regulator with some serious enforcement behind it, most notably in the Goldman Sachs $550 million levy. However, the message is now that the rating agencies, which largely escaped massive scrutiny under the Dodd-Frank Act, are not only vital to the securitization process, but also able to self-improve and self-regulate.

To be clear, the markets are all for no action against the credit-rating agencies. The SEC announcement removes an element of uncertainty from asset-backed securitizations.

“Although new regulatory challenges still remain for issuers, the SEC has eliminated an otherwise intractable obstacle to new issuance,” said Royal Bank of Scotland analysts Paul Jablansky and Brain Lancaster in a note to clients.

Some history first. The Securities Act of 1933 exempts rating agencies from being considered experts that contribute to the creation of the offering documents. Dodd-Frank repeals that exemption.

The result was that the rating agencies refused to follow the Dodd-Frank reform, and Fitch Ratings, Moody’s Investors Service and Standard & Poor’s all released statements that day saying none were willing to take “expert liability.”

The much-ballyhooed attempt by Congress to rein in the credit-rating agencies led to a standoff with the SEC, freezing the ABS markets in the interim.

And according to a letter from the SEC, it appears the regulator is going soft again, and with good reason.

“We understand that the rating agencies continue to indicate that that they are not willing to provide their consent at this time, and that without an extension of our no-action position, offerings of asset-backed securities would not be able to be conducted on a registered basis,” writes Katherine Hsu, SEC senior special counsel. “Given the current state of uncertainty in the asset-backed securities market and the benefits to investor protection resulting from Securities Act registration, the division is extending the relief.”

In the end, cooler heads are prevailing, as the SEC extension allows for both the implementation of regulations but without shutting down newly issued ABS. As with the Cuban Missile Crisis, the American public may never know how close it came to getting vast swaths of available credit wiped out in the new year.

And the SEC is once again allied with the secondary markets in an implicit nod to the necessity of credit rating agencies, which, it should be mentioned, have made considerable strides in tightening and improving rating methodology.

“It certainly alleviates the significant risk of a primary market issuance shutdown in late January,” write Barclays Capital researchers Joseph Astorina and Sarah Johns. “It also allows the securitization industry and regulators additional time to craft a compromise solution that would maintain robust public securitization markets.”

But the effectiveness of this inspired solution is contingent on Congress not getting wind of it. For the moment, the problems wrought by loose credit ratings in the run-up to the housing bust appear largely forgotten.

Good will is at an all time high and markets needed some positive news.

Let’s just hope the word doesn’t get out.

WHAT EXACTLY ARE YOU HOLDING? Informed portfolio decisions begin with RR Donnelley.

Understanding the assets in your portfolio and how to service them is a must in this economy.

RR Donnelley helps you truly know your portfolio by ranking loans for risk, providing loan-level detail on loan pools, and much more. And we can process files once you make the best decision.

Contact us and get the full picture on your portfolio.

800.773.4577

www.rrdonnelley.com www.realestate.rrd.com Copyright © 2011 R. R. Donnelley & Sons Company.

All Rights Reserved.

Return to profit Repurchases are too important to be left to random selection

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S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / P E R S P E C T I V E S

Patrick Barber As the industry continues its return to profitability and the private sector assumes more of the risk that is now borne by government, many leading participants tell RR Donnelley’s global real estate services group that one of the biggest challenges they face is the growing number of mortgage loan repurchase requests.

It goes without saying that the pre-2008 private-label securitizations and their contingent repurchase obligations — essentially standing behind the representations and warranties made at the time of the securitization — are a major contingent liability of the banks and investment banks that packaged those securities. But even traditional agency production is under a microscope as never before. The agencies have stated that a key operating goal is to recover losses through repurchases. They are doing so by focusing on uncovering misrepresentations and underwriting errors in defaulted loans and requesting a repurchase by the seller.

Many agencies are concerned that if the problem isn’t solved collectively, there is a real risk, that, first, responsible originators will exit the business, thus leaving only those participants with little to lose; and second, the agencies will become less relevant, as originators become more reluctant to sell to them.

As an originator, it is more difficult than ever to be really sure you have “sold” a mortgage in this environment, especially with these repurchase efforts in place. Even if you believe that you have underwritten and delivered a loan correctly, the cost involved in defending that decision may become prohibitive. From an accounting perspective, if an originator is under consistent pressure to repurchase sold loans, appropriate reserve requirements reflecting this contingent liability will only increase.

The conventional strategy of relying on a traditional random-sample quality-control initiative — either prefunding or post-closing — will not yield the originators’ desired outcome, which is to flag and uncover loans that have the potential to end up back on their balance sheet.

This method relies too heavily on human interaction and

judgment, which is prone to error, and on the hope that the random sample methodology will be accompanied by enough luck to uncover the proverbial needles.

One effective, but costly, alternative is to re-underwrite every loan. By re-underwriting every loan, you are likely to approach Six Sigma-level effectiveness in reducing errors.

However this “double-key” processing approach (think check processing) is very costly, and may result in an operating cost structure that is unsupportable.

The other path to effectively reducing defective loans is to use highly accurate predictive models in the process to identify the most likely offenders. By building this important layer into its quality control practices, an originator will be well positioned to implement an effective process.

Perhaps the most logical way to solve for this is by using loan-level data from production — as well as third-party sources — to develop those models that adversely select the population for quality control review. At RR Donnelley, we have built a number of predictive models that we use every day in our forensic loan underwriting platform.

These models allow us to take a population of defaulted or currently performing loans and identify those most likely to contain a material misrepresentation or underwriting error. The models are based on years of experience, and are refreshed monthly with new data. Our models are accurate in the 90th percentile and higher, with false positives in the mid-teens.

Consider a pool of 1000 loans — performing or nonperforming. If there are 100 defective loans, our models will flag approximately 110 loans as potentially defective, and in that subset will be approximately 90% or more of the actually defective loans. These models and quality data sets take time to develop, but the payoff can be significant.

This allows RR Donnelley to more intelligently address capacity and staffing issues as a due-diligence provider, as well as to continuously improve our own quality control process. For an originator, the cost benefit can be the difference between exiting the business and thriving.

Barber is business developer for RR Donnelley. RR Donnelley is a global provider of integrated communications, developing custom communications solutions that reduce costs, enhance ROI and ensure compliance.

Securitization data gets richer Interest in loan-level RMBS data among investors and dealers is at an all-time high

By Larry Barnett Following the credit crisis, RMBS market participants are placing less trust in the third-party proprietary models and devoting more attention to their own analytics to assess the expected performance of deals and track performance on an ongoing basis.

The Securities and Exchange Commission identified the lack of accurate, comprehensive and timely data summarizing deal performance as a key contributor to the credit collapse and implemented new rules related to data when it passed Regulation AB last year. The rules will put more loan-level data in investors’ hands. The question remains: Will they use it?

Luckily, the increased demand for improved analytics solutions is driving innovation.

Over the past year, loan-level data providers and analytics firms have delivered better quality data and introduced useful analytics platforms at price points that allow broad access to tools once restricted to institutions with multimillion dollar IT budgets. These advancements make loanlevel RMBS data not only richer and more comprehensive, but also more useful.

Our experience at BlackBox Logic has been that the best workflows start with the best collateral information.

Up until very recently, investors were limited to incomplete collateral information to make investment decisions.

Common problems included inaccurate base-case scenarios in predictive models and incomplete delinquency and loss information in the loan-level history.

Today, investors not only have access to loan-level data that fill these gaps, they can add new layers of data on top of the base dataset, including credit scores and property values that can be updated monthly. Additionally, they can compare the deal to a nearly unlimited combination of other loans — choosing from several hundred loan characteristics covering broad spectrums

of the RMBS markets.

Innovations by vendors including Thetica Systems, Storm Harbour, Ranieri Partners, Algorithmics and Five Bridges are allowing investors and dealers access to advanced analytics tools that before were mostly restricted to large institutions. Common cash waterfall models are now integrated with the industry’s most comprehensive loan-level dataset, and third-party modeling vendors now include the most comprehensive collateral views in their predictive algorithms.

The increased DEMAND for improved analytics solutions is driving innovation.

Innovations in the way loan-level data is produced and integrated with outside systems, and in the tools used to manipulate the data, have leveled the playing field among the largest institutions and smaller firms, leading to better risk-management practices and RMBS insights across the industry at a time when investors and brokers are hungry for new solutions.

Investors and dealers should expect this type of innovation to continue this year as the industry adjusts to meet their renewed interest in reliable and easily usable loanlevel data.

BlackBox Logic is a data aggregation service offering a comprehensive database of loan-level collateral underlying nonagency residential mortgage-backed securities for investors, broker/dealers and researchers.

Technology helps build the bridge Bond ratings, as a proxy, may not be enough to deepen RMBS credit understanding

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S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / P E R S P E C T I V E S

By Brendan Keane While technology alone will not restart the private-label residential mortgage-backed securitization market, it can provide a significant bridge to help investors and other market participants regain their confidence in securitization as an acceptable financial strategy and in RMBS as a viable investment option.

Over the past four years, nonagency securitization has all but disappeared.

The why is simple: There was and is a massive lack of trust in the expected performance of RMBS. Restoring that trust and rebuilding confidence will take time, and will require dynamic tools to help investors better understand the creditworthiness of loans underlying U.S. residential mortgage securitizations. Greater insight and transparency will be needed into straightforward aspects of the collateral such as borrower’s credit, property value and equity, ownership, and so on, as well as into more arcane issues, such as financial engineering and deal structuring. However, even “straightforward” concepts will attract attention, as recently witnessed with property ownership issues being questioned in connection with the robo-signing controversy.

The lessons learned over the last few years have come at a steep price, as many participants understood little of the risks underlying their securities. Certainly, one of these lessons has been that better technology is needed to predict performance, enhance loss mitigation and demonstrate to investors, regulators and policymakers that our industry won’t repeat past mistakes.

In the face of legislation and increased regulation stemming from the market crisis, it is imperative that potential investors and issuers alike have the ability to quickly and efficiently address fundamental risks inherent in RMBS transactions. Technology available today has improved the ability of those market participants to obtain dynamic perspectives of a variety of credit and related risk elements.

GETTING BACK RMBS CREDIT UNDERSTANDING Over the years, investors relied more heavily — some may say too heavily — on bond ratings as a proxy for risk.

Going forward, investors will increasingly have to reach these decisions themselves. However, that task is not as

daunting as it once was: That first step toward returning to the market (the “On Ramp”) can be done without exacting a tremendous upfront toll.

New, improved and cost-efficient delivery methods for examining underlying loan quality and other key RMBS elements exist today: PROPERTY VALUES Automated valuation models, broker price opinions, as well as new hybrid products and approaches, such as AVM cascades, can provide more accurate, more dynamic insight into the underlying collateral. There are even new tools to identify silent seconds that may have been added post-origination and pre-securitization.

BORROWER CREDITWORTHINESS The ability to understand a borrower’s willingness and capacity to pay, among other risks, has been greatly enhanced in just the last few years with great leaps in income verification, owner-occupancy, consumer credit monitoring, fraud detection and even behavioral modeling.

The onslaught of putbacks and litigation from poorperforming RMBS transactions and whole-loan sales will also, in our opinion, integrate these technology advances further into the origination and sales processes.

Next-generation technology exists to allow sellers to quickly aggregate data from hundreds of sources, providing a comprehensive borrower view in real time. Credit, fraud and loan application checks can be done instantly right up to the time of a loan closing to prevent a seller from erroneously misrepresenting loan, credit or other relevant metrics.

BETWEEN THE PILLARS A bridge supported by the twin pillars of credit transparency and due diligence can be a helpful metaphor for RMBS. Unfortunately, many market players inspected the strength of a structure only once, at the time the issue came to market.

If fundamental risk elements of the transaction changed over time, it would not be obvious until delin-

quencies or defaults attached to the deal — often too late for many investors, as ratings downgrades would lead to forced selling, writedowns and the eventual spiral of distrust we have witnessed over the last several years.

A better way to ensure the ongoing soundness of RMBS transactions would be for the securitization market and, perhaps, its regulators, to insist on some form of loan-byloan, or life-of-securities and monitoring of RMBS credit performance combined with predictive modeling. Fortunately, it would seem that the recent Dodd-Frank Act, Regulation AB proposals, and the American Securitization’s Project Restart reinforce this approach.

Monitoring of RMBS performance with updated borrower and property information can also be incorporated into many of the bond cash flow models now in use throughout the market.

For example, integrating home price index data or dynamically updating loan-to-value estimates on properties contained in a security would dramatically enhance the market’s understanding of RMBS performance — for too long the market relied upon an overly static approach of examining original LTVs and borrower credit scores.

Fortunately, the technology exists to update property values through AVMs while also compiling all outstand-

ing liens on a property: dynamic insight into underlying property value and borrower debt load.

THE OTHER SIDE One of the fundamental components to achieving a transparent understanding of RMBS credit risk is a rigorous due diligence approach.

The RMBS industry, particularly regulators, investors and issuer-sellers must embrace diligence to assist them in deconstructing and evaluating loan portfolios and securities.

Formal due diligence programs that regularly monitor and update the creditworthiness of securities could provide the first view into potential problems, thus anticipating poor credit performance, rather than reacting to seemingly unexplained delinquency levels.

Using proven, cost-efficient applications, originatorsellers and investors can implement creditworthiness approaches that focus on relevant credit and collateral risk attributes specific to the loans underlying a security.

Those results can provide market participants with comprehensive transparency, whether mandated by law or market practice, that will help re-establish investor, regulatory and public trust in the RMBS securitization paradigm.

Keane is SVP of the Advisory Data Valuation Group at CoreLogic. CoreLogic uses vast stores of mortgage data to form their core businesses.

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S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / F E AT U R E : T R A N S I T I O N R AT E S O F P E R F O R M I N G R M B S LO A N S

Transition rates of performing RMBS loans Monitoring delinquent status helps gauge potential for future defaults

BY DIANE WESTERBACK

For U.S. residential mortgage-backed securities, Standard & Poor’s Ratings Services believes that examining the rate at which loans move from one payment category to another — for example, from current status to 30 days delinquent, or from 90 days delinquent to foreclosure — can provide clues to the likelihood and timing of future defaults.

We recently analyzed the movement of RMBS loans over specified 12-month periods between each payment and delinquency category, with a focus on loans for which we have found that transitions to default are most difficult to predict: those that currently have no payments past due. This group of loans includes both those that have never missed a payment (which we refer to as “always current” loans) and those that are not currently past due but have missed payments in prior months (“now current” loans).

We believe loans in these categories warrant separate analysis because their delinquency status at a given point in time may fail to give a complete picture of the loan’s payment history. This is especially true for “now current” loans, many of which may have been seriously delinquent in the past, experienced erratic payment patterns, or undergone a loan modification.

For both “now current” and “always current” loans, we analyzed the most recent 12-month transition rates (between October 2009 and October 2010) for prime, Alternative-A and subprime collateral and also took a closer look at how these loans have performed since 2007. The sample of loans we analyzed includes all firstlien securitized loans from 2005 to 2008 vintage transactions available through LoanPerformance, a unit of First American CoreLogic.

Our analysis shows that the rate of transition for nondelinquent subprime and Alt-A loans to serious delinquency status has been declining since late 2009, and nondelinquent prime loans have also experienced a slower transition to serious delinquency over the past few months. We believe this trend may indicate a slowdown in new defaults for each of these collateral types.

PAST 12 MONTHS LOAN PERFORMANCE Although all “current” loans in a given month are meeting their payment obligations at that time, our analysis revealed significant differences in subsequent

payment behavior between “always current” and “now current” borrowers. We observed that “always current” loans, as of October 2009, significantly outperformed those that were “now current” over the subsequent 12-month period across all collateral types. For loans in the “always current” bucket, 97% of prime, 89% of AltA, and 80% of subprime loans remained current or had paid off in full as of October 2010; this compares with 90% of prime, 73% of Alt-A, and 62% of subprime loans in the “now current” bucket that remained current or paid off over the same period.

As we expected, the “now current” loans also transitioned into severely delinquent status at a much higher rate than the “always current” loans over the same period. The difference was the greatest for prime loans, as the percentage of “now current” loans that rolled into the 60-plus-day delinquency bucket was nearly three times that of “Always current” loans. Alt-A “Now current” loans transitioned into serious delinquency at more than twice the rate of “always current” loans, and subprime “now current” loans at nearly 1.8 times the rate. (See the appendix for a more detailed breakdown of the transition rate for each delinquency bucket. (See table 1)) While our transition analysis identified differences in performance between “now current” and “always current” loans, we believe that analyzing these relationships over time will help to put the recent performance in context.

TRANSITIONS TO DELINQUENCY We have found that observing the 12-month transition rates for a series of successive periods provides a better sense of how the “now current” and “always current’ buckets have performed over time. (See charts 1 and 2, which compare transitions into 60-plus-day delinquency — including liquidation — status starting in the September 2007 to September 2008 period and ending with the October 2009 to October 2010 period.)

The transition of “Now current” subprime and Alt-A loans peaked in October of 2009, when just over 42% of subprime loans and almost 27% of Alt-A loans had become 60-plus days delinquent over the prior 12 months.

Both figures have declined considerably since then, to 27% and 19%, respectively, for the most recent period.

The transition for “Now current” prime loans, however,

increased steadily from around 3% in the September 2007-2008 period to a peak of 7% in August 2009-2010, but has since declined slightly.

(See percentage of “now current” loans chart) The same patterns held true for loans that have never missed a payment, although the transition rate to serious delinquency was considerably lower. Transitions for both subprime and Alt-A “always current” loans have declined over the past year after rising in prior periods, while prime transition rates showed a more steady increase, peaking at around 2.5% in January 2010 before slightly tapering off to 2.2% in October 2010 (See percentage of “always current” loans chart).

SPECIFIC DELINQUENCY TRANSITIONS Applying the same transition methodology, we further broke down our analysis to look at more specific delinquency transition scenarios, both within and beyond the 60-plus-day category. (See subprime, alt-A and prime charts representing the distribution of loans from the “now current” and “always current” buckets at the end of each 12-month transition period.) We observed the following trends in each category in the Subprime “now current” loans in Chart 3: 1. Transitions to “prepayment” status have declined considerably since the September 2007-2008 period, but have been steady since early 2010.

2. Transitions to all delinquency categories taken together have been falling since first quarter 2010, from around 50% at the beginning of the year to less than 40% in October.

3. Of the loans that transitioned into delinquency, more are remaining in the 90-day delinquent bucket, which has caused the foreclosure and real estate owned (REO) buckets to shrink.

The majority of “always current” loans still had not missed a mortgage payment at the end of each of the 12-month transition periods, and the percentage of loans that remain current has been increasing since first-quarter 2010.

The percent of loans that missed a payment during the transition period but were “now current” at the end

SEE CHARTS AND TABLES RELATED TO THIS STORY ON FOLLOWING PAGES

of the period has remained consistent (at around 8%) over time.

An increase in the percentage of 90-plus-day delinquencies offset declines in the foreclosure and REO buckets, and may indicate longer foreclosure timelines.

As with subprime loans, the percentage of Alt-A loans transitioning into delinquency has been trending down after peaking in October 2009 at roughly 35%, although the decline has been more moderate than for subprime loans.

Transitions to delinquency have declined over the past year to less than 30% in October.

The prepayment rate has also decreased since the September 2007-2008 period, but has been relatively consistent since the third quarter of 2009.

Most borrowers still had not missed a mortgage payment at the end of each 12-month transition period.

Transitions to delinquency were considerably lower relative to the Alt-A ”Now current” bucket, but peaked at around the same time (October 2009).

The percentage of loans that prepaid has been relatively consistent (at about 7.5%) since early 2010.

Transitions to delinquency have steadily increased, from around 5% for the September 2007-2008 period to 10% as of October 2010, but in our view appear to be stabilizing.

The percentages of loans that prepaid over these 12-month time horizons peaked in the first quarter of 2010 but have decreased slightly in more recent months.

While transitions to delinquency have increased steadily since the third quarter of 2008, the percentage remains extremely low — at less than 5% as of October 2010 — relative to the total.

The percentage of loans that prepaid peaked at just over 20% in early 2010 before entering a seven-month decline, and have since returned to near-peak levels as of October 2010.

(See 12-month transition rates table.)

Standard & Poor’s is a credit ratings agency. Diane Westerback is managing director of Global Surveillance Analytics. Primary credit analysts Brian Grow, Daniel Larkin and Nancy Reeis contributed to this report.

Prime

CHART 1 Percent of ‘now current’ loans that transitioned into 60+ within 12 months

Alt-A

Liquidation

Subprime REO

Foreclosure

50 45 40

20

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/

Percentage

30 25 20 15 10 5 0

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04/0804/09

06/0806/09

08/0808/09

10/0810/09

12/0812/09

02/0902/10

04/0904/10

06/0906/10

08/0908/10

10/0910/10

12/0812/09

02/0902/10

04/0904/10

06/0906/10

08/0908/10

10/0910/10

CHART 2 Percent of ‘always current’ loans that transitioned into 60+ within 12 months 30

25

20 Percentage

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35

15

10

5

0

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TABLE 1 12-month transition rates for ‘always current’ and ‘now current’ loans, as % of October 2009 balance

AS OF OCTOBER 2009 COLLATERAL TYPE

INITIAL DELINQUENCY STATUS

AS OF OCTOBER 2010

BEGINNING BALANCE (BIL. $)

% CURRENT OR PAID IN FULL

% 60+ DAYS DELINQUENT (INCLUDING LIQUIDATION

Always Current

263.3

97.1

2.2

Now Current

29.5

90.0

6.3

Always Current

399.2

88.6

8.8

Now Current

102.4

73.0

18.8

Always Current

121.9

80.2

15.3

Now Current

97.5

61.6

26.9

PRIME

ALT-A

SUBPRIME

9

TABLE 2

PERCENTAGE PAID IN FULL

PERCENTAGE LIQUIDATED

PERCENTAGE IN REO

PERCENTAGE IN FORECLOSURE

PERCENTAGE 90 DAYS DELINQUENT

PERCENTAGE 60 DAYS DELINQUENT

PERCENTAGE CURRENT

PERCENTAGE OF TOTAL BEGINNING BALANCE

BEGINNING BALANCE (BIL. $)

INITIAL DELINQUENCY STATUS

COLLATERAL TYPE

PRIME ALT-A SUBPRIME

PERCENTAGE 30 DAYS DELINQUENT

CURRENT DISTRIBUTION BY DELINQUENCY STATUS AFTER 12-MONTH TRANSITION PERIOD

12-month transition rates for each delinquency bucket

Always Current

263.3

84.9

78.5

0.8

0.4

1

0.5

0.1

0.2

18.6

Now Current

29.5

9.5

77

3.6

1.4

3

1.5

0.1

0.3

13

30+

4.5

1.5

40.6

13.9

6.4

17.6

10.2

1.2

3.4

6.7

60+

2.2

0.7

27.8

6.6

5.5

27.1

17.4

2.8

7.5

5.2

90+

5

1.6

18.9

2.5

1.8

32.2

23

4.1

13.1

4.3

Foreclosure

4.9

1.6

8.5

1.1

0.7

9.8

37.7

8.8

29.1

4.2

REO

0.7

0.2

0.2

0.1

0

0.3

1.2

8.7

87.5

2

Always Current

399.2

55.70

80.9

2.5

1.4

4.3

2.1

0.3

0.7

7.7

Now Current

102.4

14.30

68.9

8.2

3.8

9.2

4.4

0.5

0.9

4.1

30+

34.9

4.90

33.2

14.1

7.7

23.9

12.9

2.1

4.3

1.9

60+

21.3

3.00

25.5

7.1

6.4

30.2

18.5

3.3

7.6

1.4

90+

70.4

9.80

16.7

3.2

2

36.7

22.5

4.7

13.3

0.9

Foreclosure

73.1

10.20

7.9

1.2

0.7

10.8

37.4

10.2

31

0.8

REO

15.8

2.20

0.1

0

0

0.3

0.7

8.4

89.8

0.6

Always Current

121.9

17.70

59.6

11.6

5.8

13.5

5.8

0.7

1.1

2

Now Current

97.5

17.70

59.6

11.6

5.8

13.5

5.8

0.7

1.1

2

30+

41.9

7.60

30.5

16

9.1

25.8

12.4

2

3.3

0.8

60+

27.9

5.10

25.7

9.1

7.7

31.3

16.6

3.1

5.8

0.5

90+

116.4

21.10

17.9

4.6

2.9

37.7

21.7

4.7

10.3

0.3

Foreclosure

112.9

20.50

8.3

1.8

1

11.6

37.7

11.3

28.1

0.3

REO

32.7

5.90

0.1

0

0

0.3

0.6

10.8

87.7

0.4

Prime

Alt-A

Liquidation

Subprime REO

90

Foreclosure

60

30

Now Current

Prepay

CHART 3 Subprime 12-month current’ bucket subprime “always Liquidationtransition rates REO from ‘now Foreclosure 90 60current” loans 30

Now Current

Prepay

100 90

Percentage

70 60 50 40 30 20 10 0

02/0802/09

04/0804/09

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Liquidation

REO

Foreclosure

90+

60+

30+

Now Current

Always Current

Prepay

100 90 80

Percentage

70 60 50 40 30 20 10 0

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04/0804/09

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08/0808/09

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CHART 5 Alt-A 12-month transition rate from bucket Alt-A “always current”60 loans Liquidation REO ‘now current’ Foreclosure 90

30

Now Current

Prepay

100 90 80

60 50 40

/

Percentage

70

20

/

12/0712/08

Subprime 12-month transition rate from ‘always current’ bucket Alt-A “now current” loans

30

22

10/0710/08

CHART 4

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10 0

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Prime

Alt-A

Liquidation

Subprime REO

90

Foreclosure

60

30

Now Current

Prepay

CHART 6 Alt-A 12-month transition rate from ‘always current’ bucket prime “now loans Liquidation REO Foreclosure 90+ 60+current”30+

Now Current

Always Current

Prepay

100 90 80

Percentage

70 60 50 40 30 20 10 0

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CHART 7 Prime 12-Month Transition Rate From ‘Now Current’ Bucket Prime “Always current” loans: Liquidation

REO

Foreclosure

90

60

30

Now Current

Prepay

100 90 80

Percentage

70 60 50 40 30 20 10 0

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12/0712/08

02/0802/09

04/0804/09

06/0806/09

08/0808/09

10/0810/09

12/0812/09

02/0902/10

04/0904/10

06/0906/10

08/0908/10

10/0910/10

CHART 8 Prime 12-Month Transition Rate From ‘Always Current’ Bucket Liquidation

REO

Foreclosure

90+

60+

30+

Now Current

Always Current

Prepay

100 90 80

Percentage

70 60 50 40 30 20 10 0

10/0710/08

12/0712/08

02/0802/09

04/0804/09

06/0806/09

08/0808/09

10/0810/09

12/0812/09

02/0902/10

04/0904/10

06/0906/10

08/0908/10

10/0910/10

More scrutiny in store for appraisals Ginnie, GSE data standards will fuel new valuations

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S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / P E R S P E C T I V E S

By Ernie Durbin Many trace the genesis of our current financial crisis to events on Wall Street in the late summer of 2007. Exotic mortgage instruments, “creative” mortgage-backed securities and credit default swaps fashioned by The Street began to unwind during this period. In reality, the crisis began well before 2007, and not on Wall Street but on Main Street. In the fall of 2007, investment markets lost confidence in the value of the underlying collateral on which these instruments were based — residential properties scattered throughout the U.S. Investors no longer take for granted the value of residential properties aggregated into portfolios. Gone are the days when we assume that values will only go up. In response to this change of mindset, a new emphasis has been placed on the valuation process.

Appraiser independence, geographic competency and a new focus on market conditions are just the forwardto-future chapters of change in the valuation space. Appraisals performed post-meltdown are different than those before. Underwriting standards have tightened, and reports require much more detailed supporting evidence, particularly regarding market conditions surrounding the subject property.

Every appraisal is now scrutinized at several levels. Automated rules are run on the appraisal report both at the desktop level and after being received by the lender or an appraisal management company. AVMs are run on every appraisal report to spot check the value provided by the appraiser.

Most of these AVMs contain their selection of comparable properties. In many instances, the appraiser is asked to review data provided by these alternative products after completing the report. At times, field or desk review appraisals are ordered as well.

In preparing their reports, appraisers must anticipate the questions that will come from this additional analysis.

No appraisals are “easy” any longer; the attitude toward

collateral has changed.

New technologies are also emerging in response. Fannie Mae and Freddie Mac are implementing the Uniform Loan Delivery Dataset and the Uniform Appraisal Dataset.

These new datasets will drive data quality and standardization. Beginning Sept. 1, 2011, all appraisals will be completed using the Uniform Appraisal Data set.

As a result, the GSEs will be able to collect standardized data from appraisals performed around the nation.

As of March 19, 2012, all conventional loan deliveries to the GSEs will have to be delivered in the MISMO v.3.0 XML format and meet required ULDD data points. These are giant steps forward in digitizing the valuation report and process.

Alternative valuation methodologies will use standardized data like those required by Fannie and Freddie to fuel new valuation reports. These new report formats will be solely delivered by XML data stream.

Rich in statistics, the next generation of appraisal reports will combine the subtlety of local market expertise with the power of detailed regression analysis. Appraisers will leverage their expertise with online tools that provide analytics beyond manual ability. Just around the corner, these new technologies will provide more detailed and accurate valuations.

In order to restore confidence in the mortgage-backed securities market, investors must trust the value of the underlying collateral. Antiquated and sometimes fraudulent valuation practices contributed to the current residential market malaise. It will certainly take a while to restore this confidence. The proper valuation of the residential real estate securing the portfolio is key.

The corrective measures taken by appraisers and underwriters since the fall of 2007 are a start. Real confidence will come when tranches can be marked to market based on standardized data and new emerging valuation technologies. Collateral is king again and accurate valuation of the securing assets is key to restoring confidence in investor markets. Long live the king.

Durbin is chief knowledge officer for AppraiserLoft. AppraiserLoft is a nationwide real estate appraisal management company that provides valuation services, ensuring FHA and Appraisal Independence compliance.

Dodd-Frank: Restore investor confidence The secondary market industry’s very survival depends on data development

By Ruth Lee While Wall Street recovered most of its ground during the fourth quarter of 2010, the securitization market for mortgages has merely limped toward recovery. That is because courting investors for mortgage-backed securities and collaterized debt obligations will entail a protracted process of re-establishing trust and credibility with mortgage investors for whom the memory of the market meltdown remains acute.

In many cases, investors are still dealing with the ramifications. Investors, including heavyweights like PIMCO and BlackRock, have started to fight back on losses they argue are not theirs to absorb, because they believe that the underlying quality of the loans (read: critical data elements) are inconsistent with what they were sold.

Understandably, many mortgage investors have lost faith in the system on which they based their investment decisions. This is one of the reasons why managing data validation effectively and demonstrably will be the hallmark of our industry’s recovery.

Which brings us to the Dodd-Frank Act and its implications for mortgage securitization. Dodd-Frank addresses many of the murkier areas of securitization that operated outside the purview of regulators and contributed to the collapse of the mortgage market.

Dodd-Frank seeks to address investor confidence in a number of ways, based on data transparency and integrity. There are several aspects of Dodd-Frank that will restore U.S. real estate finance to rationality, including a 5% credit-risk retention mandate for issuers and securitizers of loans that are not qualified mortgage loans under the Truth in Lending Act. Dodd-Frank also prohibits the hedging or transferring of risk to third parties and requires full disclosure on securitizations.

Further, it requires that the ratings agencies offer standardized, credible securities ratings. No longer will collu-

sion and exemption from best practices and disclosure be overlooked, since the ratings agencies will be both regulated and liable for their product.

Under Dodd-Frank, the Securities and Exchange Commission’s Office of Credit Ratings will regulate the ratings agencies to ensure their accountability and transparency — and to exact penalties. The OCR will also make its key findings public. Finally, the critical free-market principle of reputational risk is being applied to ratings agencies.

This is a game changer, in theory at least.

New rules to require internal controls over the credit ratings determination process also are being contemplated, as are greater public and investor disclosures. There are real teeth to Dodd-Frank here, since the OCR will be empowered to deregister a ratings agency for a pattern of bad ratings.

Clearly, the previously acceptable conflict of interest inherent to taking compensation from the same issuers that your organization rates and receiving exemption from full disclosure of all information has not worked out well.

Under the provisions of Dodd-Frank, and as the result of restoring rationality in our industry, risk mitigation for investors and creditors will be refurbished over the next few years. However, without accompanying data standardization and data integrity validation, these efforts will be more cosmetic than reconstructive.

While attorneys pore over poorly executed loans for technicalities to free their clients from foreclosure, the long-term risk for mortgages is in the data — the underlying elements on which underwriting is performed and which are ultimately relied upon to securitize a loan.

When the data is faulty, all of the resulting assumptions about the value and performance of that loan are undermined. We now know what happens next.

Our industry’s very survival depends on its development of and engagement with technology to ensure that the loans we sell to our investors are comprised of valid, accurate and consistent data.

Lee is executive vice president of Titan Lenders Corp. Titan Lender’s outsourced mortgage fulfillment services provide a variable cost alternative for mortgage bankers, brokers and investors to increase their loan closing capacity while reducing risk, errors and overhead.

S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / F E AT U R E : E M P O W E R I N G S E C O N D A R Y I N V E S T O R S T H R O U G H H P I / HW FOCUS / 26

Empowering secondary investors through HPI A close look at the importance of Home Price Index accuracy

BY LEIF WENNERBERG AND JONATHON WEINER

A house price index — commonly known as an HPI — is a practical tool for mortgage market participants to estimate current property values securing residential mortgage loans. Capital-market investors may use an HPI when evaluating mortgage-backed securities, and mortgage-market institutions may use an HPI to help measure loan-portfolio risk. Since investors in MBS portfolios rarely receive more value indicators than ZIP code and origination sale price — or perhaps an original appraisal — they must rely on indexing strategies.

These strategies use the original property value brought forward by HPI movements to estimate current value. The HPI-adjusted property value and the amortized balance of the loan together define the current loan-to-value ratio.

The CLTV provides an immediate indicator of borrower and investor equity and is an essential input for prepayment and default risk models. This dependence drives the demand for an HPI that is accurate and that has comprehensive geographical coverage.

Accuracy and coverage have increased over time. A widely used approach, initiated by Case-Shiller in 1987, uses records of multiple sales that show price changes for individual properties. OFHEO — now FHFA — began using this method in 1996, evaluating loans that originated in the 1970s and after.

These approaches were adequate for most uses until recently. The dramatic upheaval in the real estate and mortgage industry over the past few years has required index providers to update methods to account for the tremendous swings in real estate values and the large volume of REO properties.

Existing HPI approaches reflect the impact of the mortgage crisis and resulting REO properties in various ways. But it is not enough to reflect volatility — more than ever, an HPI must reflect house price trends accurately and comprehensively.

GAPS IN ZIP CODE LEVEL COVERAGE Several years ago, reasonably accurate property values could be estimated using state or metropolitan statistical area-level HPIs. House prices changed closely in step with each other across large geographic regions, and the upward trend reduced the need for finely tuned accuracy. As prices turned down, the need for accuracy increased: the varied impacts of the downturn could be sharply distinguished amongst local geographies — at the level of counties, cities and ZIP codes.

Some HPIs evolved to include trends at the ZIP code level, which is highly desirable for accuracy but introduces another issue. In many areas of the country, specific ZIP codes may not generate enough home sales for a straightforward ZIP code-specific HPI estimate.

In fact, indices often do not publish an HPI for ZIP codes with fewer than 30 transactions per quarter, resulting in coverage gaps that may require investors to use either less localized data or more expensive, property-by-property approaches to estimate values (Figure 1).

Nationally, about 15% of ZIP codes have this much activity, and they comprise about 55% of properties. Also, the number of transactions for a given ZIP code can cross the 30-transaction threshold intermittently, leaving gaps at important times (Figure 2).

There is another, more accurate approach. Rather than ignore a low-transaction ZIP code altogether or, as a common alternative, use only transaction information from the surrounding geographic area, the information from both can be combined to guide value estimation.

This is a reasonable strategy because, even in the recent turbulence, home prices are driven largely by regional factors, and local prices can be interpreted as variations around a regional trend. An HPI model that uses a mix of available ZIP code-level information and county-level information can generate a reasonable indication of local values.

AGGREGATE INDICES: IMPLICIT TRANSACTION-WEIGHTING Some indices simply aggregate reported transaction data to construct HPI models. This transaction-weighting is appealing, but it can lead to unnecessary volatility and skewed values for the HPI. Some regions have seen spikes in transaction volumes, followed by rapid declines, which are not representative of the broader, longer-term market. Other areas might simply have a higher level of transactions from month to month than surrounding areas.

The result is an index that is implicitly weighted toward most active areas and unlikely to reflect typical property values of nontransaction loans held in portfolio or backing MBS. For example, if the index pulls data from a large number of transactions in an economically depressed area, the index will be skewed toward the prices of these distressed properties. Figure 1 indicates how restricted transaction data can be for the Boston MSA. A better alternative is a regional HPI that weights data by the relative numbers of properties in sub-regions, whether or not they have been involved in a transaction during a particular time frame.

This helps smooth the noise associated with unusually high or low transactional periods in specific areas, making the index more representative of actual marketplace activity. Recent proposals to improve FHFA HPI indices indicate a trend towards property weighting.

NONDISCLOSURE STATES Transaction weighting may be problematic, but transaction data is clearly essential. Accurate, fine-grained HPIs are a challenge in nondisclosure states, where sales prices are not generally available on public records. FHFA takes one approach to this problem: It provides state-wide averages based on conforming loans.

FIGURE 1 Highlighted ZIP codes in the Boston MSA had more than 30 transactions in a quarter.

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HPI AS INDICATOR OF VALUE AND RISK In order for investors to understand the shifting market dynamics that impact property values, and the resulting loan-to-value factors driving portfolio risk, they must rely on an HPI that is as accurate as possible. It is also important for investors to understand the way an HPI is constructed, and how the methods and the types of data used might bias the results in one direction or another.

Especially in today’s rapidly evolving markets, minimizing bias and ensuring that an HPI model is designed to address the shortcomings of any pool of data it draws from is crucial. With the proper due diligence, investors and risk managers can determine the most appropriate and accurate HPI model for their value and risk analysis requirements.

FIGURE 2 The number of transactions for a given ZIP code can cross the 30-transaction threshold intermittently, leaving gaps.

1

HPI (JUN 2006=1)

0.8 0.6 0.4 0.2 0 2003

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Individual property value variations from HPI

HPI (JUN 2006=1)

Non-REO REO

-60%

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FIGURE 4 HPIs derived from increasingly comprehensive sets of price data in the state of Illinois: conforming loans only; adding non-conforming loans; and then adding public sales data.

1.1 1 0.9 0.8 0.7 Conforming (OFHEO) Conforming & Non Conforming & Non + Sales

0.6 0.5

Wennerberg is a senior product analyst and Weiner is vice president of research and development at LPS Applied Analytics.

2004

FIGURE 3

HPI (JUN 2006=1)

S E C O N D A R Y M A R K E T S & S E C U R I T I Z AT I O N / F E AT U R E : E M P O W E R I N G S E C O N D A R Y I N V E S T O R S T H R O U G H H P I / HW FOCUS / 28

But generally, HPI models based primarily on loan data, and a restricted set of loans in particular, run into a couple of difficulties. First, a significant number of nonloan sales are likely to occur in lower price tiers. In some areas, a high percentage of cash sales would not be included in the index at all.

Second, an HPI can be further biased because it is based on a restricted set of loan types. For example, an FHFA-like index derived only from conforming loans will be biased toward specific, perhaps unrepresentative, property types. To address both shortcomings, a comprehensive and accurate HPI combines public-record sales data and a loan data set that covers as broad a range of loan products as possible.

For nondisclosure states without sales data, it is especially important to formulate the HPI using nonconforming loan types, in addition to conforming, to improve accuracy and granularity. Even so, without transaction data, cash sales are omitted, which might create an upward bias in the HPI. In many states, this bias is small, and an expanded loandata set is sufficient to accurately represent sales prices.

Nevertheless, uncertainty arises. To assess how significant this uncertainty might be, it is useful to examine the impact of the different sets of price data on derived HPI values in non-disclosure states, which have the entire hierarchy of data sources.

Figure 4 shows monthly HPIs calculated from the three data sets for Illinois, and indicates how significant the effects can be. Compared to a conforming-only HPI, an expanded loan set is a little more than 5% lower in late 2010.

The figure illustrates that public sales records can have a large effect: the HPI in late 2010 is more than 15% down from the conforming-only HPI. Illinois is not typical of disclosure states, but it provides a caution when interpreting a loan-only HPI.

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2011

If your appraisal data is scanned or extracted from PDFs, talk to us.

Before it’s too late.

In 2011, the GSEs will require lenders to submit full appraisals in MISMO XML 2.6 format. If your process uses PDF extraction to get data, it will fail.

It’s not a question of “if” PDF data extraction and scanning will fail.

It’s how often, and how much it costs you. The answer isn’t good.

Do the math: The URAR form alone has over 1000 fields. Even at 98% accuracy, 20 or more fields will be corrupted. Some of those will be critical, and your pipeline will stop. You might not notice it today, because PDF extracted appraisals aren’t subjected to rigorous data analysis. But they will be, and many won’t pass.

The solution? Demand “Native XML”. No conversion, no extraction, no excuses. Just clean XML straight from the appraiser’s desktop software. Then you get exactly what they typed, even on every kind of odd form or addendum. PDF extraction just can’t do that.

We’re certain, because we create, transmit, analyze, store, and manage more appraisal data than anyone on Earth, including the GSEs. When we say there’s a problem with PDF extraction, believe it.

Protect yourself by downloading the free “MISMO XML 2.6 Appraisal Checklist” from our website. It’s a vendor questionnaire that helps you set policy now for the coming regulations. Whether you use an AMC or manage appraisals inhouse, it ensures a 100% native XML process free of pipeline problems — without changing vendors, or even paying us a dime. Why? We’d rather have you thank us later, than call us later.

Download the MISMO XML 2.6 Appraisal Checklist from the web, at www.MercuryVMP.com/XML Native XML is just one of our compliance and workflow solutions. Call us today for more.

Mercury Network 1-800-434-7260 www.MercuryVMP.com

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