Combating Risk in Today's New Mortgage World

Investors need to know how to properly evaluate MBS credit and fraud risks

Investment Dealers Digest
January 7, 2008
BYLINE: Andrea L. Felesky and Jeffrey B. Locke

As the value of mortgage-backed securities (MBS) continues to deteriorate, investors must now shift their focus from investing in these types of securities to minimizing earnings exposure, the magnitude of write-downs and mitigation of future losses from current investment vehicles. The key is to assess the risk of your secured investments in today's market.

The once lucrative process of providing subprime loans to potentially risky home buyers, then securitizing assets backed by these loans, has lost its luster and is now taking a major toll on many institutions and their senior management. In the past few months financial institutions have announced losses linked to MBS investments totaling over $50 billion, which continue to grow each day.

Investors have been unable to adequately evaluate the risks associated with MBS. Purely financial metrics to valuate the risks are no longer valid because much of the underlying collateral, the individual loans, were products of fraudulent conduct. A customer of the Mortgage Asset Research Institute studied its stated income loans and determined almost 60% of those loans were exaggerated by more than 50%. Whether the fraudulent conduct is the result of organized crime or individual greed, federal and local prosecutors have indicted a multitude of people who have allegedly committed mortgage fraud.

Based on their inability to properly assess risk in MBS and the rampant fraud in the underlying loans, investors will need new methods and metrics to analyze the current and future risks associated with these securities that are quick, efficient and reliable. We are at the beginning of a financial crisis and no one appears to know how long it will last, or the long term impact it will have on the financial institutions that were heavily invested in MBS and the financial markets as a whole. The question becomes more of how to begin to measure the risk exposure and develop a programmatic approach that mitigates or at least quantifies it so that informed decisions can be made.

To accomplish this goal, investors will need help. Determination of the overall magnitude of exposure in a pool of assets will be critical. Institutional investors will first need an efficient process to analyze the individual loans comprising the MBS before entire portfolios can be appropriately risk-assessed. Second, individual loans within the pool should be searched for the risk factors that tend to drive non-performance and fraud. Third, investors should be able to undertake a detailed analysis of the loans exhibiting those risk factors.

Hunting for Risk

A loan may have one or more risk-factor characteristics that indicate potential exposure for non-performance. Some examples of characteristics to examine are:

1. Payments: History of late payments or no longer making payments.

2. New Term Negotiation: Interest-only payments after a history of delinquent payments.

3. Loan Type: The type of loan can be a valuable indicator when evaluating and forecasting future risk and potential default. A portfolio can include subprime loans that are either fixed-rate mortgage or adjustable rate mortgage, Alt A, interest-only mortgage and negatively amortizing loans.

4. FICO Score: The FICO score used to gain loan approval can be misleading. For example, a married couple completing a loan application may be allowed to use only one FICO score for approval. There is a strong possibility that the spouse's FICO score, not used in the application process, is substantially lower.

5. Documentation: Lack of supporting documents in support of key factors used for the approval process.

6. Location of Homes: Certain areas of the country experience higher rates of foreclosures and have a higher inventory of homes with little or no equity built up in the homes.

7. Mortgage Bank: Many of the institutions that originated the loans are either in a dire financial situation or already bankrupt.

8. Investigations: The bank, broker or appraiser may be currently under investigation.

9. Loan-to-Property Value: The money needed to purchase the home by the borrower may provide an indicator of ability to pay in the future. Minimal equity in a financed property sometimes provides an outlet for the defaulted borrower to walk away from the loan agreement with minimal loss.

10. Refinance: The frequency and magnitude of a home refinanced in the last five years by the same borrower may shed light on future cash flow problems.

Using the foregoing risk factors (and possibly others that are learned over the course of having analyzed the non-performing loans) to perform a risk-based assessment of the loan portfolio will allow you to identify and segregate those loans that represent heightened risk for non-performance and fraud and require further analysis. These heightened risk loans may exhibit multiple or singular risk factors. Based upon the risk factors present, a risk scoring technique can be applied to efficiently prioritize the analysis of those loans with the greatest potential to default and negatively impact the performance of the investment. Investors must then begin the task of performing an in-depth analysis of those loans scoring above an established risk threshold.

Reviewing the loans

The in-depth analysis of the identified high-risk loans may uncover concerns that are usually not otherwise exposed during the approval and packing process. Below are some important points to remember.

1. Risk characteristics discussed above may be in multiples in a given loan or individually.

2. Insufficient controls during the underwriting process may continue to follow that loan once packaged, including lack of validated and adequate documentation.

3. Keep an eye out for fraud committed with falsified records or lack of documents. Look over the loan application and supporting documentation, HUD and appraisal records and public information. Also investigate the potential existence of a "straw buyer."

4. Transactions that were not "arms length" have a stronger likelihood of elements of fraud.

5. Review the repackaging of the MBS for fraudulent activity.

These above conditions are just a few of the common denominators found in pools of loans that are considered high risk and may warrant reserves and write-downs. Many of the issues pertaining to an individual borrower will not be identified in the consumer credit report that accompanied the loan application. Credit reports reflect a certain point in time and do not provide a real-time or accurate representation of the borrower. Additionally, the underlying fraud can often go undetected through the approval and packaging process.

To make an informed decision about the risks associated with MBS, investors need to evaluate the underlying collateral, the individual loans, of the MBS. This risk-based approach will help investors identify where the greatest exposure to current and future earnings lie and focus their time and attention where it is needed most.