Junior Lien MBS Quality Far Better than Pre-Crisis

By SAM GARCIA

The quality of newly originated home-equity assets and the borrowers who are repaying the loans is light years ahead of pre-crisis levels. Consequently, second-mortgage risk remains low. Still, rating agencies are cautious about the automated technology being used to underwrite loans.

 

Loan Quality

Pre-crisis junior-lien originations were reflective of overall residential loans and generally originated as part of a home purchase, Jack Kahan, senior managing director at KBRA, said in a written statement to HELN. Just a third of second mortgages were cash out. Combined loan-to-value ratios on purchase transactions generally stood at 95 percent or higher, and borrowers usually had less-than-prime credit scores averaging roughly 680. Underwriting was based on less than full documentation on more than half of the loans.

Compared to today’s transactions, pre-crisis transactions had far worse underwriting, Ryan O’Loughlin, senior director at Fitch, wrote in a statement to HELN. He noted that, prior to the last 12 or 18 months, there have only been a limited number of junior-lien transactions since the financial crisis.

“The few that have been issued were primarily seasoned collateral with a large portion being re-performing loans,” he explained. “This is an entirely different profile from today where the loans are almost exclusively new origination.”

Today’s junior liens are largely originated for equity extraction, which had previously been accomplished through cash-out refinances, Kahan wrote. Contemporary securitization pools have CLTV ratios that typically range from 70%  to 80% and go as high as 85%. Average FICO scores range from 720 to 730.

Documentation on today’s second-mortgage product is traditional full documentation that is commensurate with government-sponsored enterprise lending, Kahan said.

“The CLTVs, FICO scores, and documentation are all associated with generally lower risk of default for today’s junior liens,” he added.

O’Loughlin indicated that underwriting has improved measurably, “and there are more sweeping regulations that must be adhered to during the origination process (i.e., Ability to Repay rule). There are also prohibitions on certain loan features that might have been more common during peak vintage, and there are typically more sophisticated loss models in use.”

 

Automation

Smaller loan amounts on junior liens have incentivized lenders to rely on automation in the underwriting process to cut down on costs as well as speed up the process. But rating agencies don’t necessarily give the same credibility to automated valuation models and verifications.

As AVM utilization has expanded over the past decade, some AVM providers have improved valuation accuracy compared to before the financial crisis, Kahan stated. Since full appraisals are cost prohibitive on loans that are typically around $70,000 to $80,000, KBRA accepts that some junior liens may be originated using AVM values alone.

“Generally, KBRA still considers such values as less reliable relative to a full appraisal and applies haircuts to AVM values,” he said. “These haircuts increase where the AVM variance metrics indicate higher levels of variance around the value estimate.”

Automated verifications, like those that use algorithms to assess borrower credit or income using direct feeds from data providers,  are considered “in a way that accounts for KBRA’s views of their strengths and weaknesses relative to traditional underwriting processes.”

“A large majority of the automated underwriting systems we see in use align to the GSE standards, which we view as comparable to a fully documented loan,” Fitch’s O’Loughlin stated. “On the valuation side, we provide various haircuts to the property value used in our analysis as a result of the AVM provider and corresponding confidence score. Further, given the 100% loss severity we are assuming in our analysis, there is further protection to the extent there is property condition issues that are not captured by an AVM.”

O’Loughlin explained that their probability of default regression, a key component for deriving projected losses for the transactions, is based on a historical dataset of millions of loans from various vintages and includes both first and second lien collateral.

“As a result, it is being used implicitly but not so much explicitly for each specific transaction,” he said.

 

HEI

More attention has recently been given to home-equity investments, where a homeowner gives up a share of the equity in return for a cash payment. No repayment is required by the homeowner.

During a recent LinkedIn event, 2nd Lien Originations and Capital Markets Liquidity Support, hosted by Computershare Loan Services Senior Vice President Ralph Armenta, Spring EQ CEO Jerry Schiano commented that homeowners who turn to HEIs tend to have a little rougher credit and different income qualifications. This sector slightly overlaps with home-equity lending.

Also chiming in was Brian Brennan, whole loan trading, at Saluda Grade.

“It’s kind of a credit repair product,” Brennan commented. “To some extent, it tends to be a little bit lower FICO universe than with what we’re talking about with Figure and Spring EQ. But it can be a very good product from a credit repair standpoint.”

“I do see it continuing to be more widely accepted, and securitizations are getting done with that product as well,” he added.

Fitch’s O’Loughlin said the firm had a number of conversations with potential HEI issuers, though it’s not a space they are currently active in.

 

Liquidity for Future HELOC Draws

KBRA’s Kahan noted that generally, most HELOCs are fully drawn at issuance, so there is little room for additional draws. In addition, most HELOC borrowers treat the loans as closed-end loans and don’t take draws.

Brennan commented on the difficulty of managing liquidity for securitized HELOCs where draws are actively being made. But he indicated that incoming principal collections are used to fund draws, and a reserve account is set up to handle draws that exceed principal repayment. However, these structures rely on the inclusion of closed-end seconds that have no draws — though HELOC prepays consistently outweigh draws.

 

Risk

More focus on the origination process has lowered the level of risk compared to pre-crisis second mortgage transactions, Fitch’s O’Loughlin said. The rating agency conducts assessments on originators to gain an understanding of the processes and procedures that go into the loan origination.

“The guidelines are reviewed, and although an issuer may consider a loan as fully documented, Fitch may not and may analyze the loans as less than full documentation,” O’Loughlin stated. “Servicing practices are assessed to make sure the servicer has the proper procedures in place to servicer second lien transactions, and there is a review of the loan by a third party firm (third party due diligence) which is used to determine if there was an issue in the origination of the loan. All of these additional checks are much more robust than what was conducted on pre-crisis second mortgage transactions. In addition, the overall credit quality is better (lower CLTVs/higher FICOs).”

Today’s second-lien HELOC borrowers are very similar to the borrowers who previously would have refinanced their first mortgage with cash out, KBRA’s Kahan said during the webinar.

“From a second-lien perspective, we like to think about probability of default and loss severity.”

Probability of default is likely to be the same as a cash-out refinance borrower on a first lien. So, the incremental risk on the second lien, which represents a small portion of mortgages against the home, is much smaller.

“In some ways, on the default probability side, we’re not deeming second liens as any different than a first lien from a credit risk perspective.”

But the loss severity side is different, according to Kahan, because the first lien must be paid off before there is any recovery for the second lien. However, the combined loan-to-value ratios are in the 70s now versus pre-crisis ratios of 90 to 100 percent.

One of the biggest obstacles to reducing risk is the cost, according to Covius Chief Business Officer Pete Pannes. Covius is the parent of Clayton.

“Our clients’ biggest pain point has been the cost of the diligence versus a full file or a first lien,” Pannes said during the LinkedIn event. “Given the requirement for full-scope reviews in relation to the relatively small balance associated with HELOCs and seconds, that tends to be a bit of an economic challenge.”

 

 

 

 

 

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