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The first stabilization step for the future of the United States housing market was announced by the Obama Administration in February 2011. The proposal did not earmark one exact plan to be chosen, but presented three sensible alternatives to be considered in the distant future. The plan proposed a few options to use as a benchmark for the reform of the agency and private sponsored mortgage market. The mortgage industry was presented with no major surprises, no near term implementation timeline and no shock to the fragile housing market.

The much anticipated Government-Sponsored Enterprise (GSE) Reform Proposal to stabilize the future of the housing market was finally made public by the Obama Administration on February 11, 2011.  The report on the GSE’s included no major unexpected proposals, no surprises in wording (which historically can panic the mortgage market) and three options for restructuring the United States mortgage market.  All three of the options would be implemented gradually and were presented without endorsing any one option.

These options were as follows: 1) Full GSE gradual shutdown, 2) GSE gradual shutdown with a crisis mode backstop and 3) GSE gradual shutdown with reinsurance. The proposal also consisted of four key common themes within all of the proposals. The commonalities were less government, an eventual wind down of  the GSEs, a focus on private investment in the mortgage market and an emphasis on liquid rental property market (multi-family).

The first option is a full shutdown of the GSEs (Fannie Mae and Freddie Mac) and an orderly transition of the mortgage market to private capital.  This scenario contemplates the only government support for the market coming through the Federal Housing Administration (FHA), the Veterans Administration (VA) and the U.S. Department of Agriculture (USDA). The FHA/VA is the GNMA mortgage label that  recently made up close to 30% of the entire  mortgage market.  Winding down Fannie Mae and Freddie Mac with a responsible timeline is the main goal stated in the report to Congress.  The proposal presented an extremely gradual approach, but did not pinpoint any exact dates when the shut down would  begin or end. The stated goal is to bring back private investors wherever possible to accelerate the GSE elimination.  A few suggestions were mentioned as to how the role of the GSE’s could be altered to reduce their involvement in the market and allow private capital to play a greater role in mortgage finance.  Among those recommendations were to increase guarantee fees to private investors, increase the use of private insurance, lower the conforming loan limit from $417,000 (larger mortgage loans then flow to the private sector) and a focus on a  wind down of both Fannie Mae and Freddie Mac’s investment portfolios (10% annual pace). All of these suggestions were well written in the proposal, giving full respect to the fragile housing market. It emphasized matching the timing of implementation in line with the pace of healing of the market going forward.  Slow and steady wins the race.

The second option is a similar shut down of the GSEs mentioned above. The difference on this option is the government would develop a mechanism to “backstop” the mortgage market in crisis mode.  The backstop would maintain a small presence in the market during normal functioning times, but would be ready to scale up to a larger share of the agency guaranteed mortgage market if private capital withdrew in times of financial stress.  Liquidity would be provided in the form of a government guaranteed mortgage origination.  The backstop would also include higher guarantee fees than normal, but still provide the market with liquidity and origination in stressful times if private capital shuts down.

The third and last proposal contained the GSE shut down mentioned in proposal one and two, including the continued support of the FHA/VA and USDA. This option also includes a reinsurance instrument.  The proposed structure would allow private mortgage guarantee companies to insure mortgage backed securities that meet stringent underwriting standards. This includes securities that would be reinsured by a government reinsurer for a premium that would be put aside to cover claims in the future.

The  key theme in all three proposals focuses on maintaining  the GNMA  sponsored programs, while at the same time phasing out Fannie Mae and Freddie Mac.  Within that theme is a phasing in sponsorship of private label investment with proper underwriting guidelines.  All of the proposals will ultimately result in higher mortgage rates in the future.  GNMA already proposed a 25 basis point insurance premium increase starting in 2012.  Capital building will be the main theme.  Traditionally private label mortgage backed securities will be higher in costs (basis points on your mortgage rate) for a private entity to even start to initiate underwriting and securitizing.  In the end, these costs will have to be passed on through to the home buyer in the form of a higher mortgage rate.

One of the many goals of the February 11th proposal is to maintain a consistent nationwide underwriting standard to better serve American households. A second and equally important goal is to maintain mortgage credit underwriting and contain risk during the transition into the new proposal.   In the end, proving you have a job, confirming you make what you say you earn and having the underwriter actually process a mortgage application correctly (100% full documentation), will foster a stable mortgage market going forward in line with government goals.

Higher rates will be in the cards in a market that would have a high percentage of loan origination and insurance provided through the private capital markets.  Historically, private mortgages rates are 35 to 75 basis points higher than a government guaranteed mortgage.  Government guaranteed mortgages offer interest rate risk.  Private mortgages include both interest rate risk and credit risk, which necessitates higher rates. Although this is what is in the “proposal,” we will see going forward what percentage of the mortgage market actually becomes private.

The mortgage markets response was overwhelmingly positive after the announcement.  The mortgage market immediately witnessed bond prices go up in value.  No one likes surprises in this market and in this well thought out release, there were none.

The February 11, 2011 press release and a copy of proposal can be found on the U.S. Department of the Treasury’s website https://www.treasury.gov/initiatives/Pages/housing.aspx.

Christopher M. Priebe
Vice President
Mortgage Backed Securities Trader

For more information, contact:

Joel B. Cramer, CFA
Director of Sales and Marketing
joel.cramer@aamcompany.com

Greg Curran, CFA
VP, Business Development
greg.curran@aamcompany.com

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees.  This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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During the past year, The U.S. economy improved dramatically leading to a rebound in commercial real estate valuations. Improving fundamentals reduced concerns that defaults might reach catastrophic levels, and as a result, the Barclays CMBS (Commercial Mortgage Backed Securities) Index rallied sharply, generating a total return of 20.4% in 2010. Despite the strong performance and improved fundamentals, many maturing loans are encountering difficulty being refinanced. In 2010, we saw issuance of a mere $10 billion, which refinanced only half the loans maturing during the year. Due to shoddy underwriting and poor performance, many loans did not meet the criteria to be refinanced and will have to be either liquidated or modified.

There are $138 billion in commercial loans that are set to mature over the next three years. Table 1 displays these loans by year of origination. About 50% of the loans maturing between 2011 and 2013 were originated after 2005. While the loans originated before 2005 are finding it easier to refinance, loans originated after 2005 are finding it difficult to refinance due to optimistic pro forma underwriting, high loan to values (LTVs) and the prevalence of 5-year interest only loans. In addition, approximately 9% of the CMBS market is comprised of non-performing loans that will need to be worked out in a similar fashion to the loans coming due. These non-performing and maturing loans will be likely candidates to be liquidated or modified since refinancing is not likely to be an option.

Foreclosing and liquidating commercial properties in a market where refinancing is hard to obtain leads to distressed prices and larger losses. In comparison, loan modification can buy time for the borrower to improve the performance of the property, and for market valuations to rise, thereby mitigating losses. Loan modifications have been positive for the CMBS market with about 85% of loans modified since 2001 paying off in full. This is unlike the residential mortgage backed securities market, where loan modification has proved to be ineffective. Therefore, we expect that many more servicers will choose to modify maturing and delinquent loans as opposed to liquidate them in the open market.

A loan modification is a change in the terms of a loan. This strategy is used to ensure a borrower continues to be able to pay monthly principal and interest. Loan modification can be a change of one or more terms of a loan. The most popular method of modification has been the extension of the maturity date, followed by interest rate reduction, change in the amortization term, principal reduction, and, in some cases, a combination of these methods are employed.

Charts 1 and 2 show the modification methods used between 2001 and 2005 (Chart 1), and between 2006 and 2010 (Chart 2) as a percentage of all modifications in the CMBS space.        

According to Standard &Poor’s, since the year 2000, 629 loans have been modified, which constitutes about 4.2% of the CMBS universe. Modification volume has nearly tripled since 2006 to almost $29 billion and with almost $16 billion modified in 2010 alone. The composition of the loan modification terms have also changed. In Chart 1, maturity date extension used to be the main source of modification prior to 2006, with about 64% of the maturing loans being modified using maturity date extensions only. This number has decreased to 42%, even though the actual volume for the loans that had maturity date extensions has risen to $12 billion. Servicers are more aggressively using multiple modification strategies to mitigate losses since simply lengthening the loan terms has not been enough to keep loans current and prevent them from defaulting. Rather than maturity extensions, these charts reflect that the extensions are being deemphasized, with a change in amortization term making up about 13% of modifications since 2006 compared to 3% between 2001-2005. Generally, loans with an LTV of less than 100% are offered maturity extensions, while loans with low debt service coverage ratios are offered interest rate reductions. Only loans with very high LTVs are being offered principal reduction.

Liquidations and modifications have a significant impact on the cash flows of CMBS securities. If distressed properties are liquidated, principal will be received earlier than anticipated, shortening the average lives of the bonds, while modifications delay the receipt of principal, thereby, lengthening the average lives of the bonds. With most of the CMBS universe trading at a premium, the evaluation of the disposition of these distressed loans will significantly impact the cash flows and the inherent valuation of these securities. To further complicate matters most of these distressed loans are larger in size and make up a significant portion of the 2005 and latter vintage securitizations. The change in terms of these loans will cause an even greater variance in the average lives of the bonds than smaller loans. For these reasons, we prefer seasoned securities issued before 2005 and the last cash flow senior bonds that are less susceptible to variance in cash flows due to liquidations and modifications of the distressed loans.

The CMBS market will benefit overall from the increased funding availability from the reemergence of the securitization market, but will also benefit from increased loan modifications as a means of mitigating losses. Given the positive track records of loans that have been modified to date with 85% of loans paying off without a loss to the investors, the servicers will aggressively use loan modifications and will employ multiple strategies to keep loans current. Thus, the interpretation of strategies used by the servicers and the timing of such modifications will be pivotal in bond valuations and trading decisions.

1  “U.S. CMBS Loan Modifications Reached An All-Time High In 2010,” U.S. CMBS Loan Modifications Reached An All-Time High In 2010, Standard and Poors, January 4, 2011, Page 9; Website, January 18, 2011.

Mohammed Ahmed
Structured Products Analyst

For more information, contact:

Joel B. Cramer, CFA, Director of Sales and Marketing
joel.cramer@aamcompany.com

Greg Curran, CFA, VP, Business Development
greg.curran@aamcompany.com

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Following GMAC’s (Ally Financial) announcement that it was suspending foreclosures in states that follow a judicial foreclosure process, JPMorgan Chase, PNC Financial and Bank of America have followed suit (with Bank of America suspending foreclosures in all 50 states).  At issue is whether the banks which are servicers of these loans (both for mortgages held on-balance sheet and mortgages included in securitizations, the latter being a much larger universe) failed to properly verify that they possessed original mortgage and note documents prior to initiating the foreclosure process.

There are several implications:

  • In judicial foreclosure states, the banks/servicers represent to the court, via notarized affidavit, that they have verified possession of the original mortgage and note documentation.  It has become apparent that such verifications were not actually done on a case-by-case basis in many instances, but were batch processed (at rates of up to 10,000 cases per month in some instances).  Regardless of the validity of such a foreclosure proceeding, failure to verify possession of original documents potentially makes the banks guilty of perjury for each instance of foreclosure proceeding where such verification did not occur.  The exact number of batch processed affidavits remains to be determined, but investigations are already under way by state Attorneys General, and there is the potential for a monetary penalty for each instance of proven perjury (the highest per-instance penalty we have heard is $40,000, though each state is different).  In addition to facing suit from state Attorneys General, in states with a judicial foreclosure process, an additional risk factor is the individual judges, who can find the bank/servicer in contempt and could throw the entire proceeding out (although this seems less of a risk than just having to restart the entire process).  The focus on judicial foreclosure states arises from the affidavit process, which is not present in administrative foreclosure states (thus no perjury issue, as the foreclosure process runs through the state’s administrative bureaucracy rather than the courts).
  • In addition to documentation verification/perjury issues, there is a question about instances where foreclosures proceeded without the required or correct documents, which could amount to fraud, and would leave past foreclosures and current legal title to previously foreclosed properties in doubt.  This highlights a bigger issue with the documentation chain from original sale and mortgage, through a multiple-step securitization process, which generally requires original paperwork at each step, and where there is evidence that record keeping has been uneven in past years.  The biggest implication is for MBS security holders who are left with questions about perfected claim on collateral, but which could result in suits against MBS underwriters and servicers.  However, we view this as a secondary issue at the moment.
  • Finally, beyond the nuts-and-bolts of the foreclosure process, the impact on the residential real estate market is likely to be a dramatic slowdown in resales of foreclosed/previously owned property.  This is both because foreclosures account for 1-in-4 sales currently, and because buyers may hesitate to purchase ANY previously owned property if serious questions are raised about the validity of title to the property.  The impact on resale transactions is likely to manifest itself starting with October sales transaction data.  While the interim impact may be a boost to housing prices as non-foreclosure sales tend to be at a higher price vs. bank foreclosure sales (thus boosting home price indexes like Case-Schiller), the slowdown in foreclosure sales would likely lead to a much larger shadow inventory that will ultimately hit the market once the documentation issue is resolved.  As a result, the time until the residential real estate market clears is probably pushed out.

Key Risks to Banks:

  • Penalties associated with potential perjury
  • Litigation risk from MBS investors that are harmed by a slowdown/reversal in the foreclosure process
  • Increased cost arising from protracted servicing of defaulted mortgages which weighs on mortgage banking profitability
  • Renewed political and regulatory risk given the headlines and the election season

While the obvious risks are relatively easy to identify, they are at this point, very difficult to quantify.  As the dimensions/cost/timing of this issue become more apparent, we will follow-up with additional details.  Despite a range of opinions about the materiality of the foreclosure issue, we currently believe that it results in an incremental monetary cost to fix, rather than a material credit impact that would change our view on the sector as a whole.  However, we acknowledge that we are early in the discovery process, and that the combination of the absolute amount of distressed residential mortgages, as well as increased political and regulatory scrutiny, could ultimately evolve into a considerably more material credit issue for the bank sector.  At that point, it could become a systemic issue for the economy and therefore, the Corporate market.

Impact on Structured Credit

The foreclosure moratorium will immediately halt the liquidation of properties backing the delinquent loans serviced by the four banks as outlined above  Without an actual sale of the property through the foreclosure process, no losses will be realized on these delinquent loans and hence no losses will be charged against the subordinate bonds in a non-agency mortgage securitization.  The end result will be an ever increasing backlog of delinquent loans, which, in the absence of offsetting liquidations, will cause 60+ day delinquencies to rise.  Depending on the length of the moratorium, subordinate bonds will marginally benefit from the interruption at the expense of senior notes as it delays loss recognition and allows more trust cash flow in the form of larger interest payments to flow to the junior bonds.  Additionally, the senior notes lose access to principal recovered from property sales, causing average lives to extend.

Non-Agency note holders lose when the foreclosure timeline extends due to the increased costs associated with servicing delinquent loans for longer periods of time.  Servicers are required to advance scheduled principal and interest, as long as those advances are deemed to be recoverable, as well as any and all tax and insurance payments due on the property.  Once the homes are sold, the servicers are first in line to be repaid any monies advanced on the loans as well as any other reasonable cost incurred during the foreclosure process.  Any remaining sales proceeds are then released to pay senior note holders.  If the foreclosure process was to be terminated for an extended period of time, perhaps 12 months or longer, these costs could increase materially, leading to much higher loss severities at the time the properties are ultimately liquidated and greater losses being passed on to note holders.

As also noted above, much of the problem resides in the paperwork associated with the foreclosure process in the judicial states.  If it turns out that the servicers are able to address the shortcomings with increased staffing to properly verify the contents of the affidavit and to sign the affidavit in the presence of a proper notary, the moratorium could be concluded in a matter of months.  In this case, increased foreclosure costs should be manageable and realized loss severities should not increase appreciably.  If, however, the moratorium spreads to include other servicers and non-judicial states, these delays could become much longer and the costs will increase accordingly.  While litigation and fines can’t be ruled out if the servicers are found to have committed perjury, any costs associated with the ensuing litigation and any and all penalties arising from that litigation are the responsibility of the servicers and should not be charged to the mortgage securitizations.

One unfortunate outcome of an extended foreclosure moratorium is the moral hazard it presents homeowners to stop paying their mortgages without fear of eviction from their homes.  In the absence of a timely foreclosure process, delinquent homeowners could remain in their homes for a year or more, effectively living rent free. It might be an attractive option for homeowners with properties that are substantially underwater.

While a meaningful extension of the foreclosure moratorium beyond 6 to 12 months would certainly not be a positive development for the non-agency market, there are some securities that would benefit from the delay in loss recognition aside from the subordinate bonds mentioned above.   Most notable would be short dated sequential and scheduled sinking fund bonds in non-agency CMOs backed by prime borrowers.  These bonds have first claim on principal receipts at the expense of other, longer dated classes and therefore pay down rather quickly.  There is a provision in most prime, non-agency securitizations where these bonds lose their priority claim on principal cash flow if the credit enhancement of the transaction is exhausted and losses begin to be allocated to the senior bonds.  In this instance, the sequential and scheduled sinking fund bonds share losses and principal receipts pro-rata with other senior classes of the securitization dramatically lengthening their expected average lives and exposing them to greater losses.  If, however, there is a material delay in loss realization, these bonds will maintain their priority position longer, paying down more rapidly and will represent a much smaller portion of the transaction once the moratorium is lifted.  In the future as losses begin to flow through to the senior notes, these bonds will be allocated a lesser share of those losses than they originally would have received and might avoid taking losses altogether.

So far we haven’t seen any realignment of security pricing to factor in more than a modest interruption of the foreclosure process.  However, if recent headlines are any indication, there is the very real risk that this becomes a very sensitive political situation which could cause the market to begin to factor in a much longer moratorium, potentially covering more servicers and more non-judicial states.

Scott A. Edwards, CFA
Director of Structured Products

N. Sebastian Bacchus, CFA
Vice President, Corporate Credit – Financials

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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Executive Summary

As the reverberations from the Subprime Mortgage Crisis continue to impact the economy, capital markets and ultimately structured products securities, insurance companies face ongoing issues related to valuation guidance prescribed by the NAIC and FASB for these securities. While the Subprime Crisis has been well documented and vetted through the mainstream media, there has been a dearth of education for investors regarding appropriate and practical methods for valuing these fixed income securities, especially the scenario modeling of cash flows to derive a fair value estimate. The following discussion is divided into two parts. The first part provides a framework for constructing a cash flow.

Background

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements (FAS 157), which provided a universal framework for fair value estimations. The standard called for valuation to occur from an “exit” price standpoint, or the value a buyer would receive to sell an asset or paid to transfer a liability in an active market. Subsequently, the financial markets experienced the most significant recession since the 1930’s, causing a plethora of valuation difficulties as markets saw trading volume temper to the point of inactivity. These difficulties have caused FASB to make several modifications to FAS 157, which are now included within FASB Accounting Standards Codification (ASC) Topic 820 – Fair Value Measurements and Disclosures. Non-agency residential mortgage backed securities (nonagency RMBS) represent one particular market that has experienced these valuation issues. Insurers have traditionally been significant investors in RMBS and other asset-backed securities due to the historically attractive risk-adjusted yield opportunities. However, the housing market began to “bubble” as lending practices across the U.S. grew more creative while borrower classifications became more convoluted as further variability was introduced into borrowers’ rates. Ultimately, the “housing bubble” burst, causing these securitized pools of mortgage loans to lose significant value as homeowners continued to struggle to make mortgage payments, thus slowing, or in some cases ending, the cash flow to security holders. The financial crisis exposed the fact that many security owners may not have fully understood the securitization process and makeup of the mortgages underlying their investment. Financial reporting problems resulted across many industries and the accounting community called for accounting standards to further expand fair value and impairment definitions.

An Asset Manager’s Considerations in Analyzing RMBS by AAM

Mortgage loan characteristics:

Prior to a discussion on constructing a cash flow model, we thought it would be helpful to review the primary factors that will help determine the model’s inputs. The first factor to consider is the type of loan, which is generally categorized by the weighted average quality of the borrowers in the pool of mortgages being analyzed. The quality of the borrower is most often determined by the borrower’s credit rating or FICO score. While there are no universally established ranges for the various borrower credit classifications, a borrower with a FICO score of 720 or higher is generally considered a prime borrower. Alternative-A or Alt-A borrowers often include those who do not provide full documentation and generally have FICO scores ranging from mid 600’s to the low 700’s. A credit score below the mid 600’s is considered a subprime borrower. A breakdown of the credit scores for the loans backing a security is typically available for most non-agency RMBS in the monthly remittance data supplied by the servicer. As logic would dictate, a pool of mortgages backed by borrowers with lower weighted average credit scores will usually experience a higher rate of default, all other factors being equal.

The second factor to consider is the year of origination, or vintage, of the mortgages in the pool. During the recent housing cycle, home prices increased substantially across most of the United States from 2002 to 2007, peaking in mid 2006. As home prices subsequently declined, many borrowers who purchased homes near the peak in prices now owe more than their homes are worth (negative equity). This condition reduces both the financial incentive to stay current on payments and the ability of homeowners to sell a property in times of financial stress. As a result, those borrowers with negative equity are much more likely to default. Thus, securities backed by mortgages issued in more recent years have experienced higher delinquency and default rates than those issued in prior years.

The third factor is the loan-to-value (LTV) of the underlying mortgages. The LTV ratio divides the amount being borrowed against a property’s price at the time of purchase. It illustrates how much equity a buyer had in a property or how much leverage a buyer employed at the time of purchase. Unfortunately, the LTV ratio has a major shortcoming. While the LTV is adjusted for principal repayments, it neglects to take into account home price appreciation or depreciation after the date of purchase. Changes in LTV ratios can be inferred by broad changes in home prices, but the accuracy of any estimated LTV is subject to the multitude of factors that go into valuing a specific property. Given the substantial declines in residential real estate over recent years, the LTV ratios published in the remittance reports for most securitizations are too low.

The fourth factor to consider is whether the bond issue is backed by mortgages that fall into the adjustable rate (ARM) or affordability products classification. As home prices moved higher, buyers started stretching to purchase larger and more expensive homes. Affordability products, such as floating rate and interest only mortgages, became much more prevalent allowing a buyer to reduce the initial monthly payment. As many of these issue initial or “teaser” rates reset, the borrower could no longer afford the monthly payment. Consequently, these types of loans have experienced higher delinquency and default rates than fixed rate mortgages, all other factors being equal.

Other characteristics that can have an impact on a non-agency RMBS and should be considered are the geographic concentration and type of occupancy. The geographic concentration of the properties in the pool of mortgages will impact performance if there is a large concentration of states experiencing above average default and delinquency rates. The states experiencing the highest foreclosures are Nevada, Florida, Arizona, and California. There are also several types of occupancy including owner-occupied, investment, and vacation properties. Defaults in investment and vacation properties have been running at a higher rate than owner-occupied properties. Taking all of these characteristics into consideration will provide a more robust and reliable model.

Loan Performance:

The performance data utilized for cash flow modeling typically focuses on three key elements of the collateral in mortgage-backed securities: the future default rate assumptions, roll rates, and severity of losses.

Default rates in most cash flow models are based on the current delinquency and default experience for the type of loan (i.e. prime, Alt-A, subprime), the vintage year of origination, and the rate of change for delinquencies and defaults. The most commonly used method for projecting future losses is the constant default rate (CDR). Under this method, CDR is expressed as an annualized percentage of mortgages that default in a pool. A CDR of 10 means that 10% of the outstanding mortgages in a pool are expected to default over a 12 month period. Since 2007, CDRs for all three types of loans have increased to historically high levels.

Remittance data from the servicer for each non-agency RMBS will include the percentage of the pool at the various stages of delinquency. Not all borrowers that are delinquent will end up in foreclosure and default on a loan. Roll rates are defined as the percentage of delinquencies that are 60 days or more late that ultimately default on the loan. Securitizations with lower quality buyers and higher LTV ratios have typically experienced higher roll rates than those bonds backed by higher quality buyers and lower LTV ratios.

After a borrower defaults on a loan and the bank takes possession of the property, the bank will eventually sell the property to recover funds. The percentage of the loan’s remaining principal balance that is lost after the sale is defined as the severity. For example, assume a borrower defaults on a loan that has a $500,000 remaining balance. After the bank takes possession of the home, it is sold for $350,000. After legal fees and other costs are subtracted, the net recovery is $300,000. In this example, the severity of the loss is 40%. Severity ratios are usually included in the remittance data from the servicer.

Constructing Scenarios:

While arguments can be made for different methodologies to construct scenarios to analyze non-agency RMBS, it is our view that a model should focus on the three key elements of collateral performance mentioned above: future default rate assumptions (CDR), roll rates, and severity of losses. The challenge that insurance companies and investment professionals face is how to determine the appropriate levels for each of these factors. A good starting point for scenario testing begins with a review of the current delinquency and default rates for the loans backing the issue and the rate of change for delinquencies and defaults.

The exhibit below provides a recent snapshot of the performance statistics for the three primary sectors of the non-agency RMBS market, but the current remittance data for the individual issue being analyzed will provide more meaningful data. Additionally, historical trends should be incorporated into the modeling process.

Loan Performance

In addition to the current performance, a forward looking forecast based on the broad trends of the housing market and mortgages underlying the bond needs to be considered. While there are many differing views on the direction of the housing market, the current consensus economic view calls for minor improvements in the residential real estate market during 2010. Home prices would appear to be at or near a bottom based on the S&P/Case-Shiller Index, which has shown month-overmonth improvements in home prices since June of 2009. However, unemployment is expected to remain at elevated levels and home foreclosures are anticipated to continue mounting, which may put further pressure on the housing inventories and prices. Taking these factors into consideration, we believe that a conservative scenario would assume defaults will be higher than the current and past experience for some period of time before gradually declining.

By incorporating the actual performance trends of the underlying collateral with a forecast based on the trends of the broader housing market, a framework can be developed for cash flow modeling. In our view, the model should reflect current experience of the mortgage pools using current roll rates, default rates, and severities to liquidate the seriously delinquent loans as a starting point for determining future CDR’s. These factors can be used to project a ramp of future default rates, beginning with a CDR that is higher than the current default rate and declines over a specified time horizon to a terminal rate. Over a longer period of time, the residential housing market should stabilize and ultimately prices will increase. The majority of homeowners who have remained current on their loans through this extremely difficult economic cycle will likely remain current in the future. As such, future CDR levels over time should regress towards historical levels. For example, assume the underlying mortgage loans for a bond deal have the following characteristics and performance, as of December 31, 2009:

Loan Performance 2

Taking into consideration these characteristics and performance measures and acknowledging that over time performance will ultimately revert to its historical mean, we suggest the following scenario:

Loan Performance 3
In the exhibit above, 75% of the loans that are delinquent by sixty days or more are immediately defaulted at a 50% severity. Then, the model projects sequential future defaults of 3 CDR for six months, 2 CDR for twelve months, 1 CDR for six months, and 0.25 CDR for the remaining life of the security (terminal CDR).

The output from the model will be a series of future cash flows beginning in the current period and ending when the security has entirely paid off. To calculate fair value, the next step is to determine an appropriate discount rate to apply to these cash flows. The discount rate can have a substantial impact on the net present value result. Therefore, it needs to be based on reasonable and supportable assumptions and commensurate with the risks of the security. We believe that a reasonable methodology would utilize a risk free rate plus an appropriate risk premium that reflects observable risk premiums for bonds with similar characteristics. The process for determining the discount rate should be documented and verifiable by an auditor. Once the discount rate is determined and applied to the cash flows, the result of the net present value calculation will represent the fair value of the security.

We believe this approach provides a reasonable framework for valuing non-agency RMBS in the event that quoted market prices are not orderly and/or there is no active market. Additionally, these methods can be used to bifurcate credit impairment losses in accordance with FASB’s amendment to ASC 320 Other than Temporary Impairment, originally issued as FSP 115-2 (FSP 115-2) and SSAP 43r. These types of analyses should be updated on a quarterly basis with changes in the performance reflected in the model assumptions.

An Auditor’s Perspective On Non-Agency RMBS Analysis by Johnson Lambert & Co. LLP

As auditors, we utilize a risk-based approach to examine a company’s financial statements. We use assertions to assess the risks associated with a particular financial statement line item. Investment assets are frequently assessed for the valuation assertion, whether the values carried by the entity are carried at appropriate amounts. The valuation assertion, as it relates to investments, has confounded auditors and their clients over the past two years as the continuing recession causes investment markets and regulatory bodies to react to newly presented fair value problems.

The amount of non-agency RMBS as a percentage of a company’s entire investment portfolio, the complexity of the investment, and the credit rating of the borrower helps determine the nature and extent of auditor testing of non-agency RMBS. An auditor will spend more time on a portfolio that includes a high percentage of complex RMBS compared to the total portfolio, especially if the credit rating or weighted-average quality of the underlying borrowers is low.

Recently, more so than any other, there is higher risk associated with management’s assertion regarding investment valuation. Estimates of future cash flows are involved, and determining the reasonableness of those estimates requires a great deal of auditor judgment.

Non-Agency RMBS Valuation:

The popularity of non-agency RMBS holdings within the insurance industry coupled with the FASB’s issuance of FSP 115-2 in April 2009 triggered the NAIC to revise Statement of Statutory Accounting Principles No. 43: Loan-backed and Structured Securities (SSAP 43r) during 2009. FSP 115-2 and SSAP 43r, help define the nature of an investment’s impairment and further present a basic framework in defining fair value for difficult to value securities including RMBS. The guidance places responsibility on management to be able to support assumptions in their cash flow model for investment valuation.

Due to the current economic climate, a considerable amount of non-agency RMBS are no longer actively trading, making valuation difficult under the “exit” pricing strategy required by accounting guidelines. To gain comfort over the investment amounts in a company’s financial statements, first, we look to the client to understand their methodology on investment valuation. The insurer’s investment manager, such as AAM, should be a valuable resource in this process. The investment manager can provide information regarding basic loan characteristics that could affect the value of a security and also discuss the major assumptions in its cash flow model. The investment manager can provide historical data on trends in default rates and loss severity, which can be used to support current cash flow assumptions and, ultimately, fair value. If the investment manager has a SAS 70 report on internal controls, useful information relating to the accuracy of calculations may be available for auditors to rely on, decreasing testing for the auditor, which invariably decreases cost for the client.

Assumptions Driving the Cash Flow Model:

To become comfortable with the value of non-agency RMBS on a company’s books, it is important to understand the assumptions involved in the cash flow analysis used to arrive at a fair value estimate. Auditors will be most interested in key assumptions in the cash flow model that create significant variability within the financial reporting process. As discussed by AAM in the preceding paragraphs, items such as default rates, roll rates, and severity of losses affect the estimated fair value of non-agency RMBS, and would be of particular interest to auditors in assessing these types of securities.

In order to determine whether or not the assumptions are appropriate, auditors must develop expectations regarding the cash flow assumptions. Trends in the underlying factors affecting inputs into the model, including credit rating, vintage, LTV, and adjustable rate products provide a sufficient place to begin creating these expectations. Additionally, auditors will consider general trends in the housing market and unemployment rates. If these factors are not seeing sizable improvements, it stands to reason that default rates on non-agency RMBS are likely to remain higher than usual in the foreseeable future. For example, if a company holds a non-agency RMBS with a mid-range credit rating, originating in 2008 as an adjustable rate product, we may not reasonably expect a full cost recovery based on current economic conditions, including recessed home values, and high unemployment rates.

In addition, expectations can be developed utilizing publicly available industry data. An auditor of an insurance company may be able to benchmark the company’s non-agency RMBS holdings against nonagency RMBS holdings of other insurance companies. If the company’s RMBS portfolio varies greatly from similar insurance company RMBS investments, valid questions may be raised regarding the reasonability of the assumptions driving the cash flow model. In addition to the cash flow modeling provided above, on January 25, 2010, the Securities Valuation (E) Task Force of the NAIC issued guidance (1) on RMBS valuation and determining designations for RMBS held by an insurer. The guidance includes specific instructions for valuing RMBS in relation to Risk Based Capital calculations that may be useful in evaluating cash flow modeling assumptions.

Importance of Documentation:

More often than not, there will be some assumptions that will not meet the auditors’ expectations, whether they are based on knowledge of the economy, industry averages, or some other benchmark. Client documentation of the RMBS valuation process is critical. There will be times when it makes sense for a company to deviate from industry averages, or special circumstances that require stepping away from the beaten path. These circumstances are not inherently wrong, but the auditor must be able to understand the reasoning behind the departure. If a company clearly documents their reasoning behind assumptions, deviations from the norm, and cash flow discount factor selection up front, headaches will be avoided down the road.

The key considerations outlined above should be the Company’s focus in preparation for an audit which includes the valuation of non-agency RMBS in active markets, non orderly transactions or concerns regarding credit loss impairment. The framework provides a basis for companies to identify what questions auditors may ask about these securities, so they can be prepared with thoughtful responses at year-end.

A Final Thought:

It has become evident over the past several years that a straightforward definition of fair value is difficult to achieve. As more of the financial reporting world moves toward International Financial Reporting Standards, it has become even more apparent that transparency may be the only constant achieved. Hopefully the analysis above has shown that companies must take a greater role in understanding their investment portfolio make-up and specific security characteristics; and in documenting this understanding, with the help of their asset manager. We are certain that as the markets continue to develop, and new and more creative investment vehicles are explored, the auditing industry and insurance regulators, as advocates for these public markets, will further demand more rationale and support from those charged with governance and asset managers.

Works Cited:

(1) – Task Force E, subgroup of the Financial Conditions (E) Committee of the National Association of Insurance Commissioners. Final Version of the Interim Reporting Instructions for the Year Ending December 31, 2009. For Use in Reporting Residential Mortgage Backed Securities. Can be accessed through: www.rmbs.naic.org.

Written by:

Kevin K. Adams
CFA Senior Portfolio Manager
AAM

Joshua W. Partlow, CPA
Principal
Johnson Lambert & Co. LLP

Erik T. Braun, CPA
Manager
Johnson Lambert & Co. LLP

Lauren Williams, CPA
Associate
Johnson Lambert & Co. LLP

About Johnson Lambert & Co. LLP:
Joshua W. Partlow, CPA, Erik T. Braun, CPA, and Lauren Williams, CPA are affiliated with Johnson Lambert & Co. LLP, a CPA firm formed in 1986. Johnson Lambert & Co. LLP’s business strategy, unique among CPA firms, is to focus aggressively on distinct industry niches where the firm can differentiate itself by possessing an unparalleled depth of technical expertise and experience specifically relevant to client needs. Insurance is one of only three industry niches on which the firm has elected to focus. Similarly the firm is selective in the nature of the services provided to selected industry niches, providing almost exclusively audit/assurance and business tax services. For contact and further information visit www.jlco.com

This publication/paper has been prepared by AAM and Johnson Lambert & Co. LLP. It is provided to you for informational purposes only. The information contained in this publication has been obtained from sources that AAM and Johnson Lambert & Co. LLP believe to be reliable, but AAM and Johnson Lambert & Co. LLP does not represent or warrant that it is accurate or complete. The views in this publication are those of AAM and Johnson Lambert & Co. LLP and are subject to change and AAM and Johnson Lambert & Co. LLP has no obligation to update its opinions or the information in this publication. Neither AAM or Johnson Lambert & Co. LLP, nor any of their respective officers, directors, members, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The securities discussed in this publication may not be suitable for all investors. The value of and income from any investment may fluctuate from day to day as a result of changes in relevant economic markets (including changes in market liquidity). The information in this publication is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results.