Friday, January 29, 2016

Rhee on Mortgage-Backed Securities

June-RheeJune Rhee (Yale - Business School) has posted Getting Residential Mortgage-Backed Securities Right: Why Governance Matters (Stanford Journal of Law, Business, and Finance) on SSRN.  Here's the abstract:

Residential mortgage-backed securitization (RMBS) is a type of asset-backed security in which the RMBS investor's return on its investment comes from the monthly mortgage payments received from the underlying pool of mortgages. Before securitization, mortgage lenders kept loans on their balance sheet until maturity retaining mortgage risks. Through securitization, however, these lenders were able to sell these mortgages and their risks to other entities (RMBS investors) that were more willing and believed to be better suited to take on such risks. Before the financial crisis, RMBS was a popular investment opportunity widely held by pension funds, mutual funds and other financial firms. As these entities participated in the mortgage market, sources of funding for potential homeowners expanded and mortgage risks were distributed to entities better fit to take on the risk. These benefits were not sustainable, however, as the integrity of mortgage and RMBS value was undermined as seen during the 2007 financial crisis.

In a recent RMBS lawsuit brought by the RMBS investors against the mortgage lenders (referred to as mortgage originators in RMBS), two-thirds of sample mortgages acting as a collateral for RMBS were shown to have breached the representations and warranties provided by the mortgage lender. This means that two-thirds of the collateral for RMBS were lower quality than represented by the lenders and that the collateral was insufficient to support the stated quality of RMBS. The warranties included compliance with the mortgage lenders' underwriting guidelines, accuracy of mortgage level information and no fraud in issuing and managing these mortgages. In another lawsuit brought by institutional investors against an issuer of RMBS, the investors showed a "systemic and pervasive deviation from usual, customary and lawful servicing practices by servicers managing the collateral mortgages" for the investors of RMBS. As revealed in the financial crisis, these examples unfortunately were not rare occurrences. One has to wonder how this massive undermining of mortgage and RMBS integrity was possible. RMBS investors were considered more "sophisticated" players in the market. This paper attempts to answer this question through a close analysis of the RMBS contractual structure.

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