Long-Term Viability in Mortgage Market Hinges on Reps-and-Warrants Overhaul

The landmark mortgage settlement that JPMorgan Chase and federal regulators are negotiating stems from an inherent, industrywide broken loan manufacturing process and equally flawed representations-and-warranties framework.

JPMorgan may be trying to put the sins of the past behind it. However, put-back risk for the industry is alive and well despite efforts by the federal government to impose what it deems to be appropriate mortgage underwriting standards for lenders and customers.

Today, a false sense of security pervades the industry in large measure due to strict and sometimes seemingly arbitrary (e.g., a 43% debt-to-income ratio requirement) underwriting requirements imposed by the Consumer Financial Protection Bureau on mortgage lenders. Based on the characteristics of loans originated today, mortgage default risk is generally exceptional. The quality of the loan manufacturing process itself is a major determinant of default that occurs, most notably, due to deficiencies in underwriting and the collateral valuation process. Steps to tighten loan quality standards since the mortgage crisis, such as the Qualified Mortgage rule, address one aspect of default risk, but establishing standards for loan manufacturing quality remain elusive. Standardizing loan quality for now may mitigate the toxic effects from poor origination practices. However, in time, the pain experienced during the crisis will, as it always does, give way to a desire to "adjust" loan quality and products to conform to the new environment where the lessons of the past are perceived to have been learned.

Someone once said there are no bad products, just bad implementation. Interestingly enough, the option adjustable-rate-mortgage product originated by World Savings had performed well in terms of credit and interest rate risk in good and bad markets for many years, because the process underlying the product was rock-solid. The product was targeted to financial savvy customers with irregular incomes that needed a loan instrument that provided variable payment options to align with their income stream. Appraisals were performed in-house and at arms-length from production units rather than farmed out to vendors that relied on the loan officers for their next meal. Properties could not be "white elephants" located across the street from a gas station. Further, borrower incomes and assets were fully documented.

Most importantly, World Savings was a portfolio lender so it ate what it killed and as a result had a vested interest in maintaining the quality of the loan as well as the underlying process used to originate it. The character of World Savings' option ARM radically changed once the company was sold to Wachovia. The product was expanded well beyond its intended customer base, which eventually contributed to heavy losses. However, the lending infrastructure necessary to handle the massive volumes of option ARM loans during the late boom period were not up to the task. Underwriting and appraisal quality suffered, exacerbating a widespread deterioration in loan quality.

Lurking behind the scenes of efforts to reawaken the private securitization market are precedent-setting processes that will expose lenders to material put-back risk in the future unless steps are taken to set industry standards for loan origination and processing. In the few private securitization deals done post-crisis, the high level of loan quality coupled with 100% loan file due diligence has given investors a greater level of confidence in how pools are put together to the point of overlooking aspects of the loan dispute resolution process that pose risk to the system in the long-term.

There is little standardization or clarity in how loans are vetted against contractual reps and warrants, beckoning a significant outbreak of put-back mania sometime after the next boom-and-bust cycle. This Wild West of reps and warrants sets a terrible precedent for an industry struggling to figure out how to reboot the private secondary market.

With the private secondary market spigot only dribbling out securities today, such variability in the reps-and-warrants process may result in relatively low risk for a time. However, at some point, when the taps are turned back on, a healthy secondary market can only happen with standardization of the reps-and-warrants process.

The Federal Housing Finance Agency has flagged the need to build such standardization into pooling and servicing agreements, which would include reps and warrants. However, the industry isn't waiting for this to happen and is effectively setting the precedent for a proliferation of alternative reps-and-warrants language that introduces confusion and uncertainty into the market.

We standardized the wrong thing. Setting standards for loan manufacturing quality is essential to getting the secondary market back on track. Dictating underwriting standards via QM is inherently inefficient public policy that limits the availability of good products to qualified customers and resembles more of a plodding 1950s central planning effort rather than smart post-crisis market reforms. Getting reps-and-warrants right in contractual agreements may not be headline worthy, but the long-term viability of the mortgage secondary market is dependent on this outcome.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland.