By Joy Wiltermuth and Natalie Harrison
NEW YORK (IFR) - Credit rating opinions on new types of residential mortgage bonds have become increasingly divided, making it harder for investors to gauge their risks.
Ten years since the RMBS sector helped lead to the 2008 financial crash, primary issuance is expected to set a new post-crisis record.
Bank of America Merrill Lynch (NYSE:BAC) strategists predict volumes will reach US$75bn by year-end, the highest since 2008. There has already been around US$51bn issued in 2018, they said.
These securities pool home loans from some of the best and also more challenged US homebuyers. Their comeback has been fueled by the buyside looking to get a stake in the current buoyant US housing market.
But there are concerns about the alphabet soup of ratings being applied by agencies. Ratings should help investors judge how safe an investment is, but sometimes it is unclear if the correct one has been applied.
About 40% of the RMBS sold this year came with "split" ratings, when deals were vetted by multiple credit agencies, versus around 5% four years ago, according to a recent Fitch Ratings report.
Split ratings can highlight more liberal metrics being used by one rating agency over another.
"Rating agency competition is generally positive for the market by providing a greater number of perspectives for an investor to consider," Fitch said. "That said, a ratings divide makes it more important for RMBS investors to be cognizant of the differences between agencies."
But that can sometimes be a challenge, especially as ratings models can change - and potentially sting investors in the process.
"A change in rating agency methodology that results in downgrades even when the performance of loans is unchanged, can adversely impact liquidity," Neil Aggarwal, senior portfolio manager at Semper Capital, told IFR.
SPLIT RATINGS
With the prevailing issuer-pay model, future rating assignments are always at the whim of the payer.
One concern is that different rating approaches could lead to ratings shopping - when issuers seek the highest ratings at the best price - and skimpier credit buffers to protect investors from losses.
"If investors don't differentiate between ratings, there is a risk that issuers will choose based on rating levels more frequently than they are now," said Suzanne Mistretta, a senior director at Fitch Ratings.
For now, and despite past mistakes, ratings from at least one of the three majors - Fitch, Moody's and S&P - are often required for an investor to be able to buy a new issue.
This month Moody's agreed to pay a US$16.25m fine to settle claims that it failed to ensure the accuracy of models it used to rate some US mortgage bonds sold from 2010 to 2013.
S&P paid US$1.5bn three years ago to settle claims that it supplied inaccurate ratings to mortgage bonds in the run-up to the crisis.
S&P completed a second round of revisions to its US RMBS methodology earlier this year, which impacts deals issued in 2009 and later.
Prime deals are expected to see few changes under the new criteria, but weaker collateral deals could see ratings fluctuate one to three notches from the prior model.
"I have to know what the rating agencies are thinking," Aggarwal said. "Any changes can have a tremendous impact on my liquidity and ability to exit a trade."
LAYERED RISKS
As it stands right now, the market remains a shadow of its former self even with its recent growth. That limits more widespread fallout to the economy if bonds were suddenly downgraded en masse.
In the peak years before the market collapsed, a combined US$2.5trn of RMBS was sold to investors in 2005 and 2006.
But some investors are cautious that risks are bubbling up in the sector, particularly on pools of non-qualified mortgages, often to self-employed borrowers.
Being self-employed is not necessarily a bad thing: recent deals include high FICO borrowers earning good money.
But when these loans are on investment properties, rather than primary residences, the default risk - and potential losses for bond investors - rises.
"I've been waiting for this market to come back for years. I'm extremely excited we're seeing growth and I want it to evolve," Paul Norris, head of structured products at Conning, told IFR. "But I also want to be cautious about what I am buying as the risks have still not been fully understood."
Underwriting has become more lenient.
Only 12 months of bank statements are often required for non-qualified mortgage loans versus 24 months after the crash, Norris said.
Analyzing cash flowing from a bank account also has its limitations.
"It's hard to know whether everything going through the bank statement is money to repay a mortgage or if it's cash flowing to a business," said Norris.