Innovation in the US residential transition loan market — short term mortgages for investors that buy homes to fix up and sell — is happening faster than rating agencies can keep up. This is constricting the industry's access to securitization and impeding investors which cannot participate in deals that lack a rating.
As a specialised branch of the US mortgage market, RTL loans are fairly new. The first substantial securitization was in 2018, and Mayer Brown estimated that nearly $10bn was originated in 2022.
Rating agencies are naturally wary of assets they have not had the chance to study for long periods.
So far, Morningstar DBRS is the only agency that will rate RTL — or 'fix and flip' — deals. It finalized its methodology in August 2023 and rated its first deal last year: Toorak’s $240m TRK 2024-RRTL1.
This year, at least three new entrants have brought their first rated RTL securitizations.
But while that is encouraging for issuers and investors, the rating agencies' caution still hobbles the sector.
DBRS Morningstar's criteria cap how much deals can include of certain collateral types it perceives as riskier. Typical limits are about 30% for ground-up construction and 5% for multifamily construction.
Ground-up, unlike rehabilitation, involves tearing down a house and building a new one on a plot of land. Multifamily units can house five or more families. Because of these projects' longer timelines and higher costs, the rating agency sees loans for them as riskier than rehab loans.
Agency inertia
At present, rating agencies seem slow to modify their criteria. So while DBRS Morningstar's RTL securitization ratings can lure in new issuers and lead to more standardized deals — as they have done — they may also be throwing obstacles in the way of innovation.
For example, some fix and flip lenders have carved out a niche by focusing on ground-up construction. One is Asset Based Lending, but because DBRS Morningstar's rating criteria do not permit deals with large components of multifamily, ground-up or 'heavy rehab' loans, it has so far issued only unrated securitizations.
That is the core issue: the market evolves faster than rating agencies adapt to it.
Meanwhile, the US housing market is severely undersupplied. A Brookings Institution report in November put the shortage at anywhere from 1.5m to 5.5m units, and estimated the true number at 4.4m.
Creating more housing is an urgent need — and clearly the lighter rehab favoured by DBRS cannot do all the work.
Absent from the field
Investors ultimately have the final say about what they buy and at what spreads, and the existence of unrated deals proves they can invest without that aid. But ratings are supremely important in structured finance and markets tend only to flourish once they are rated.
Rating agencies are right to be conservative about new risks — it's their job to protect investors.
But since the 2008 financial crisis, they have arguably swung too far towards caution.
Now that the RTL market has been going a few years, rather than simply refusing to rate deals, or setting hard limits on collateral types, could the agencies not estimate the risks and require appropriate credit enhancement?
Sure, the agencies might feel little incentive to create rating criteria that are so conservative issuers don't want to use them. But this would still help the market, and issuers' needs and the rating standards would be likely to converge over time.
Rating agencies insist their role is to evaluate credit risks, not to influence issuer behaviour and market activity. Again, they are right in this.
But it is also true that the rigour of their oversight can raise standards and transparency in markets, and hence help them to develop.
Innovation will take place, with or without the rating agencies — as is happening with RTLs.
But for as long as they stand aloof, the market is missing out on an influential voice that could help its education and raise standards. That is to the market's detriment — and society's.