When Fitch last week became the third of the major credit rating agencies to propose a change to the way it assesses RMBS, an initial assessment might have concluded that this was a big benefit to issuers, would enhance the efficiency of the capital markets and that the asset class was perhaps less risky for investors. But the reality is far more nuanced.
Fitch proposed to be less punitive than in the past when judging the loans used as collateral in RMBS. Moody’s and S&P proposed other changes to their criteria earlier in the year that were similarly issuer-friendly in nature.
The changes proposed by all three would result in issuers needing to provide lower overcollateralization. This would make issuing RMBS cheaper, with the savings possibly also being fed down to loan originators.
The rating methodology changes come in response, it is said, to the availability of newer mortgage performance data and incorporation of new standards that were not previously common practice, such as the tendency for servicers to resolve delinquent mortgages through modification rather than foreclosure and liquidation.
Ratings agencies separate decisions made about their scoring criteria from their own commercial concerns, following reforms made after the 2008 financial crisis. Nonetheless, some people in the market suspect that they are realigning their standards to be competitive with each other.
Baked into the rating agency business model, where issuers pay for ratings, is the motivation for issuers to shop around for the best outcome. If one rating agency makes its criteria more lenient, for any reason, there is a commercial incentive for others to follow.
There is nothing to suggest that the rating agencies that changed their RMBS criteria were motivated by anything other than the ability to make better judgements from newly available data and changing practices in the mortgage market.
Even so, RMBS market participants should be more vigilant rather than less. These rating criteria changes have been made absent of performance data gathered during a typical recession, and at a time when the housing market is slowing and mortgage delinquencies are rising.
It could be argued that the Covid recession was proof that mortgages can withstand economic shock and still perform well, with minimal losses and with most delinquencies cured through loan modifications.
But the Covid recession met with huge government stimulus into the economy, which made it a short-lived recession, and at a time of rock-bottom interest rates.
There is no guarantee of such federal remedies being administered to the next downturn.
Buyers' responsibility
One criticism frequently made of ratings agencies is that they are behind the times — often something said when an upgrade fails to yield a rally in bond prices. Such a critique downplays the importance of the ratings agencies, however, especially in the more complex areas of credit, like securitization.
The underlying the point is that investors make the ultimate decision about what is creditworthy and what isn’t through their allocations.
Moreover, investors are not a homogenous mass. Some will want to be compensated for the lower overcollateralization, others will happily accept it.
But now that issuers are likely to have greater wiggle room on RMBS to weaken investor protections such as overcollateralization, it will be up to buyers to scrutinise each deal and push back when they think they are getting a raw deal.
Better data and more flexible arrangements for mortgage borrowers in distress should indeed create a more efficient RMBS market. But the investors who end up bearing the risk will be the real arbiters of what that is worth to issuers.