New lender disclosure requirements aren't just disrupting the market for private-label mortgage bonds; they could also impact the market for bonds that transfer credit risk of mortgages insured by Fannie Mae and Freddie Mac to the private sector.
The Consumer Financial Protection Bureau's TILA/RESPA integrated disclosure rules, known as TRID, which took effect in October, was intended to help homeowners understand the total costs of a home loan. But because of the number of variable to account for on the forms, compliance has proven extremely difficult. This has caused private investors to reject loans at an unprecedented rate, out of concern that they could be held responsible for noncompliance.
The Federal Housing Finance Agency, Fannie and Freddie's regulator, has directed the government-sponsored enterprises not to conduct loan-level reviews for technical compliance, at least during a transitional period. Moody's Investors Service believes that this creates a risk for investors in bonds linked to the performance of loans insured by Fannie and Freddie, known as credit risk transfer transactions.
Connecticut Avenue Securities and Structured Agency Credit Risk are general obligations of Fannie and Freddie, respectively, yet investors can lose interest or principal in the event that enough loans insured by the GSEs default.
While the CFPB has said it would be lenient on lenders that make good faith efforts to comply, the rule opens the door to private action by borrowers.
The most likely way that a TRID violation could cause a loss to a loan, according to Yehudah Forster, a senior vice president and lead author of the report, is if the borrower successfully used it in a defense to a foreclosure; in that case, the holder of the loan (an MBS trust) could be responsible for up to $4,000 in damages plus attorney’s fees.
If, for example, that came to $20,000, this would reduce proceeds from a foreclosure, potentially leading to increase in loss severity on that loan.
Fannie or Freddie, as guarantor to the loan, would be responsible for making good on the losses to holders of the mortgage bonds backed by the loan. And the GSEs might withhold funds from investors in risk transfer bonds, which act as a form of reinsurance.
The risk is only to future CAS and STACR. "None of the deals done so far have had loans subject to TRID," Forster said. "It remains to be seen when these loans will show up in a reference pool."
Moody's thinks that risk of TRID violations will be "slightly credit negative" for those future deals.
Fannie and Freddie both released statements saying that the Moody's report overstates the possibility that TRID-related losses could impact investors in CAS and STACR.
"We require our sellers to be TRID compliant," Freddie said in its statement, which was emailed to ASR. "If we become aware of a loan with a material TRID violation, we have the ability to remove it from the STACR reference pool in order to eliminate potential losses from being passed on to investors."
Likewise, Fannie's statement said that it expects lenders to make good-faith efforts to comply with TRID and remains committed to working with these partners during this time of transition. "If a TRID violation were to occur that results in assignee liability, this would result in a repurchase under our rep and warranty framework and therefore would not result in a loss to the CAS investor," the company said.
Moody's itself expects that overall losses on CAS and STACR owing to TRID violations to be "fairly small," despite its expectations that the frequency of TRID violations on loans purchased by Fannie and Freddie will initially be high. And these losses are likely to be mitigated because lenders will be compelled to repurchase some of the loans with TRID violations from the GSEs.
By contrast, future private-label residential mortgage-backed securities will be less exposed to these risks, because private-label issuers are conducting thorough third-party due diligence for the loans that they purchase. Moody’s noted that this "due diligence feedback loop" is enabling lenders who sell to private-label issuers to cure TRID violations and fix flawed processes. By contrast, "lenders who sell only to the GSEs do not directly benefit from this feedback and may be slower to improve processes."
Damages for TRID violations are less significant than damages for violating predatory lending laws, which could cause losses to a securitization transaction in excess of the loan’s balance. By comparison, TRID caps damages at a fairly small amount and their occurrence will depend on a number of conditions. For individual claims, TRID limits potential damages to statutory damages of up to $4,000, actual damages and borrower attorney's fees and court costs. Furthermore, borrowers can receive only one set of damages on a loan, even if there are multiple TRID violations.
Moody's said that credit risk transfer transaction will only realize losses owing to TRID violations if numerous conditions occur.
First, if a borrower defaults and the loan goes to foreclosure, then the borrower successfully asserted a TRID violation as a counterclaim permitted under state law, then it would have to be determined that the loan contained a TRID violation that carries assignee liability (a subset of all potential TRID violations). This violation would also have to carry statutory damages (a subset of TRID violations that carry assignee liability). And even then, only investors who are not otherwise made whole through enforcement of lender representations and warranties or removal of the loan from the transaction.
It could take some time to determine whether any damages occur; Moody's noted that there is some uncertainty surrounding which potential TRID violations carry assignee liability and which of these carry statutory damages. "The potential violations that carry statutory damages bear more risk because the borrower need not prove harm to win them," the report states.
"Actual damages are less of a risk because borrowers would need to prove that their reliance on the erroneous information caused them harm, which historically has been near impossible."