Representations and Warranties in Mortgage-Backed Securities

Abstract

Representations and warranties (R&Ws) are essential elements of private-label mortgage-backed securities (MBS) transactions. R&Ws protect investors from the risk of production defects in the mortgage loans backing an MBS and also increase the efficiency of the mortgage securitization process by limiting the need for pre-securitization due diligence of individual loans. Lenders breached R&Ws in a high proportion of loans from the 2005–2007 origination vintages. Post-crisis litigation revealed the widespread nature of the breaches, which tended to concentrate in a few specific areas: 1) the truth and accuracy of data about the mortgage loans, 2) compliance with underwriting guidelines, and 3) compliance with appraisal industry standards. For purposes of determining whether a breach of the data R&W is material, the standard should be three percentage points for errors in either a loan’s loan-to-value ratio or its debt-to-income ratio. Additionally, any misclassification of a loan’s occupancy status into a lower-risk classification should be material. Examples of material underwriting defects include the failure to consider risk layering or permitting exceptions without compensating factors documented in the loan file. An example of a material defect in an appraisal would be noncompliance with industry standards by failing to use the most appropriate comparable properties for analysis.