Editor’s Letter

Welcome to the Spring 2022 issue of The Journal of Structured Finance. Issuance activity through late March is outpacing last year’s levels in most sectors. However, challenges are emerging along several dimensions and the outlook for the remainder of 2022 is uncertain.

Rising rates. Rising rates are no longer merely a possibility. The Fed has already started taking action at the short end of the curve and the market has responded with significant jumps in rates at longer maturities. Writing this in the closing days of March, the 10-year Treasury is yielding 2.46%, compared to 1.67% a year ago. The rate for a 30-year fixed-rate mortgage is at 4.95%, and likely heading higher. Beyond affecting the prices of outstanding fixed-income securities, an environment of higher rates will likely be a drag on new activity in both the mortgage sector and the broader securitization market.

CFPB enforcement risk. The US District Court in Delaware ruled in December that securitization trusts are subject to CFPB enforcement authority. The case is Consumer Financial Protection Bureau v. National Collegiate Master Student Loan Trust (No. 1:17-cv-1323-SB). On February 11, the District Court certified two questions for interlocutory appeal to the US Court of Appeals for the Third Circuit. If the District Court’s ruling stands, it will mean that securitization trusts could be exposed to greater risk of costs and damages from litigation. The risk would likely to be greatest for deals backed by loans to risky borrowers.

More recently, the CFBP released policy guidance about mitigating harm from automobile repossessions.¹ The policy guidance does not mention securitizations, but somewhat surprisingly, the related press release does. It includes a seemingly throwaway comment that “[s]ometimes, auto loans are bundled and sold to investors as securities.”² Is this is hint that the CFPB might intend to pursue auto ABS trusts when servicers engage in improper repossession practices? It remains to be seen.

Contractual protections and remedies. The New York State Court of Appeals addressed contractual protection and remedies in its March 17 decision in U.S. Bank v. DLJ Mortgage Capital.³ Interpreting the language of the governing agreement for the HEAT 2007-1 MBS transaction, the court ruled that the trust can compel the issuer to repurchase loans that breach representations and warranties (R&Ws) only if the issuer received notice of the breaches before the start of the lawsuit. The ruling means that investors cannot recover for breaches revealed during the litigation discovery process unless they start a new lawsuit or unless those breaches were previously known to the issuer.

The new U.S. Bank decision is the most recent in a line of decisions from New York’s highest court that have interpreted MBS contracts narrowly, often in ways that are adverse to MBS investors. One key outcome was that R&Ws expire six years after a deal’s closing date.⁴ Another important outcome essentially nullified an R&W that there had been no untrue statement in connection with the sale of loans into a deal.⁵ A third case partially thwarted a bond insurer’s claim that it had been fraudulently induced to issue a bond insurance policy. It was allowed to recover only what it could get for breaches of R&Ws.⁶ A fourth case emphasized the need for a trustee to comply with all the “conditions precedent” for demanding the repurchase of defective loans before it can commence a lawsuit. That case was originally dismissed because the conditions precedent had not been satisfied, but the court allowed the trustee to refile it after completing them.⁷ In 2020 the court ruled that the detailed requirements of the loan putback process would apply even if the issuer commited gross negligence by including numerous defective loans in a deal.⁸

While the U.S. Bank decision is about a 2007-vintage MBS, more recent deals have even weaker contractual protections. I wrote a little bit about this in the editor’s letter for the Fall 2020 JSF. Moody’s has been reminding market participants of the issue for somewhat longer. In 2017 the rating agency discussed how R&Ws tended to be particularly weak in deals backed by reperforming loans (Tai, Shin, and Haider 2017). Later that year the rating agency discussed how R&W frameworks for MBS backed by nonprime loans were becoming weaker than those for deals backed by prime-quality loans. Moody’s noted several negative features of the R&W frameworks in nonprime deals: 1) weak review triggers that could hide defective loans, 2) the potential for conflicts of interest to cause breaches to go undetected, 3) the absence of a clear enforcement process could weaken arbitration decisions, and 4) weaker financial capacity of transaction parties responsible for repurchasing defective loans (Shen and Forster 2017).

In July 2018 Moody’s discussed the value of third-party diligence reviews and highlighted that they can be more effective than R&Ws at preventing problems if all the loans in a deal are reviewed. However, around that time, several issuers were moving from a system of 100% preclosing reviews to the sampling approach that had been common before the mortgage meltdown. Moody’s noted that the revival of sampling would bring greater reliance on R&Ws. The rating agency explained that certain weaknesses were starting to appear in the R&W frameworks for MBS deals backed by prime-quality loans. It noted the following: 1) weak R&W counterparties, 2) materiality conditions, 3) prescribed tests that would fail to detect certain types of R&W breaches, 4) unspecified scope of review possibly controlled by a conflicted party, 5) sunset provisions, and 6) poor reporting on breach reviews (Forster 2018). Later, in March 2019, Moody’s reported on how poor reporting on R&W breaches increased the risk of defective loans remaining in MBS pools (Vasudevan, Forster, and Jiang 2019).

The steady trend of eroding contractual protections may soon reach a tipping point, at least for residential MBS. The issue is heightened for residential mortgage loans compared to most other asset classes because they have long average lives. Trouble can develop many years after a deal’s closing. Securities law protection for MBS investors has been largely illusory, primarily because of the short time limits for starting lawsuits. Without reliable contractual protections, MBS investors have nothing to rely on except trusting transaction parties to behave properly. If an issuer or sponsor delivers defective loans into a deal, the defects might not reveal themselves for a number of years and investors may well be stuck with the consequences. Moreover, without reliable legal remedies for investors (either under the securities laws or contractually), there is little to deter an issuer from including defective loans in large numbers.

Geopolitical risk. The war in Ukraine continues. Russia pummels Ukrainian cities with rockets and artillery. Ukrainian forces bravely resist, inflicting significant losses on the Russian military. The sanctions imposed on Russia by the United States and allied countries are isolating the aggressor economically and causing broader economic disruptions, including supply chain issues. Additionally, the war’s future implications for international stability, trade, and economic growth remain highly uncertain. Nonetheless, the stock market is higher now than it was on February 24, the date on which Russia invaded Ukraine.

The war’s most immediate effect on securitization has been in the aircraft ABS sector. Hundreds of leased aircraft remain stranded on Russian soil. It is unclear when or if the lessors will regain control over them. The rating agencies have already commented on the issue (Wadson et al. 2022; Subramanian, Newman, and Szilank 2022).

A likely consequence of the war in Ukraine will be decreased reliance by European countries on natural gas sourced in Russia. In the short run, European countries will continue to buy gas from Russia. In the medium term, The US is likely to become a major supplier, transporting liquified natural gas (LNG) in giant tankers across the Atlantic. Longer term, Europe plans to gradually substitute renewable energy sources for fossil fuels. Interestingly, however, on February 2 the EU announced that it would classify certain investments in natural gas and nuclear projects as “green” activities.⁹ The EU appears to be viewing natural gas and nuclear energy as bridge energy sources along the path to a carbon-free future.¹⁰ That announcement initially raised the hackles of environmental groups.

Meanwhile, Russia stands accused of serious war crimes in its conduct of the war. The indiscriminate bombing and shelling of civilian structures and the civilian population appear to be “grave breaches” of the Geneva Convention.¹¹ However, the likelihood of any successful enforcement action in response to those breaches seems remote.

Credit ratings. Credit ratings embody analyses that include both quantitative and qualitative aspects. The inclusion of qualitative factors in the analysis should not, however, make ratings subjective. They are supposed to be objective opinions about credit risk. This follows from various legal requirements. One such requirement is that a given symbol used by a rating agency must mean the same thing regardless of the type of security or issuer to which it is applied.¹² Another is that rating agencies must determine ratings by applying methodologies.¹³ More specifically, a rating agency must have internal controls to allow management to detect a failure to “[a]dhere to an implemented policy, procedure, or methodology for determining credit ratings.”¹⁴

The requirement to apply a prescribed methodology for determining credit ratings resonated in the world of sports during the Winter Olympics in February. One of the most popular sports in the Winter Olympics is figure skating. The scoring of figure skating competitions necessarily includes qualitative aspects, most notably the “grade of execution” adjustment for each jump, spin, and step sequence that a skater performs. Achieving perfect objectivity in the scoring may be unattainable. Nonetheless, the International Skating Union tries to maximize objectivity by providing an extensive body of technical materials to guide judges.¹⁵ Additionally, at high-level competitions, the rules call for using multiple judges in order to ameliorate the effects of individual bias.

By contrast, the system for picking the teams to play in the NCAA football playoffs is less transparent and probably less objective. Georgia beat Alabama on January 10 to become the national champions. Georgia had beaten Michigan in the semi-finals, and Alabama had beaten Cincinnati. But how did Georgia, Alabama, Michigan, and Cincinnati get to the semi-finals? Answer: The college football playoff (CFP) selection committee picked them. The committee ranks the leading teams each week during the latter portion of the regular season. The four top-ranked teams from the final week go to the playoffs. So how does the ranking work? There is a written protocol, but the criteria are vague.¹⁶ The key guidance states the following:

The committee will select the teams using a process that distinguishes among otherwise comparable teams by considering:

• ▪ Conference championships won,

• ▪ Strength of schedule,

• ▪ Head-to-head competition,

• ▪ Comparative outcomes of common opponents (without incenting margin of victory), and,

• ▪ Other relevant factors such as unavailability of key players and coaches that may have affected a team’s performance during the season or likely will affect its postseason performance.

That is not much to work with when the stakes are so high. In the 2021 season, the week-by-week rankings of the teams that finished in the top 10 were as follows:

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EXHIBIT 1

College Football Playoff Selection Committee Rankings 2021

The weak objectivity of the system is likely vexing to a team like Ohio State, which had been in the top four for several weeks but missed being there at the end. The CFP playoff selection process is a great example of what the market should not want in credit ratings.

This issue has a mortgage theme. It opens with an article by Mike Fratantoni, chief economist of the Mortgage Bankers Association. He discusses how the use of electronic documentation for residential mortgage loans has increased in recent years. He notes that the Covid-19 pandemic provided a shock that accelerated the acceptance of purely electronic documentation. This is a very hot topic. Electronic documentation has the potential to make loan originations faster and cheaper. It is broadly supported by the mortgage industry, and the legal framework for using electronic documentation has existed for over 20 years.

Using technology to get documents to a borrower for review prior to closing is absolutely a good idea. However, when it comes to the actual mortgage note, I must confess that I remain a member of the very small minority that still favors an old-fashioned paper note with a “wet signature.” I have three reasons:

• ▪ First, closing a mortgage loan with an “eNote” loses the element of ceremony that goes along with signing a paper note. Mortgage loans and home purchases are often the biggest financial transactions in a person’s life. There is some benefit to the ceremonial aspect, which highlights the magnitude of the obligation. Having a wet signature is part of that.

• ▪ Second, eNotes necessarily come with potential security vulnerabilities. I expect all types of computer security to eventually become hackable. If eNotes are hacked, a borrower might have to deal with multiple parties claiming ownership of their loan. Having a single paper note addresses that risk and seems appropriate for long-term obligations amounting to hundreds of thousands of dollars.

• ▪ Third, without a physical note that can be stamped “PAID” and returned to a borrower upon the satisfaction of their loan, I don’t see how the borrower gets incontrovertible evidence that their debt has been repaid. Borrowers should want to have that evidence to protect themselves.

The issue’s second article is by Frank E. Nothaft, Patrick H. Kiser, and Molly Boesel all of Corelogic. They examine the effects of the pandemic on the mortgage market. They discuss the ups and downs of lone originations and nonagency MBS issuance. The also discuss delinquency and forbearance trends, including a geographic analysis. The third article is by Laurie S. Goodman, Karan Kaul, and Michael Neal, all of the Urban Institute. They focus on America’s shortage of affordable housing and examine how changes in the mechanisms for financing manufactured homes and accessory dwelling units could potentially help to bridge the shortfall. The fourth article is by Francis Parisi of Pace University. He analyzes the drivers of home price appreciation. He concludes that policy responses to the Covid-19 pandemic may have changed the mix of economic factors that drive home prices. He predicts that the rate of home price appreciation is likely to slow down over the next few years.

The next section is the selected highlights from GlobalCapital for the first quarter of 2022. The selection was compiled and curated by GC securitization editor, Jennifer Kang. Six stories are featured, covering the following subjects:

• ▪ BNY Mellon’s efforts to sell its Alcentra money management business

• ▪ the resurgence of “print and sprint” CLO issuance strategies sparked by the war in Ukraine

• ▪ strong demand for floating-rate assets driven by Fed tightening, particularly single-asset/single-borrower CMBS and CRE CLOs

• ▪ challenges for the CLO market in moving from LIBOR to SOFR (2 stories)

• ▪ aircraft ABS and the effects of the war in Ukraine

Next comes a selection of industry news items from the Structured Finance Association, also from Q1 2022. The selection includes more than two dozen news snippets covering timely and important developments in the structured finance market. I encourage you to read them all, but I want to especially direct your attention to the item from March 17. That item reports on the results of a survey by the SFA about market preferences for pricing fixed-rate securities. The survey responses indicate a strong preference for using a Treasury-based curve, rather than a SOFR-based swap curve, for fixed-rate pricing. The item includes a link to the full survey results, which I recommend reading.

As always, we welcome your submissions. Please encourage those you know who have good articles or who have made good presentations on structured finance or project finance-related subjects to submit them to us.

Submission guidelines can be found at https://jsf.pm-research.com/authors. If you have comments or suggestions, you can e-mail them directly to me at m.adelson{at}pm-research.com.

Mark Adelson

Editor

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