In July 2017, the United Kingdom’s Financial Conduct Authority (FCA) announced that financial institutions will no longer be required to publish LIBOR rates after December 2021, signaling the effective end of LIBOR. Given that the FCA provided a four-year transition period for market participants to identify and implement alternative reference rates, market participants are rapidly approaching the “fourth quarter” of the transition away from LIBOR.
Winning in the fourth quarter is more difficult when you finish the third quarter down by 28 points. And so, it is critical that institutions assess their progress to date in preparing for the cessation of LIBOR and making plans to implement an alternative reference rate. At this stage of an institution’s transition plan, a number of milestones need to be completed in order for an institution to reasonably consider itself “on-track.”
These include having the workstreams listed below and a detailed plan in place to complete the execution of these tasks over the next year:
- LIBOR Transition Project Team Established – Financial institutions should have established a dedicated project team responsible for managing the transition from LIBOR. For larger institutions with LIBOR exposure in multiple business units, business unit leaders should be identified and made responsible for LIBOR transition activities in their business unit.
- Identification of LIBOR Exposure – Legacy contracts should already have been evaluated and exposure to LIBOR products maturing beyond year-end 2021 should have been quantified. During the upcoming year, monthly and quarterly updates on LIBOR exposure should be communicated to management.
- Assessment of LIBOR Contracts – Contracts should be reviewed to determine whether clear fallback language has been incorporated. Contracts with a) clear fallback language, b) fallback language requiring legal interpretation, and c) no fallback language must be identified and inventoried.
- Remediate Contracts without Clear Fallback Language – For contracts without adequate fallback language, institutions need to identify and finalize options for alternative reference rates, remediation plans, and a communication strategy with stakeholders when LIBOR is terminated.
- Assess Financial Exposure to Alternative Reference Rates – Because institutions will likely be impacted by exposure to alternative reference rates beginning in January 2022, plans need to be in the works for performing analyses on how the new alternative reference rate is likely to impact income, funding, liquidity, and capital levels.
- Stop Use of LIBOR on New Products – It may not need to be said, but one of the most effective methods of mitigating LIBOR exposure is to stop creating new LIBOR products. To the extent new LIBOR products need to be issued, institutions must ensure that clear, easy-to-follow fallback language has been incorporated.
- Update and Remediate Technology – LIBOR is likely embedded in many applications and systems that set pricing on products, determine contractual payments, and determine the fair value for instruments. Plans need to be developed and implemented to update and test technology applications with LIBOR exposure.
Consider engaging with external data and technology vendors to ensure operational readiness to transition away from LIBOR. Each business line and core function such as Finance or Treasury needs to inventory technology, operations, and modeling tools to ensure every LIBOR touch point is properly accounted for.
- Validate Models With LIBOR Assumptions – As we discussed last month, many models rely on LIBOR as an assumption or as part of the cash flow discounting mechanism. Validators of models transitioning from LIBOR to an alternative reference rate need to account for this. And unscheduled validations may become necessary for models that might not otherwise be up for review before the end of 2021.
The cessation of LIBOR is a significant event impacting a broad set of financial products and market segments. Because it is intertwined in the products, technology, and models of a financial institution, LIBOR transition must be sufficiently planned, resources must be mobilized, and alternative reference rates must be implemented into every business and process.
The “fourth quarter” of the LIBOR transition game is upon us and the stakes are too high to rely on the second string. Financial institutions cannot underestimate the operational, technical, legal, communication, and risk management work required to move existing transactions off LIBOR and prepare for alternative reference rates. Although these efforts to transition from LIBOR should already be in full swing, they will continue to require additional time and resources. Teams that seem to be in control of the game still need to finish strong.
Financial institutions that have not begun a comprehensive LIBOR transition plan are running out of time and will need to mount a furious fourth-quarter comeback. It’s not too late, but with the last year of the LIBOR transition dawning, financial institutions that are behind in their planning need to hustle. No one can afford to lose this game. The costs of failing to prepare are simply too high.
In the past two months, investors have seen outsized buyouts of delinquent loans from GNMA pools, leading to a significant uptick in prepayment speeds. Nearly all of these buyouts were driven by bank servicers, including Wells Fargo, US Bank, Truist, and Chase. GNMA buyout speeds in July’s report were the fastest, with Wells Fargo leading the charge on their seriously delinquent loans. The August report saw lower but still above-normal buyout activity. For September, we expect a further decline in bank buyout speeds, as the 60-day delinquent bucket for banks has declined from 6.6% just prior to the July report to 2.2% today.
During that same time, buyouts from non-banks were nearly non-existent. We note that the roll rate from 60-day delinquent to 90-day delinquent (buyout-eligible) is comparable between banks and non-banks. So buyout-eligible delinquencies for non-banks continue to build. That pipeline, coupled with the fact that non-banks service more than 75% of GNMA’s current balance, presents a substantial risk of future GNMA buyouts.
As discussed in previous posts, the differential in buyouts between banks and their non-bank counterparts is mainly due to bank servicers being able to warehouse delinquent loans until they reperform, modified or unmodified, or until they can otherwise dispose of the loan. Non-bank servicers typically do not have the balance sheet or funding to perform such buyouts in size. If these large non-bank servicers were to team with entities with access to cheap funding or were to set up funding facilities sponsored by investors, they could start to take advantage of the upside in re-securitization. The profits from securitizing reperforming loans is substantial, so non-bank servicers can afford to share the upside with yield-starved investors in return for access to funding. In this scenario, both parties could engage in a profitable trade.
Where do delinquencies stand for non-bank servicers? In the table below, we summarize the percentage of loans that have missed 3 or more payments for the top five non-bank servicers, by coupon and vintage. In this table, we show 90-day+ delinquencies, which are already eligible for buyout, as opposed to the 60 day delinquency analysis we performed for banks, where 60 day delinquencies feed the buyout-eligible bucket via a 75% to 80% roll-rate from 60-day to 90-day delinquent.
In this table, 2017-19 vintage GN2 3.5 through 4.5s show the largest overhang of non-bank delinquencies coupled with the largest percentage of non-bank servicing for the cohort.
We summarize delinquencies for the top five non-bank servicers because they presumably have a better chance at accessing liquidity from capital markets than smaller non-bank servicers. However, we observe significant build-up of 90-day+ delinquency across all non-bank servicers, which currently stands at 7.7% of non-bank UPB, much higher than the 6.6% bank-serviced 60-day delinquency in June.
Within the top five non-bank servicers, Penny Mac tended to have the largest buildup of 90-day+ delinquencies and Quicken tended to have the lowest but results varied from cohort to cohort. In the graph below, we show the 90+ delinquency pipeline for all GN2 30yr multi-lender pools.
While we cannot say for certain when (or if) the market will see significant buyout activity from non-bank servicers, seriously delinquent loans continue to build. This overhang of delinquent loans, coupled with the significant profits to be made from securitizing reperforming loans, poses the risk for a significant uptick in involuntary speeds in GN2 multi-lender pools.
 For this analysis, we focused on the roll rate for loans in 30yr GN2 Multi-lender pools vintage 2010 onward. See RiskSpan for analysis of other GNMA cohorts.
 Over the past two months, 77% of bank-serviced loans that were 60-days delinquent rolled to a buyout-eligible delinquency state compared to 75% for non-banks.
 This analysis was performed for loans that are securitized in 30yr GN2 multi-lender pools issued 2010 onward. The top five servicers include Lakeview, Penny Mac, Freedom, Quicken, and Nationstar (Mr. Cooper).
 Reperforming loans could include modifications or cures without modification. Even with a six-month waiting period for securitizing non-modified reperforming loans, the time-value of borrowing at current rates should prove only a mild hinderance to repurchases given the substantial profits on pooling reperforming loans.
There is justified concern within the investor community regarding the residential mortgage loans currently in forbearance and their ultimate resolution. Although most of the 4M loans in forbearance are in securities backed by the Federal Government (Fannie Mae, Freddie Mac or Ginnie Mae), approximately 400,000 loans currently in forbearance represent collateral that backs private-label residential mortgage-backed securities (PLS). The PLS market operates without clear, articulated standards for forbearance programs and lacks the reporting practices that exist in Agency markets. This leads to disparate practices for granting forbearance to borrowers and a broad range of investor reporting by different servicers. COVID-19 has highlighted the need for transparent, consistent reporting of forbearance data to investors to support a more efficient PLS market.
Inconsistent investor reporting leaves too much for interpretation. It creates investor angst while making it harder to understand the credit risk associated with underlying mortgage loans. RiskSpan performed an analysis of 2,542 PLS deals (U.S. only) for which loan-level foreclosure metrics are available. The data shows that approximately 78% of loans reported to be in forbearance were backing deals originated between 2005-2008 (“Legacy Bonds”). As you would expect, new issue PLS has a smaller percentage of loans reported to be in forbearance.
Not all loans in forbearance will perform the same and it is critical for investors to receive transparent reporting of underlying collateral within their PLS portfolio in forbearance. These are unchartered times and, unlike historic observations of borrowers requesting forbearance, many loans presently in forbearance are still current on their mortgage payments. In these cases, they have elected to join a forbearance program in case they need it at some future point. Improved forbearance reporting will help investors better understand if borrowers will eventually need to defer payments, modify loan terms, or default leading to foreclosure or sale of the property.
In practice, servicers have followed GSE guidance when conducting forbearance reviews and approval. However, without specific guidance, servicers are working with inconsistent policies and procedures developed on a company-by-company basis to support the COVID forbearance process. For example, borrowers can be forborne for 12-months according to FHFA guidance. Some servicers have elected to take a more conservative approach and are providing forbearance in 3-month increments with extensions possible once a borrower confirms they remain financially impacted by the COVID pandemic.
Servicers have the data that investors want to analyze. Inconsistent practices in the reporting of COVID forbearances by servicers and trustees has resulted in forbearance data being unavailable on certain transactions. This means investors are not able to get a clear picture of the financial health of borrowers in transactions. In some cases, trustees are not reporting forbearance information to investors which makes it nearly impossible to obtain a reliable credit assessment of the underlying collateral.
The PLS market has attempted to identify best practices for monthly loan-level reporting to properly assess the risk of loans where forbearance has been granted. Unfortunately, the current market crisis has highlighted that not all market participants have adopted the best practices and there are not clear advantages for issuers and servicers to provide clear, transparent forbearance reporting. At a minimum, RiskSpan recommends that the following forbearance data elements be reported by servicers for PLS transactions:
- Last Payment Date: The last contractual payment date for a loan (i.e. the loan’s “paid- through date”).
- Loss Mitigation Type: A code indicating the type of loss mitigation the servicer is pursuing with the borrower, loan, or property.
- Forbearance Plan Start Date: The start date when either a) no payment or b) a payment amount less than the contractual obligation has been granted to the borrower.
- Forbearance Plan Scheduled End Date: The date on which a Forbearance Plan is scheduled to end.
- Forbearance Exit – Reason Code: The reason provided by the borrower for exiting a forbearance plan.
- Forbearance Extension Requested: Flag indicating the borrower has requested one or more forbearance extensions.
- Repayment Plan Start Date: The start date for when a borrower has agreed to make monthly mortgage payments greater than the contractual installment in an effort to repay amounts due during a Forbearance Plan.
- Repayment Plan Scheduled End Date: The date at which a Repayment Plan is scheduled to end.
- Repayment Plan Violation Date: The date when the borrower ceased complying with the terms of a defined repayment plan.
The COVID pandemic has highlighted monthly reporting weaknesses by servicers in PLS transactions. Based on investor discussions, additional information is needed to accurately assess the financial health of the underlying collateral. Market participants should take the lessons learned from the current crisis to re-examine prior attempts to define monthly reporting best practices. This includes working with industry groups and regulators to implement consistent, transparent reporting policies and procedures that provide investors with improved forbearance data.
Having good Prepayment and Credit Models is critical in the analysis of Residential Mortgage-Backed Securities. Prepays and Defaults are the two biggest risk factors that traders, portfolio managers and originators have to deal with. Traditionally, regression-based Behavioral Models have been used to accurately predict human behavior. Since prepayments and defaults are not just complex human decisions but also competing risks, accurately modeling them has been challenging. With the exponential growth in computing power (GPUs, parallel processing), storage (Cloud), “Big Data” (tremendous amount of detailed historical data) and connectivity (high speed internet), Artificial Intelligence (AI) has gained significant importance over the last few years. Machine Learning (ML) is a subset of AI and Deep Learning (DL) is a further subset of ML. The diagram below illustrates this relationship:
Due to the technological advancements mentioned above, ML based prepayment and credit models are now a reality. They can achieve better predictive power than traditional models and can deal effectively with high-dimensionality (more input variables) and non-linear relationships. The major drawback which has kept them from being universally adopted is their “black box” nature which leads to validation and interpretation issues. Let’s do a quick comparison between traditional and ML models:
Within ML Models are two ways to train them:
- Supervised Learning (used for ML Prepay and Credit Models)
- Regression based
- Classification based
- Unsupervised Learning
Let’s compare the major differences between Supervised and Unsupervised Learning:
The large amounts of loan level time series data available for RMBS (agency and non-agency) lends itself well for the construction of ML models and early adopters have reported higher accuracy. Besides the obvious objections mentioned above (black box, lack of control, interpretation) ML models are also susceptible to overfitting (like all other models). Overfitting is when a model does very well on the training data but less well on unseen data (validation set). The model ends up “memorizing” the noise and outliers in the input data and is not able to generalize accurately. The non-parametric and non-linear nature of ML Models accentuates this problem. Several techniques have been developed to address this potential problem: reducing the complexity of decision trees, expanding the training dataset, adding weak learners, dropouts, regularization, reducing the training time, cross validation etc.. The interpretation problem is a bit more challenging since users demand both, predictive accuracy and some form of interpretability. Several interpretation methods are used currently, like PDP (Partial dependence plot), ALE (accumulated local effects), PFI (permutation feature importance) and ICE (individual conditional expectation) but each has its shortcomings. Some of the challenges with the interpretability methods are:
- Isolating Cause and Effect – This is not often possible with supervised ML models since they only exploit associations and do not explicitly model cause/effect relationships.
- Mistaking Correlation for Dependence – Independent variables have a correlation coefficient of zero but a zero correlation coefficient may not imply independence. The correlation coefficient only tracks linear correlations and the non-linear nature of the models makes this difficult.
- Feature interaction and dependence – An incorrect conclusion can be drawn about the features influence on the target when there are interactions and dependencies between them.
While ML based prepay and credit models offer better predictive accuracy and automatically capture feature interactions and non-linear effects, they are still a few years away from gaining widespread acceptance. A good use for such models, at this stage, would be to use them in conjunction with traditional models. They would be a good benchmark to test traditional models with.
Note: Some of the information on this post was obtained from publicly available sources on the internet. The author wishes to thank Lei Zhao and Du Tang of the modeling group for proofreading this post.