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Is Your Enterprise Risk Management Keeping Up with Recent Regulatory Changes?​

For enterprise risk managers, ensuring that all the firm’s various risk management structures and frameworks are keeping up with ever-changing regulatory guidance can be a daunting task. Regulatory updates take on particular importance for model risk managers. MRM is required not only to understand and comply with the regulatory guidance specific to model risk management itself, but also to understand the regulatory ramifications of the risk models they validate.

This post focuses on recent updates to eight ERM areas that can sometimes seem like a moving target when it comes to risk compliance.

The timeline below illustrates the extensive variability that can exist from regulator to regulator when it comes to which ERM components are of most concern and the nature and speed of adoption. To take one example, model risk management guidance was issued in 2011 and all Fed- and OCC-regulated institutions were in general compliance with it by 2014. The FDIC, however, did not issue the same guidance until 2017 and enforcement varies considerably. Although every FDIC-regulated institution is technically required to be in compliance with the MRM guidance, several have yet to undergo even their first MRM exam. Things get even cloudier for credit unions as the NCUA has not issued any guidance or regulation pertaining to MRM. The NCUA requires MRM practices to be observed during Capital Planning and Stress Testing (per its 2019 capital planning guide). But this narrow definition allows most credit unions to skirt regulator-required MRM entirely.

Because it can be difficult to stay on top of which regulator is requiring what and when, here is a quick summary of recent updates, organized by risk area.

Bank Secrecy Act (BSA) / Anti Money Laundering (AML) 

The past year has seen five guidance updates pertaining to BSA/AML. Most of these seek to increase the effectiveness, predictability, and transparency of BSA/AML regulatory exams. Other updates clarify specific aspects of BSA/AML risk.

  1. Updated Sections of the FFIEC BSA/AML Examination Manual (OCC 2021-10/SR 21-9 & OCC 2021-28). The updated sections:
    • Reinforce the risk-focused approach to BSA/AML examinations, and
    • Clarify regulatory requirements and include updated information for examiners regarding transaction testing, including examples.
  1. Interagency Statement on Model Risk Management for Bank Systems Supporting BSA/AML Compliance and Request for Information (OCC 2021-19/SR 21-8) as of April 12, 2021. This guidance:
    • Outlines the importance of MRM governance to AML exams,
    • Is designed to be flexible when applying MRM principals to BSA/AML models,
    • Updates MRM principles and validation to be more responsive,
    • Seeks not to apply a single industry-wide approach, and
    • Directs validators to consider third-party documentation when reviewing AML models.
  1. Answers to Frequently Asked Questions Regarding Suspicious Activity Reporting and Other AML Considerations (OCC 2021-4) as of January 21, 2021. These include instructions around:
    • Requests by law enforcement for financial institutions to maintain accounts,
    • Receipt of grand jury subpoenas/law enforcement inquiries and suspicious activity report (SAR) filing,
    • Maintaining a customer relationship following the filing of a SAR or multiple SARs,
    • SAR filing on negative news identified in media searches,
    • SAR monitoring on multiple negative media alerts,
    • Information in data fields and narrative, and
    • SAR character limits.
  1. Joint Statement on Bank Secrecy Act Due Diligence Requirements for Customers Who May Be Considered Politically Exposed Persons (OCC 2020-77/SR 20-19) as of August 21, 2020. This statement:
    • Explains that the BSA/AML regulations do not define what constitutes a politically exposed person (PEP),
    • Clarifies that the customer due diligence rule does not create a regulatory requirement and that there is no supervisory expectation for banks to have unique, additional due diligence steps for PEPs,
    • Clarifies how banks can apply a risk-based approach to customer due diligence in developing risk profiles for their customers, and
    • Discusses potential risk factors, levels and types of due diligence.
  1. OCC-Proposed Rule Regarding Exemptions to Suspicious Activity Report Requirements as of December 17, 2020:
    • The proposed rule would amend the agency’s SAR regulations to allow the OCC to issue exemptions from the requirements of those regulations on when and how to file suspicious activity reports (SARs).
Allowance for Loan and Lease Losses (ALLL)/ Current Expected Credit Losses (CECL) 

Current Expected Credit Losses: Final Rule (OCC 2020-85/SR 19-8/FIL-7-2021) as of October 1, 2020. The rule:

    • Applies to all community banks that adopted CECL in 2020 per GAAP requirements,
    • Exempts all other institutions until 2023,
    • Adopts all of the 2020 CECL IFR, and
    • Clarifies that a banking organization is not required to use the transition during fiscal quarters in which it would not generate a regulatory capital benefit.
Asset Liability Management (ALM) and Liquidity Risk Management 

Four important updates to ALM and liquidity risk guidance were issued in the past year.

  1. Net Stable Funding Ratio: Final Rule (OCC 2021-9) as of February 24, 2021. The rule:
    • Implements a minimum stable funding requirement designed to reduce the likelihood that disruptions to a covered company’s regular sources of funding will compromise its liquidity position,
    • Requires the maintenance a ratio of “available stable funding” to “required stable funding” of at least 1.0 on an ongoing basis,
    • Defines “available stable funding” as the stability of a banking organization’s funding sources,
    • Defines “required stable funding” as the liquidity characteristics of a banking organization’s assets, derivatives, and off-balance-sheet exposures,
    • Requires notification of a shortfall, realized or potential within 10 business days, and
    • Provides public disclosure rules for a consolidated NSFR.
  1. Volcker Rule Covered Funds: Final Rule (OCC 2020-71) as of July 41, 2020. The rule:
    • Permits the activities of qualifying foreign excluded funds,
    • Revises the exclusions from the definition of “covered fund,”
    • Creates new exclusions from the definition of covered fund for credit funds, qualifying venture capital funds, family wealth management vehicles, and customer facilitation vehicles, and
    • Modifies the definition of “ownership interest.”
  1. Interest Rate Risk: Revised Comptroller’s Handbook Booklet (OCC 2020-26) as of March 26, 2020. The updated Handbook:
    • Expands discussions on MRM expectations for reviewing and testing model assumptions,
    • Addresses funds transfer pricing (FTP), and
    • Adds guidelines for advanced approaches to interest rate risk management consistent with the Pillar 2 supervisory approach.
  1. Capital and Liquidity Treatment for Money Market Liquidity Facility and Paycheck Protection Program: Final Rule (OCC 2020-96) as of November 3, 2020. This rule:
    • Permits a zero-percent risk weight for PPP loans,
    • Eliminates the regulatory capital impact and liquidity rule provisions for participating in the PPP and Money Market Liquidity Facility.
Artificial Intelligence (AL)/ Machine Learning (ML) 

The only recent regulatory update pertaining to AI/Machine Learning has been a request for comment related to usage, controls, governance, and risk. At present, there is no formal guidance specifically related to AI or ML models. The OCC’s semi-annual risk perspectives includes just a couple of sentences stating that users of ML models should be able to defend and explain their risks. The Fed’s feedback has been similarly broad. Movement seems afoot to issue more detailed guidance on how ML models should be governed and monitored. But this is likely to be limited to specific applications and not to the ML models themselves.

The Request for Information and Comment on Financial Institutions’ Use of Artificial Intelligence, Including Machine Learning (OCC 2021-17) as of March 31, 2021, seeks respondents’ views on appropriate governance, risk management, and controls over artificial intelligence, and any challenges in developing, adopting, and managing artificial intelligence approaches.

Capital Risk 

We focus on the two items of capital risk guidance issued in the past year. The rule applies to community banks with total assets of less than $10 billion as of December 31, 2019.

  1. Temporary Asset Thresholds: Interim Final Rule (OCC 2020-107) as of December 2, 2020:
    • The rule allows these institutions to use asset data as of December 31, 2019, to determine the applicability of various regulatory asset thresholds during calendar years 2020 and 2021.
  1. Regulatory Capital Rule: Eligible Retained Income: Final Rule (OCC 2020-87) as of October 8, 2020:

The final rule revises the definition of eligible retained income to the greater of:

    • Net income for the four preceding calendar quarters, net of any distributions and associated tax effects not already reflected in net income, and
    • The average of a Bank’s net income over the preceding four quarters.
Fair Lending 
  1. Community Reinvestment Act: Key Provisions of the June 2020 CRA Rule and Frequently Asked Questions (OCC 2020-99) as of November 9, 2020:

The rule establishes new criteria for designating bank assessment areas, including:

    • Facility-based assessment areas based on the location of a bank’s main office and branches and, at a bank’s discretion, on the location of the bank’s deposit-taking automated teller machines, and
    • Deposit-based assessment areas, which apply to a bank with 50 percent or more of its retail domestic deposits outside its facility-based assessment areas.
  1. Community Reinvestment Act: Implementation of the June 2020 Final Rule (OCC 2021-24) as of May 18, 2021. The OCC has determined that it will reconsider its June 2020 rule. While this reconsideration is ongoing, the OCC will not implement or rely on the evaluation criteria in the June 2020 rule pertaining to:
    • Quantification of qualifying activities
    • Assessment areas
    • General performance standards
    • Data collection
    • Recordkeeping
    • Reporting
Market Risk 
  1. Libor Transition: Self-Assessment Tool for Banks (OCC 2021-7) as of February 10, 2021. The self-assessment tool can be used to assess the following:
    • Five primary topics: Assets and contracts; LIBOR risk exposure; Fallback language; Consumer impact; Third-party service provider
    • The appropriateness of a bank’s Libor transition plan
    • Bank management’s execution of the bank’s transition plan
    • Related oversight and reporting
  1. Standardized Approach for Counterparty Credit Risk; Correction: Final Rule (OCC 2020-82) as of September 21, 2020. The issuance corrects errors in the standardized approach for counterparty credit risk (SA-CCR) rule:
    • Clarifying that a Bank that uses SA-CCR will be permitted to exclude the future exposure of all credit derivatives
    • Revising the number of outstanding margin disputes
    • Correcting the calculation of the hypothetical capital requirement of a qualifying central counterparty (QCCP)
  1. Agencies Finalize Amendments to Swap Margin Rule (News Release 2020-83) as of June 25, 2020:
    • Swap entities that are part of the same banking organization will no longer be required to hold a specific amount of initial margin for uncleared swaps with each other, known as inter-affiliate swaps.
    • Final rule allows swap entities to amend legacy swaps to replace the reference to LIBOR or other reference rates that are expected to end without triggering margin exchange requirements.
Operations Risk
  1. Corporate and Risk Governance. Revised and New Publications in the Director’s Toolkit (OCC 2020-97) as of November 5, 2020:
    • Defines permissible derivatives activities,
    • Allows engagement in certain tax equity finance transactions,
    • Expands the ability to choose corporate governance provisions under state law,
    • Includes OCC interpretations relating to capital stock issuances and repurchases, and
    • Applies rules relating to finder activities, indemnification, equity kickers, postal services, independent undertakings, and hours and closings to FSAs.
  1. Activities and Operations of National Banks and Federal Savings Associations: Final Rule (OCC 2020-111) as of December 23, 2020:
    • Focuses on key areas of planning, operations, and risk management,
    • Outlines directors’ responsibilities as well as management’s role,
    • Explains basic concepts and standards for safe and sound operation of banks, and
    • Delineates laws and regulations that apply to banks.
  1. Operational Risk: Sound Practices to Strengthen Operational Resilience (OCC 2020-94) as of October 10, 2020:
    • Outlines standards for operational resilience set forth in the agencies’ rules and guidance,
    • Promotes a principles-based approach for effective governance, robust scenario analysis, secure and resilient information systems, and thorough surveillance and reporting,
    • Introduces sound practices for managing cyber risk.
Contact us to learn more.

RiskSpan VQI: Agency Mortgage Risk Layers for Q2 2021

RiskSpan’s Vintage Quality Index computes and aggregates the percentage of Agency originations each month with one or more “risk factors” (low-FICO, high DTI, high LTV, cash-out refi, investment properties, etc.). Months with relatively few originations characterized by these risk factors are associated with lower VQI ratings. As the historical chart above shows, the index maxed out (i.e., had an unusually high number of loans with risk factors) leading up to the 2008 crisis.

RiskSpan uses the index principally to fine-tune its in-house credit and prepayment models by accounting for shifts in loan composition by monthly cohort.

Rising Home Prices Contribute to More High-DTI Loans and Cash-out Refis

The Vintage Quality Index rose noticeably during the second quarter of 2021 — up to a value of 83.40, compared to 76.68 in the first quarter.

Unlike last quarter, when a precipitous drop in high-LTV loans effectively masked and counterbalanced more modest increases in the remaining risk metrics, this quarter’s sizeable VQI jump is attributable to a more across-the-board increase in risk layers.

A sharp rebound in the percentage of high-LTV loans, a metric that had been in steady decline since the middle of 2019, was accompanied by modest increases in borrowers with low credit scores (FICO below 660) and high debt-to-income ratios (greater than 45%).

The spike in home prices across the country that likely accounts for the rise in high-LTV mortgages also appears to be prompting an increasing number of borrowers to seek cash-out refinancings. More than 22 percent of originations had LTVs in excess of 80 percent at the end of Q2, compared to just 17 percent at the end of Q1. Similarly, nearly 25 percent of mortgages were cash-out refis in June, compared to 22 percent in March.

Modest declines were observed in the percentages of loans on investment and multi-unit properties. All other risk metrics were up for the quarter, as the plots below illustrate.

Population assumptions:

  • Monthly data for Fannie Mae and Freddie
  • Loans originated more than three months prior to issuance are excluded because the index is meant to reflect current market
  • Loans likely to have been originated through the HARP program, as identified by LTV, MI coverage percentage, and loan purpose, are also excluded. These loans do not represent credit availability in the market as they likely would not have been originated today but for the existence of

Data assumptions:

  • Freddie Mac data goes back to 12/2005. Fannie Mae only back to 12/2014.
  • Certain fields for Freddie Mac data were missing prior to 6/2008.

GSE historical loan performance data release in support of GSE Risk Transfer activities was used to help back-fill data where it was missing.

An outline of our approach to data imputation can be found in our VQI Blog Post from October 28, 2015.

EDGE: Extended Delinquencies in Loan Balance Stories

In June, we highlighted Fannie Mae’s and Freddie Mac’s new “expanded delinquency” states. The Enterprises are now reporting delinquency states from 1 to 24 months to better account for loans that are seriously delinquent and not repurchased under the extended timeframe for repurchase of delinquent loans announced in 2020.

This new data reveals a strong correlation between loan balance and “chronically delinquent” loans. In the graph below, we chart loan balance on the x-axis and 180+Day delinquency on the y-axis, for 2017-18 production 30yr 3.5s through 4.5 “generic” borrowers.[1]

As the graph shows, within a given coupon, loans with larger original balances also tended to have higher “chronic delinquencies.”

EDGE-Orig-Loan-Size

The graph above also illustrates a clear correlation between higher chronic delinquencies and higher coupons. This phenomenon is most likely due to SATO. While each of these queries excluded low-FICO, high-LTV, and NY loans, the 2017-18 30yr 3.5 cohort was mostly at-the-money origination, whereas 4.0s and 4.5s had an average SATO of 30bp and 67bp respectively. The higher SATO indicates a residual credit quality issue. As one would expect, and we demonstrated in our June analysis, lower-credit-quality loans tend also to have higher chronic delinquencies.

The first effect – higher chronic delinquencies among larger loans within a coupon – is more challenging to understand. We posit that this effect is likely due to survivor bias. The large refi wave over the last 18 months has factored-down higher-balance cohorts significantly more than lower-balance cohorts.

EDGE-Factors

Higher-credit-quality borrowers tend to refinance more readily than lower-credit-quality borrowers, and because the larger-loan-balance cohorts have seen higher total prepayments, these same cohorts are left with a larger residue of lower-quality credits. The impact of natural credit migration (which is observed in all cohorts) tends to leave behind a larger proportion of credit-impaired borrowers in faster-paying cohorts versus the slower-paying, lower-loan-balance cohorts.

The higher chronic delinquencies in larger-loan-balance cohorts may ultimately lead to higher buyouts, depending on the resolution path taken. As loan balance decreases, the lower balance cohorts will have reduced risk to these potential buyouts, leaving them better protected to any uptick in involuntary speeds.

Contact us if you are interested in seeing variations on this theme. Using Edge, we can examine any loan characteristic and generate a S-curve, aging curve, or time series.

[1] We filtered for borrowers with LTV<=80, FICO>=700, and ex-NY. We chose 2017-18 production to analyze, to give sufficient time for loans to go chronically delinquent. We see a similar relationship in 2019 production, see RiskSpan for details.

Climate Terms the Housing Market Needs to Understand

The impacts of climate change on housing and holders of mortgage risk are very real and growing. As the frequency and severity of perils increases, so does the associated cost – estimated to have grown from $100B in 2000 to $450B 2020 (see chart below). Many of these costs are not covered by property insurance, leaving homeowners and potential mortgage investors holding the bag. Even after adjusting for inflation and appreciation, the loss to both investors and consumers is staggering. 

Properly understanding this data might require adding some new terms to your personal lexicon. As the housing market begins to get its arms around the impact of climate change to housing, here are a few terms you will want to incorporate into your vocabulary.

  1. Natural Hazard

In partnership with climate modeling experts, RiskSpan has identified 21 different natural hazards that impact housing in the U.S. These include familiar hazards such as floods and earthquakes, along with lesser-known perils, such as drought, extreme temperatures, and other hydrological perils including mudslides and coastal erosion. The housing industry is beginning to work through how best to identify and quantify exposure and incorporate the impact of perils into risk management practices more broadly. Legacy thinking and risk management would classify these risks as covered by property insurance with little to no downstream risk to investors. However, as the frequency and severity increase, it is becoming more evident that risks are not completely covered by property & casualty insurance.

We will address some of these “hidden risks” of climate to housing in a forthcoming post.

  1. Wildland Urban Interface

The U.S. Fire Administration defines Wildland Urban Interface as “the zone of transition between unoccupied land and human development. It is the line, area, or zone where structures and other human development meet or intermingle with undeveloped wildland or vegetative fuels.” An estimated 46 million residences in 70,000 communities in the United States are at risk for WUI fires. Wildfires in California garner most of the press attention. But fire risk to WUIs is not just a west coast problem — Florida, North Carolina and Pennsylvania are among the top five states at risk. Communities adjacent to and surrounded by wildland are at varying degrees of risk from wildfires and it is important to assess these risks properly. Many of these exposed homes do not have sufficient insurance coverage to cover for losses due to wildfire.

  1. National Flood Insurance Program (NFIP) and Special Flood Hazard Area (SFHA)

The National Flood Insurance Program provides flood insurance to property owners and is managed by the Federal Emergency Management Agency (FEMA). Anyone living in a participating NFIP community may purchase flood insurance. But those in specifically designated high-risk SFPAs must obtain flood insurance to obtain a government-backed mortgage. SFHAs as currently defined, however, are widely believed to be outdated and not fully inclusive of areas that face significant flood risk. Changes are coming to the NFIP (see our recent blog post on the topic) but these may not be sufficient to cover future flood losses.

  1. Transition Risk

Transition risk refers to risks resulting from changing policies, practices or technologies that arise from a societal move to reduce its carbon footprint. While the physical risks from climate change have been discussed for many years, transition risks are a relatively new category. In the housing space, policy changes could increase the direct cost of homeownership (e.g., taxes, insurance, code compliance, etc.), increase energy and other utility costs, or cause localized employment shocks (i.e., the energy industry in Houston). Policy changes by the GSEs related to property insurance requirements could have big impacts on affected neighborhoods.

  1. Physical Risk

In housing, physical risks include the risk of loss to physical property or loss of land or land use. The risk of property loss can be the result of a discrete catastrophic event (hurricane) or of sustained negative climate trends in a given area, such as rising temperatures that could make certain areas uninhabitable or undesirable for human housing. Both pose risks to investors and homeowners with the latter posing systemic risk to home values across entire communities.

  1. Livability Risk

We define livability risk as the risk of declining home prices due to the desirability of a neighborhood. Although no standard definition of “livability” exists, it is generally understood to be the extent to which a community provides safe and affordable access to quality education, healthcare, and transportation options. In addition to these measures, homeowners also take temperature and weather into account when choosing where to live. Finding a direct correlation between livability and home prices is challenging; however, an increased frequency of extreme weather events clearly poses a risk to long-term livability and home prices.

Data and toolsets designed explicitly to measure and monitor climate related risk and its impact on the housing market are developing rapidly. RiskSpan is at the forefront of developing these tools and is working to help mortgage credit investors better understand their exposure and assess the value at risk within their businesses.

Contact us to learn more.

Why Mortgage Climate Risk is Not Just for Coastal Investors

When it comes to climate concerns for the housing market, sea level rise and its impacts on coastal communities often get top billing. But this article in yesterday’s New York Times highlights one example of far-reaching impacts in places you might not suspect.

Chicago, built on a swamp and virtually surrounded by Lake Michigan, can tie its whole existence as a city to its control and management of water. But as the Times article explains, management of that water is becoming increasingly difficult as various dynamics related to climate change are creating increasingly large and unpredictable fluctuations in the level of the lake (higher highs and lower lows). These dynamics are threatening the city with more frequency and severe flooding.

The Times article connects water management issues to housing issues in two ways: the increasing frequency of basement flooding caused by sewer overflow and the battering buildings are taking from increased storm surge off the lake. Residents face increasing costs to mitigate their exposure and fear the potentially negative impact on home prices. As one resident puts it, “If you report [basement flooding] to the city, and word gets out, people fear it’s going to devalue their home.”

These concerns — increasing peril exposure and decreasing valuations — echo fears expressed in a growing number of seaside communities and offer further evidence that mortgage investors cannot bank on escaping climate risk merely by avoiding the coasts. Portfolios everywhere are going to need to begin incorporating climate risk into their analytics.

Hurricane Season a Double-Whammy for Mortgage Prepayments

As hurricane (and wildfire) season ramps up, don’t sleep on the increase in prepayment speeds after a natural disaster event. The increase in delinquencies might get top billing, but prepays also increase after events—especially for homes that were fully insured against the risk they experienced. For a mortgage servicer with concentrated geographic exposure to the event area, this can be a double-whammy impacting their balance sheet—delinquencies increase servicing advances, prepays rolling loans off the book. Hurricane Katrina loan performance is a classic example of this dynamic.

Hurrican-Season-a-Double-Whammy-for-Mortgage

EDGE: Extended Delinquencies in FNMA and FHLMC Loans

In June, the market got its first look at Fannie Mae and Freddie Mac “expanded delinquency” states. The Enterprises are now reporting delinquency states out to 24 months to better account for loans that are seriously delinquent and not repurchased under the extended timeframe for repurchase of delinquent loans announced in 2020. In this short post, we analyze those pipelines and what they could mean for buyouts in certain spec pool stories. 

First, we look at the extended pipeline for some recent non-spec cohorts. The table below summarizes some major 30yr cohorts and their months delinquent. We aggregate the delinquencies that are more than 6 months delinquent[1] for ease of exposition. 

Recent-vintage GSE loans with higher coupons show a higher level of “chronically delinquent” loans, similar to the trends we see in GNMA loans. 

Digging deeper, we filtered for loans with FICO scores below 680. Chronically delinquent loan buckets in this cohort are marginally more prevalent relative to non-spec borrowers. Not unexpectedly, this suggests a credit component to these delinquencies.

Finally, we filtered for loans with high LTVs at origination. The chronically delinquent buckets are lower than the low FICO sector but still present an overhang of potential GSE repurchases in spec pools.

It remains to be seen whether some of these borrowers will be able to resume their original payments —  in which case they can remain in the pool with a forbearance payment due at payoff — or if the loans will be repurchased by the GSEs at 24 months delinquent for modification or other workout. If the higher delinquencies lead to the second outcome, the market could see an uptick in involuntary speeds on some spec pool categories in the next 6-12 months.

Contact us if you are interested in seeing variations on this theme. Using Edge, we can examine any loan characteristic and generate a S-curve, aging curve, or time series.

[1] The individual delinquency states are available for each bucket, contact us for details.

Non-Agency Delinquencies Fall Again – Still Room for Improvement

Serious delinquencies among non-Agency residential mortgages continue marching downward during the first half of 2021 but remain elevated relative to their pre-pandemic levels.

Our analysis of more than two million loans held in private-label mortgage-backed securities found that the percentage of loans at least 60 days past due fell again in May across vintages and FICO bands. While performance differences across FICO bands were largely as expected, comparing pre-crisis vintages with mortgages originated after 2009 revealed some interesting distinctions.

The chart below plots serious delinquency rates (60+ DPD) by FICO band for post-2009 vintages. Not surprisingly, these rates begin trending upward in May and June of 2020 (two months after the economic effects of the pandemic began to be felt) with the most significant spikes coming in July and August – approaching 20 percent at the low end of the credit box and less than 5 percent among prime borrowers.

Since last August’s peak, serious delinquency rates have fallen most precipitously (nearly 8 percentage points) in the 620 – 680 FICO bucket, compared with a 5-percentage point decline in the 680 – 740 bucket and a 4 percentage point drop in the sub-620 bucket. Delinquency rates have come down the least among prime (FICO > 740) mortgages (just over 2 percentage points) but, having never cracked 5 percent, these loans also had the shortest distance to go.

Serious delinquency rates remain above January 2020 levels across all four credit buckets – approximately 7 percentage points higher in the two sub-680 FICO buckets, compared with the 680 – 740 bucket (5 percentage points higher than in January 2020) and over-740 bucket (2 percentage points higher).

So-called “legacy” vintages (consisting of mortgage originated before the 2008-2009 crisis) reflect a somewhat different performance profile, though they follow a similar pattern.

The following chart plots serious delinquency rates by FICO band for these older vintages. Probably because these rates were starting from a relatively elevated point in January 2020, their pandemic-related spike were somewhat less pronounced, particularly in the low-FICO buckets. These vintages also appear to have felt the spike about a month earlier than did the newer issue loans.

Serious delinquency rates among these “legacy” loans are considerably closer to their pre-pandemic levels than are their new-issue counterparts. This is especially true in the sub-prime buckets. Serious delinquencies in the sub-620 FICO bucket actually were 3 percentage points lower last month than they were in January 2020 (and nearly 5 percentage points lower than their peak in July 2020). These differences are less pronounced in the higher-FICO buckets but are still there.

Comparing the two graphs reveals that the pandemic had the effect of causing new-issue low-FICO loans to perform similarly to legacy low-FICO loans, while a significant gap remains between the new-issue prime buckets and their high-FICO pre-2009 counterparts. This is not surprising given the tightening that underwriting standards (beyond credit score) underwent after 2009.

Interested in cutting non-Agency performance across any of several dozen loan-level characteristics? Contact us for a quick, no-pressure demo.

In ESG Policy, ‘E’ Should Not Come at the Expense of ‘S’

ESG—it is the hottest topic in our space. No conference or webinar is complete without a panel touting the latest ESG bond or the latest advance in reporting and certification. What a lot of these pieces neglect to address is the complicated relationship between the “E” and the “S” of ESG. In particular, that climate-risk exposed properties are also often properties in underserved communities, providing much-needed affordable housing to the country.

Last week, the White House issued an Executive Order of Climate-Related Financial Risk. The focus of the order was to direct government agencies toward both disclosure and mitigation of climate-related financial risk. The order reinforces the already relentless focus on ESG initiatives within our industry. The order specifically calls on the USDA, HUD, and the VA to ‘consider approaches to better integrate climate-related financial risk into underwriting standards, loan terms and conditions, and asset management and servicing procedures, as related to their Federal lending policies and programs.” Changes here will likely presage changes by the GSEs.

In mortgage finance, some of the key considerations related to disclosure and mitigation are as follows:

Disclosure of Climate-Related Financial Risk:

  • Homes exposed to increasing occurrence to natural hazards due to climate changes.
  • Homes exposed to the risk of decreasing home prices due to climate change, because of either increasing property insurance costs (or un-insurability) or localized transition risks of industry-exposed areas (e.g., Houston to the oil and gas industry).

Mitigation of Climate-Related Financial Risk:

  • Reducing the housing industry’s contribution to greenhouse gas emissions in alignment with the president’s goal of a net-zero emissions economy by 2050. For example, loan programs that support retrofitting existing housing stock to reduce energy consumption.
  • Considering a building location’s exposure to climate-related physical risk. Directing investment away for areas exposed to the increasing frequency and severity of natural disasters.

But products and programs that aim to support the goal of increased disclosure and mitigation of climate-related financial risk can create situations in which underserved communities disproportionately bear the costs of our nation’s pivot toward climate resiliency. The table below connects the FEMA’s National Risk Index data to HUD’s list of census tracts that qualify for low-income housing tax credits, which HUD defines as tracts that have ‘50 percent of households with incomes below 60 percent of the Area Median Gross Income (AMGI) or have a poverty rate of 25 percent or more.’ Census tracts with the highest risk of annual loss from natural disaster events are disproportionally made of HUD’s Qualified Tracts.

As an industry, it’s important to remember that actions taken to mitigate exposure to increasing climate-related events will always have a cost to someone. These costs could be in the form of increased insurance premiums, decreasing home prices, or even loss of affordable housing options altogether. All this is not to say that action should not be taken, only that balancing social ESG goals should also be considered when ambitious environmental ESG goals come at their expense.

The White House identified this issue right at the top of the order by indicating that any action on the order would need to account for ‘disparate impacts on disadvantaged communities and communities of color.’

“It is therefore the policy of my Administration to advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk (consistent with Executive Order 13707 of September 15, 2015 (Using Behavioral Science Insights to Better Serve the American People), including both physical and transition risks; act to mitigate that risk and its drivers, while accounting for and addressing disparate impacts on disadvantaged communities and communities of color (consistent with Executive Order 13985 of January 20, 2021 (Advancing Racial Equity and Support for Underserved Communities Through the Federal Government)) and spurring the creation of well-paying jobs; and achieve our target of a net-zero emissions economy by no later than 2050.”

The social impacts of any environmental initiative need to be considered. Steps should be taken to avoid having the cost of changes to underwriting processes and credit policies be disproportionately borne by underserved and vulnerable communities. To this end, a balanced ESG policy will ultimately require input from stakeholders across the mortgage industry.

Mortgage DQs by MSA: Non-Agency Performance Chart of the Month

This month we take a closer look at geographical differences in loan performance in the non-agency space. The chart below looks at the 60+ DPD Rate for the 5 Best and Worst performing MSAs (and the overall average). A couple of things to note:

  • The pandemic seems to have simply amplified performance differences that were already apparent pre-covid. The worst performing MSAs were showing mostly above-average delinquency rates before last year’s disruption.
  • Florida was especially hard-hit. Three of the five worst-performing MSAs are in Florida. Not surprisingly, these MSAs rely heavily on the tourism industry.
  • New York jumped from being about average to being one of the worst-performing MSAs in the wake of the pandemic. This is not surprising considering how seriously the city bore the pandemic’s brunt.
  • Tech hubs show strong performance. All our best performers are strong in the Tech industry—Austin’s the new Bay Area, right?

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