At its heart, the failure of the private-label residential mortgage-backed securities (PLS) market to return to its pre-crisis volume is a failure of trust. Virtually every proposed remedy, in one way or another, seeks to create an environment in which deal participants can gain reasonable assurance that their counterparts are disclosing information that is both accurate and comprehensive. For better or worse, nine-figure transactions whose ultimate performance will be determined by the manner in which hundreds or thousands of anonymous people repay their mortgages cannot be negotiated on the basis of a handshake and reputation alone. The scale of these transactions makes manual verification both impractical and prohibitively expensive. Fortunately, the convergence of a stalled market with new technologies presents an ideal time for change and renewed hope to restore confidence in the system.


Trust in Agency-Backed Securities vs Private-Label Securities

Ginnie Mae guaranteed the world’s first mortgage-backed security nearly 50 years ago. The bankers who packaged, issued, and invested in this MBS could scarcely have imagined the technology that is available today. Trust, however, has never been an issue with Ginnie Mae securities, which are collateralized entirely by mortgages backed by the federal government—mortgages whose underwriting requirements are transparent, well understood, and consistently applied.

Further, the security itself is backed by the full faith and credit of the U.S. Government. This degree of “belt-and-suspenders” protection afforded to investors makes trust an afterthought and, as a result, Ginnie Mae securities are among the most liquid instruments in the world.

Contrast this with the private-label market. Private-label securities, by their nature, will always carry a higher degree of uncertainty than Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., “Agency”) products, but uncertainty is not the problem. All lending and investment involves uncertainty. The problem is information asymmetry—where not all parties have equal access to the data necessary to assess risk. This asymmetry makes it challenging to price deals fairly and is a principal driver of illiquidity.


Using Technology to Garner Trust in the PLS Market

In many transactions, ten or more parties contribute in some manner to verifying and validating data, documents, or cash flow models. In order to overcome asymmetry and restore liquidity, the market will need to refine (and in some cases identify) technological solutions to, among other challenges, share loan-level data with investors, re-envision the due diligence process, and modernize document custody.


Loan-Level Data

During SFIG’s Residential Mortgage Finance symposium last month, RiskSpan moderated a panel that featured significant discussion around loan-level disclosures. At issue was whether the data required by the SEC’s Regulation AB provided investors with all the information necessary to make an investment decision. Specifically debated was the mortgaged property’s zip code, which provides investors valuable information on historical valuation trends for properties in a given geographic area.

Privacy advocates question the wisdom of disclosing full, five-digit zip codes. Particularly in sparsely populated areas where zip codes contain a relatively small number of addresses, knowing the zip code along with the home’s sale price and date (which are both publicly available) can enable unscrupulous data analysts to “triangulate” in on an individual borrower’s identity and link the borrower to other, more sensitive personal information in the loan-level disclosure package.

The SEC’s “compromise” is to require disclosing only the first two digits of the zip code, which provide a sense of a property’s geography without the risk of violating privacy. Investors counter that two-digit zip codes do not provide nearly enough granularity to make an informed judgment about home-price stability (and with good reason—some entire states are covered entirely by a single two-digit zip code).

The competing demands of disclosure and privacy can be satisfied in large measure by technology. Rather than attempting to determine which individual data fields should be included in a loan-level disclosure (and then publishing it on the SEC’s EDGAR site for all the world to see) the market ought to be able to develop a technology where a secure, encrypted, password-protected copy of the loan documents (including the loan application, tax documents, pay-stubs, bank statements, and other relevant income, employment, and asset verifications) is made available on a need-to-know basis to qualified PLS investors who share in the responsibility for safeguarding the information.


Due Diligence Review

Technologically improving the transparency of the due diligence process to investors may also increase investor trust, particularly in the representation and warranty review process. Providing investors with a secure view of the loan-level documentation used to underwrite and close the underlying mortgage loan, as described above, may reduce the scope of due diligence review as it exists in today’s market. Technology companies, which today support initiatives such as Fannie Mae’s “Day 1 Certainty” program, promise to further disrupt the due diligence process in the future. Through automation, the due diligence process becomes less burdensome and fosters confidence in the underwriting process while also reducing costs and bringing representation and warranty relief.

Today’s insistence on 100% file reviews in many cases is perhaps the most obvious evidence of the lack of trust across transactions. Investors will likely always require some degree of assurance that they are getting what they pay for in terms of collateral. However, an automated verification process for income, assets, and employment will launch the industry forward with investor confidence. Should any reconciliation of individual loan file documentation with data files be necessary, results of these reconciliations could be automated and added to a secure blockchain accessible only via private permissions. Over time, investors will become more comfortable with the reliability of the electronic data files describing the mortgage loans submitted to them.

The same technology could be implemented to allow investors to view supporting documents when reps and warrants are triggered and a review of the underlying loan documents needs to be completed.


Document Custody

Smart document technologies also have the potential to improve the transparency of the document custody process. At some point the industry is going to have to move beyond today’s humidity-controlled file cabinets and vaults, where documents are obtained and viewed only on an exception basis or when loans are paid off. Adding loan documents that have been reviewed and accepted by the securitization’s document custodian to a secure, permissioned blockchain will allow investors in the securities to view and verify collateral documents whenever questions arise without going to the time and expense of retrieving paper from the custodian’s vault.


Securitization makes mortgages and other types of borrowing affordable for a greater population by leveraging the power of global capital markets. Few market participants view mortgage loan securitization dominated by government corporations and government-sponsored enterprises as a desirable permanent solution. Private markets, however, are going to continue to lag markets that benefit from implicit and explicit government guarantees until improved processes, supported by enhanced technologies, are successful in bridging gaps in trust and information asymmetry.

With trust restored, verified by technology, the PLS market will be better positioned to support housing financing needs not supported by the Agencies.

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