Mortgage investors turn to analytics firms for due diligence on MBS assets

Baseline Capital and Edeus are two firms that have released evaluation tools for residential mortgage assets to help investors assess credit risk in securitisation pools

The recent crisis in subprime mortgage lending has seen swathes of mortgage-backed securities containing poor quality mortgages decline substantially in price, with previously highly rated tranches of mortgage-backed securities becoming credit impaired. Loss of confidence in the rating agencies arising from this has created opportunities in the due diligence market, as investors seek improved ways of analysing risk.

Baseline Capital, which runs KB Analytics, has developed 'The Mortgage Investor', a monthly data set and quarterly commentary to support the evaluation of underlying UK residential mortgage assets. Using a statistical model that assesses trends in credit quality on a market-wide basis, it is designed to help holders of residential mortgage-backed securities better understand the credit risks to which they're exposed.

Also entering the market is Exact, a new company born from Edeus - previously a specialist mortgage lender. Exact MD Alan Cleary has launched the Asset Quality Assessment Service (AQA) under the Edeus brand, which offers RMBS investors a means by which to understand the credit quality of the assets they hold at a granular level. Analysing up-to-date credit information on borrowers and underlying assets, it utilises its own suite of scorecards, tailored to each segment of the mortgage market. Importantly, both are intended to support the rating agencies' credit analysis.

Tim Fletcher, sales and marketing director at Baseline/KBA, explains the reasoning behind the new product: "The rating agencies gave the market a wake-up call when they said people should do their own analysis. We aim to help investors who don't have access to the underlying data do this for themselves."

The product enables purchasers of mortgage-backed securities to better estimate the net present value of the underlying assets. And given that mortgages originated in recent years have shown a higher tendency to slip into arrears (see chart), this may prove an increasingly useful tool for investors.

"It's about granular data," says Fletcher. "For an investor looking to buy, it is vital to see how the assets on a particular book might perform; from here, a decision to go ahead or not based on these assets can be confidently made."

AQA offers similar levels of analysis: "Many investors bought mortgage assets through securitisations," says Cleary. "The issue was that they didn't really understand the risk of the underlying assets. We take every single loan, put them in order of risk, and then predict what percentage will go delinquent and what the estimated loss severity is. This is as granular as you get."

Extra homework

From an investor point of view there appears to be a demand for this. Michael Ezra is a former MBS investor and now an advisor to hedge funds and wealth managers on investment strategies. He says: "In the past investors did not always carry out sufficient work on mortgage-backed securities they were purchasing. If the maturity profile was in line with the investors' appetite for duration, the credit rating provided by a major rating agency high enough, and the yield sufficient, tranches of mortgage-backed securities were often purchased without much further work."

Such lack of due diligence does not cause a problem when the prices of the underlying assets are rising, but if the market falls it can lead to losses that might have been foreseen. Reliability and detail of data is key. "It is important for investors purchasing tranches of mortgage-backed securities to rigorously analyse the pool," Ezra says. "If an investor is purchasing a subordinated tranche of an MBS they are more at risk from the poorest quality mortgages in the pool than those who purchase the senior tranches."

Both Fletcher and Cleary are confident about the efficacy of their products in this area. Baseline uses a pool of over 320,000 UK residential mortgages across all lending types - between 2% and 3% of the national market - to calculate its findings. While Fletcher accepts this is "not a mammoth percentage", he argues that a large database is "unnecessary to take a statistical view of things".

Exact uses AQA to effectively re-underwrite the underlying assets in a book of mortgages, examining the current credit score of borrowers and equity in the underlying assets on 100% of the mortgage book (versus traditional due diligence, which looks at roughly 15% and checks the paper trail at point of origination). It takes into account credit information on borrowers and underlying assets, and also assesses fraud.

"Mortgage assets are complex and mistrusted - that's why the market has so discounted their value. It's about segmenting customers into the right risk banding: a high risk customer with a high loan-to-value is entirely different than someone with 50% LTV," Cleary says.

As well as potential buyers, the products also benefit those with existing portfolios of mortgage assets. According to Cleary: "At the moment, one thing keeping CEOs of banks or building societies with mortgage assets awake at night is credit quality - the underlying risks on their mortgage book," he says. "It is a precarious situation, and the one place you don't want to be is in the dark; AQA remedies that."

'The Mortgage Investor' works along similar lines: "It allows you to see what the arrears trends and emergence trends are on an asset, and then go through a similar process to predict what will happen in the future," says Fletcher. "It gives people the tools to evaluate any offer they may get, and decide whether it is to their advantage to hold on to the asset or dispose of it."

Cleary feels that the need for these types of product is especially acute in the current market: "With mortgage assets declining in value, you need to manage the creditworthiness of the book. If you're looking at it from an MBS point of view, you need to know what the cashflow is going to be; and for this you have to take the losses out. We will produce a report that calculates, very clearly, the probable loss severity on this pool. This is vital."

Cleary is bullish about the future: "We did our biggest ever AQA last month and we are confident that the market will be busy next year. It will eventually run out - depending on how much mortgage asset out there is still tradable - that's why we tailor the product to all types of buyer. But even so, I would have thought some of the rating agencies could use this; it's complementary to what they do."

David Patrikarakos.