July 12, 2013
Ain’t Misrepresentin’
According to Wikipedia, the performers in the musical Ain’t Misbehavin’ “present an evening of rowdy, raunchy, and humorous songs that encapsulate the various moods of the era and reflect” a “view of life as a journey meant for pleasure and play.” In U.S. RMBS Roundtable: Arrangers And Investors Discuss The Role Of Representations And Warranties In U.S. RMBS Transactions, S&P does something similar with securitization. It presents the views of industry players as they try to predict and shape the future of the recently emerging private-label RMBS market, in the hopes of “achieving a healthy and sustainable RMBS market.” (2)
ACT I: Lookin’ Good but Feelin’ Bad
The piece contains a lot of important insights, including the following point made by investors: “standardizing R&Ws would be a step towards improving the transparency and their ease of understanding. Smaller investors noted that they can be particularly limited in distinguishing R&Ws given the complexities involved.” (3)
This point encapsulates in so many words the classic market for lemons problem, famously formalized by George Akerlof. The lemon problem leads us to ask how a buyer is to price a purchase where the buyer has less information about the product than the seller. Because of this information assymetry, the purchaser will assume the worst about the product and offer to buy it with that in mind.
R&Ws are an attempt to overcome that problem because the RMBS arranger or the mortgage originator promises to compensate the investor for lemons that are contained with a mortgage pool securing an RMBS. Consistent with that view, investors noted that “they expected to be compensated for losses caused by origination defects, rather than legitimate life events.” (2) In other words, origination defects are the lemons that should be borne by the arranger/originator with its superior information about the mortgages. And “legitimate life events” represent the credit risk that the investors have signed up for.
ACT II: That Ain’t Right
Arrangers and originators made the following points:
- [o]ne arranger indicated that the R&W process should be governed only by the contractual obligations negotiated for each deal. (2)
- [o]riginators have strict underwriting guidelines and said they take great care to follow those procedures before issuing a loan. Arrangers are also currently subjecting all or almost all loans to a third-party due-diligence review. (2)
- arrangers said that standardizing R&Ws will not be an easy task as differences between arrangers and product types will limit the degree to which R&Ws can be homogenized. (3)
These points clearly align with the interests of the seller in a market for lemons. To restate them a bit, 1. caveat emptor; 2. arrangers and originators don’t sell lemons (!); and (3) it is too hard to come up with provisions that consistently protect investors so don’t bother trying.
ENCORE: Find Out What They Like
S&P notes that there “was broad agreement that one of the keys to achieving a healthy and sustainable RMBS market is aligning the interests of arrangers and investors.” (2) From that broader perspective, S&P is right that the industry should work toward a state of affairs that “minimizes the cost of unknown risks and ultimately reduces losses and related litigation.” (2) Given the spate of lawsuits over reps and warranties, we had fallen shy of that mark in the past (here, for example). It remains to be seen if the industry can get it better next time and if the incentives are aligned enough to do so.
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