Finding Fraud: Fitch To Overhaul Ratings Process, Will Review Originators and Issuers

Fitch Ratings today issued a wide-ranging press statement that offered some analysis of the problems plaguing the RBMS and mortgage-related derivatives market, and dropped some bombshells on changing the ratings process.

First, Fitch noted that fraud is a bigger problem among recent subprime vintages than previously thought:

… the extraordinarily high level of defaults encountered by the 2006 vintage cannot be explained by home price declines alone. It has become increasingly evident that loans originated with lax underwriting and higher instances of fraud can have a material impact on a securitization.

This will likely be reported as big news, but it really shouldn’t be — to those of us with any background servicing loans, and especially to anyone who has ever worked in default management, this has long been a known quantity. It’s been well known by most servicers for years that fraud, in a more traditional sense, is usually one of the key drivers behind default activity.

The difference here, of course, is that lax underwriting standards enabled fraud at levels large enough that it’s now being discovered by investors as if it were new; which is some ways, it is, because it’s now “material” to securitizations.

Apparent fraud in the form of occupancy misrepresentation, poor or lack of underwriting relating to suspicious items on credit reports, incorrect calculation of debt-to-income ratios, poor underwriting of ’stated’ income loans for reasonability, substantial numbers of first-time homebuyers with questionable credit/income — all are cited by Fitch as problems for investors.

The rating agency said that in response, it will implement a new system reviewing originators, conduits and/or issuers prior to rating certain securitized transactions — a process that will include on-site discussions of valuation methods and risk management practices, as well as a review of due diligence reports and on-site sampling of files.

That’s for each deal, if I’m reading the press statement properly.

The agency said it won’t rate subprime RMBS issues going forward without completion of the review process, and that it would extend its so-called “enhanced review” to other securitizations in the Alt-A space where needed.

Fitch also indicated that it will seek to change the language used in the representations and warranties process — which may be even bigger news, depending on what changes Fitch will propose.

I’m guessing that at least part of the changes being considered by Fitch here would include adding language that certifies proper due diligence performed up front for any deal, as well as some minimum standard for risk management. This would, of course, have the effect of making the “enchanced review” process disclosed today something more like a “regular review.”