Third-party originated (TPO) loans previously maintained a reputation for putting residential mortgage-backed securities investors at heightened risk, but times are changing and TPO loans originated after the financial crisis are exhibiting the highest of performance standards today.
Moody’s Investors Service (MCO) released a report saying loans originated by third-party brokers and correspondent lenders continue to equal retail loans in payment performance, thanks to higher underwriting guidelines and additional scrutiny of loans sourced by third-party originators.
"The narrower gap in recent loan performance is because of tighter lending and regulatory controls over TPOs," Moody's analysts noted in a recent report.
This is all credit positive for newer residential mortgage-backed securities transactions, Kathy Kelbaugh, a vice president with Moody’s said in a report titled, 'Tighter Originator Controls on Recent Third-Party Residential Mortgage Originations Decrease Risk in US RMBS.'
"The risks to RMBS from third-party originations will vary depending on whether it is a broker or a correspondent that initiates the loans and on how much oversight originators and aggregators exercise over the third parties," says Kelbaugh.
After studying default rates on Fannie and Freddie third-party and retail loans from the past decade, Moody’s analysts discovered that recent third-party originated loans are performing just as well, if not better, than retail mortgages. That’s a drastic change considering research shows loans originated between 2004 and 2008 defaulted more frequently than retail originations.
The drop in defaults is tied to changes third parties made in the originations process to cut down on defective credit and appraisal underwriting as well as fraud, Moody’s analysts explained.
Broker-sourced loans also face more scrutiny today. "They still collect documentation directly from brokers, but now use third-party fraud-detection tools and typically directly access information from the Internal Revenue Service to verify the income the borrower reports on the loan application," Moodys added.
Sarah Hu, an MBS strategist with the Royal Bank of Scotland (RBS), is not surprised by this trend and believes it’s the direct result of heightened underwriting standards in the MBS segment.
"I think after the financial crisis many of the banks are more aware of the risks from the TPOs, and their underwriting standards have become more restrictive," Hu told HousingWire.
She added that TPOs in many cases could even feature "better credit quality" when compared to retail loans because investors don't want the same credit issues again. The focus now, she explains, is on preventing putback risk.
"They want to improve that risk,” she added. "You are likely to see loans with higher credit quality – top FICOs and credit." And that trend is especially prevalent on the third-party originations side of the market.