The two types of representation and warranty frameworks prevalent post-crisis can adequately detect and remedy reps and warrants breaches, but they have different strengths and weaknesses, says Moody’s Investors Service.
Transactions with open-ended reviews of loans, such as those recently sponsored by Redwood Trust (RWT) and WinWater, can be very effective at catching reps and warrants breaches if there is a controlling holder conducting the review, but can break down without one, according to the report, “Open-Ended and Prescriptive RMBS R&W Frameworks Can Both Be Effective, Balancing Different Strengths and Drawbacks.”
“As the most subordinate investor and the first to incur a loss, the controlling holder has skin-in-the-game and benefits from pursuing R&W breaches,” says Moody’s Vice President and Senior Analyst Peter McNally.
If the transaction does not have a controlling holder, then the appointed reviewer will likely limit the scope of its review and will have difficulty remedying the breaches, which requires investor involvement.
Prescriptive frameworks, such as those used in transactions sponsored by JPMorgan Chase (JPM) and Goldman Sachs (GS), establish pass/fail tests that ensure that each loan receives the same review, but can be bounded in scope and therefore miss defective loans.
“Prescriptive frameworks are more transparent and don’t rely on a reviewer to decide what elements to examine,” says Moody’s Vice President and Senior Credit Officer Yehudah Forster, co-author of the report. “As a result, there is a lower likelihood of a misalignment of interests.”
Remedying breaches in transactions with prescriptive reps and warrants frameworks is also less costly because arbitration is less likely to occur.
The prescriptive frameworks’ well-defined boundaries, though, can leave openings for some defective loans to remain un-remedied. If the pass/fail tests don’t capture all of the elements of the reps and warrants, they can miss certain breaches. In addition, the framework can provide mitigating factors that absolve the reps and warrants provider from remedying certain breaches.