Improved Due Diligence is Key to Secondary Market Revival

It will take greater accountability in financial transactions, specifically more stringent due diligence, for investors to be confident enough to buy mortgage-backed securities again. The stock and bond markets have rebounded strongly over the past year from the global financial meltdown of 2008. But recovery in the market for private residential mortgage-backed securities continues to be held up by continuing concerns about the underpinnings of these deals. The most frequently asked question we hear is: “What will it take for investors to start buying mortgage-backed securities again?” This question gains more urgency now that the federal government has withdrawn its presence that has largely kept the secondary market alive since the meltdown began in September 2008. The answer is that it will take greater accountability in financial transactions –- specifically, more stringent due diligence –- for investors to feel confident enough to buy these securities. No longer will a review of 10% or 20% of a securitized pool of mortgages be an acceptable representation of the whole pool. Rather, analysis of the entire pool will be expected, at least until investors feel comfortable with something less. This enhanced scrutiny will be demanded by the rating agencies, who have themselves been subjected to a vast amount of criticism the past two years for not performing their role in the quality assurance process. Standard & Poor’s, for example, has gone on record that it will not rate future mortgage deals unless due diligence is performed by an approved firm. Fitch Ratings and Moody’s Investors Service have developed their own criteria for the greater due diligence they will require going forward. A chief reason for the meltdown in the residential MBS market –- besides sheer greed — was the lack of accountability. Specifically, the industry failed to follow its longstanding “80-20 rule,” which holds that when the right 20% of a mortgage file is properly scrutinized — for property valuation, debt, and borrower income — 80% of the problems can be avoided. Centralized appraisal practices mandated by Fannie Mae are believed to be addressing the collateral valuation issue. Lenders have tightened borrower guidelines and are demanding more document disclosures. All of this will serve to re-open the flow of financing to borrowers, but improved due diligence also must be a key to long-term market revival. Alex Santos is president of Florida-based Digital Risk.