Tuesday, August 07, 2007

They're Just Mortgages. We're Not Expected to Understand Them.

by Tanta on 8/07/2007 09:27:00 AM

I was going to post something on this yesterday, but it blew my mind so badly that I had to take refuge in Star Trek reruns until my faith in technology was restored. Sorry about the delay and everything.

Fitch sent out a press release describing the modifications it is making to the software it uses to rate mortgage-backed securities. I was, personally, a little shocked to discover that Fitch just now got around to working with state-level adjustments for RE market volatility. They are still working on incorporating MSA (Metropolitan Statistical Area) level factors. In other words, their analysis of loss frequency and severity due to rapid changes in a local real estate market just went from a blunt instrument to a somewhat less blunt instrument; the "pinpoint laser" thing is in the works.

But these two items are another order of magnitude entirely:

3) New Documentation Category: ResiLogic initially provided three categories for documentation, reflecting the categorization of loans in the model development sample. However, after evaluating lender programs and the recent performance of subprime and Alt-A mortgages, Fitch's analysts felt that greater differentiation was called for. This has resulted in the introduction of a new 'Low' documentation category, which indicates default risk which is greater than the existing 'Reduced' category but less than the existing 'None' category. Fitch will publish a research report the week of Aug. 6, 2007 describing the mapping between lenders documentation programs and the new categories.

4) Change in DTI Ratio: Back-end DTI ratio data is generally more available than front-end data in the data files provided by mortgage issuers. Therefore Fitch has modified ResiLogic to utilize back-end DTI. However, Fitch continues to be concerned by the prevalence of missing DTI data. Fitch will use a default assumption for missing subprime DTI of 50%.
OK, so we'll have to wait for the new report to find out how bad the doc type problem is, but I'm going to guess that Fitch has been lumping things like an AUS-approved loan with a single paystub and a verbal verification of employment in the same bucket with a "stated income" program for a W-2 borrower in which there is no documentation of income whatsoever. That would tend to improve the performance history of true "stated income" loans.

I'm hoping I'm wrong about that, but the following item gives me zero confidence in the matter. Long-time readers of this site are pretty familiar with "DTI," which people like me use to refer to the borrower's total monthly obligations, including but not limited to the mortgage payment, divided by the borrower's gross monthly income. The reason most of you all have never heard of "HTI" is that it's so damned obsolete in most quarters that not even your Tanta cares about it.

Many moons ago, lenders used two ratios to qualify borrowers for mortgages: the so-called "front ratio" or HTI, which included just the mortgage payment, and the "back ratio" or DTI, which included total debt. After a number of years, industry consensus became that HTI really isn't very strongly predictive of default as a separate measure, and so nearly every lender dispensed with a benchmark for HTI. Lately we've obviously gone a little nuts with the DTIs we will allow, but the point is that every credit model out there--except, apparently, Fitch's--used DTI as the sole measure in the model, or at most the primary determinant of capacity evaluation with HTI being considerably less weighted in the analysis.

Fitch is saying one of two things, and I'm still not sure which: either they really did use HTI instead of DTI in their models, which means that the weighted average DTI information they've been publishing is junk, or they've really been using DTI all along but didn't realize it, because they didn't understand the difference. I'm inclined to the latter view only because I believe that DTI is the only data they're getting from issuers. I do not know how anyone could look at DTIs of 50% and assume that other debt had to be added to that to get the borrower's total picture and still rate these deals with a straight face.

Of course Fitch is saying that this factor is of only modest impact. Well, duh. My own view of the matter has always been that DTI is a critical measure of loan quality, but not if you don't verify the "I" part. If you let borrowers and originators just back into a "stated income" that produces the right ratio, it doesn't exactly matter what that number is, and it's better to ignore it entirely in your evaluation of credit than to use it, because you end up giving "credit" to loans that have low but entirely bogus DTIs. I don't exactly have huge confidence in Fitch's handling of this problem now that I know that they've also had some trouble identifying doc types with any precision.

This is not a little bitty deal, a quibbling over geeky details of underwriting archana. This is big bad-ass deal. Fitch just came out and admitted that "ResiLogic" is working with corrupt or missing data, that Fitch's analysts don't know how to "crack" a mortgage tape (that is, how to map an originator-specific data field into a standard one that can compare across deals), and that there is no reason for any of us to believe them when they say that certain loan characteristics are more or less predictive of default. Some of you may have suspected this before today. But I'll admit that I didn't think they were making mistakes at this elementary a level. It's hard to get the rocket science right. Defining the DTI field? Lord love a duck.

In other news, Fitch is having a conference call today at 11:00 ET to discuss this matter. I may attempt to listen in, although I'm telling you now I'm not sure I can stand any more of this.