Electronic Mortgages: Towards a new trend in paperless mortgage lending

– Vinod Kothari

vinod@vinodkothari.com

Paperless lending based on e-agreements and electronic documentation seems to be the future. The mortgage market is seeing the emergence of electronic mortgage note called ENotes. ENotes, which are issued as electronic negotiable instruments, have become popular in the US mortgage market. The COVID pandemic has given strong push the popularity of contactless and paperless lending format in the mortgage market too.

Like the transfer of shares and bonds world-over has been replaced by demat trades, the replacement of paper mortgages may be replaced by electronic version, sooner than one can imagine.

Electronic documentation has been given legal validity in most countries world-over. The USA passed the Uniform Electronic Transactions Act (UETA) way back in 2000, and Electronic Signatures in Global and National Commerce Act (commonly known as the ESIGN Act) in the year 2000. Most countries have similar enabling laws[1]. These laws grant legal validity to electronic mortgage documentation too. Armed with this power, US national mortgage depository MERS® introduced electronic mortgages almost 16 years ago[2].  The Mortgage Industry Standards Maintenance Organization® (MISMO) eMortgage Community of Practice was formed in 2001 to develop standards for efficient eMortgage processes, transactions, and XML data protocol. However, eNotes surged during the pandemic months. It is reported that by end of May, 2020, there were 597,139 eNotes, with the numbers for Q1 of 2020 being 300% of the corresponding quarter in the previous year.

Concept of ENotes

The typical mortgage creation process in US practice, based on a loan for purchase of a house (“purchase money loan”) involves the creation of promissory note whereby the borrower passes possession/control of property documents to the lender, for the purpose of securing a loan. If the mortgage is transferred by the original lender, the promissory note is “indorsed” to the transferee. Under the ENote format, the mortgage is electronically signed and registered with MERS. The electronic mortgage is stored in an electronic vault maintained by MERS[3]. As the mortgage changes hands by way of transfer of the mortgage, the original lender’s name is replaced by transferee – as would have happened in case of dematerialised shares.

UETA and E-Sign laws facilitated the creation of electronic negotiable instruments by the concept of “transferable records”, which was intended to be an electronic version of the mortgage promissory note[4]. The transferable record methodology involves a depository called “controller” of the note, who is responsible for recording, registering and evidencing the transfers of interest in the note.

Judicial recognition of ENotes

Rulings such as New York Community Bank v. McClendon, 29 N.Y.S.3d 507 (N.Y. App. Div. 2016), and Rivera v. Wells Fargo Bank, N.A., 189 So. 3d 323, 329 (Fla. Dist. Ct. App. 2016) have recognised the right of an assignee of an eNote in taking foreclosure action. Courts have held that the assignee needs to establish that it is either the controller of the authoritative copy of the ENote or is the beneficiary thereof, and produces the paper trail of the transfers leading up to the right of the assignee.

Market acceptability of ENotes

Fannie Mae[5] and Ginnie Mae[6] started accepting ENotes. Ginnie Mae has started accepting ENotes only recently and as part of the initial phase, issuers may apply to participate as e-Issuers and begin securitizing government-backed mortgages comprised of digital collateral with Ginnie Mae approval.

However, it is stated that the real push to ENotes came in 2018 when Quicken Loans initiated a complete process of end-to-end electronic mortgage closing, called e-closing[7]. Quicken Loans launched a digital mortgage product called Rocket Mortgage, in November, 2015, presumably one that allows closing a mortgage in less than 10 minutes. In less than 2 years, Quicken Loans became the largest mortgage lender in the USA.

Remote Notarisation – the other part of the digital mortgage eco-system

To prove that a document is authentic in all its aspects, notarization is necessary. The new system of Remote Online Notarization (“RON”) was adopted back in 2010.

RON typically allows documents to be notarized in electronic form with the signer signing with an electronic signature and appearing before a commissioned electronic notary online via audio-video technology. This allows anyone with an Internet connection to get documents signed and notarized online.

This process has several benefits in terms of security and fraud prevention. RON has had growing acceptance in the US.

It is said that before Covid-19, ENotes were growing at a modest pace as the industry collaborated on solutions to facilitate broader adoption, including acceptance of RON[8].

Other Benefits of ENotes

Apart from the benefits already discussed above, the growing acceptance of ENotes has much to do with several other benefits as well, such as, reducing the operational costs, faster turnaround times, faster signing process, improved data quality and validation, etc.

These give ENotes the push towards a completely paperless mortgage process apart from the convenience factor.

Conclusion

Considering the more than $9 trillion size of US mortgage industry, digital mortgage lending is still a long way to go. Digital mortgages are still less than 5% of the total mortgage originations, whereas digital personal loans are close to 60% of the total loan originations.

The growing acceptance of ENotes is certainly providing the push required from the traditional to a completely “e” driven mortgage process.

[1] The eIDAS Regulation (Electronic Identification and Authentication and Trust Services) is the e-sign law in the EU. The Personal Information Protection and Electronic Documents Act (PIPEDA) is a similar law in Canada. The Electronic Transactions Act 1999 is the governing law in Australia.

[2] Refer to https://www.mersinc.org/index

[3] For a white paper on the ENote methodology, see here: https://www.mersinc.org/publicdocs/eNote_White_Paper.pdf

[4] See section 15 of UETA

[5] https://www.fanniemae.com/deliveremortgage/

[6] https://www.ginniemae.gov/newsroom/Pages/PressReleaseDispPage.aspx?ParamID=203

[7] https://www.housingwire.com/articles/48774-the-fully-digital-mortgage-has-truly-arrived-as-use-of-enotes-skyrockets-by-nearly-5000/

[8] https://cib.db.com/insights-and-initiatives/flow/trust-and-agency/digital-mortgages-come-of-age.htm#2

Evolution of securitisation – Genesis of MBS

finserv@vinodkothari.com

Securitisation as a concept, has a history of over 50 years. In this write up, the author traces the events leading up to the evolution of securitisation in 1970 with the issuance of the first MBS program by Ginnie Mae.

Fifty years of global securitisation – list of chapters

List of chapters for the anthology on fifty years of global securitisation –

Go back to fifty years of securitisation page.

Read more

Fifty years of global securitization

Vinod Kothari

Some people love it; some love to hate it, and some just live it. No matter which one of the clubs one belongs to, but there is no doubt that securitization is a major financial phenomenon.

Year 2020 marks 50 years of the inaugural mortgage-backed pass-through transaction done in 1970 by Ginnie Mae. Securitization has turned fifty.

The world is not in exactly right environment to do either a champagne party or otherwise – however, one should not gloss over the massive change that securitization has made, to the financial landscape of the world, over these five decades. Irrespective of the jury verdict on whether it was responsible for the Global Financial Crisis, the fact is that it had such a major impact that its short-lived absence from the scene could put world’s financial system into doldrums. And now, there are regulators’ reports looking at this very instrument with optimism to lead the recovery out of the COVID disruption.

To commemorate 50 years of securitization, we propose to bring an anthology of write-ups by senior securitization professionals, particularly those who have seen its boom and bust. The write-ups may be along the following lines:

  • Historical write-ups, recounting the development of early MBS by the agencies, the way it was perceived then and major economists’ remarks about this instrument
  • Contribution of securitization to mortgage markets globally, particularly in mortgage availability and affordability
  • Contribution of securitization to financial inclusion, making smaller and community lenders reach out to capital markets through larger intermediaries
  • Securitization and emerging markets
  • Lessons learnt from the GFC and how regulatory systems have evolved thereafter
  • Legal robustness of securitization – has it proved itself over decades of crises?
  • Off-balance securitization – development of accounting standards over the years, and does off-balance sheet securitization have any relevance left?
  • Significant risk transfers and capital relief
  • Market reports from major countries.

List of Chapters

For a work-in-progress list of Chapters, see here.

Publication details

The anthology is proposed to be a compilation in e-book form. We will be in touch with some publishers to seek interest in publication.

Structure of the Chapters

The anthology will be collaborative effort of several leading authors, experts, researchers and practitioners from all over the world. Each of the contributors are leading luminaries in their own field. So while substantial discretion will be used by the contributors, some pointers for contributors are as follows:

  • This e-book will hopefully have a very long shelf-life. Hence, the stance of the write-ups is not contemporaneous state of the market. Rather, the write-ups trace developments over time, to identify trends. The contributors deploy their wisdom to think of the trends that will continue, wither away, or strengthen. The commemorative is all about continuity and change.
  • We are wanting to minimise current market data or statistics, for reasons discussed above.
  • Each of the write-ups may provide a larger, macro view before narrowing down on micro aspects.
  • One of our very important objectives is to have the contribution of securitization to development of financial markets, financial inclusion, stability and robustness of systems, etc. It is not merely a historical account, but an important document on lessons to be learnt, and to provide a place from where one may look at the decades to come.
  • For scholars/practitioners who have been watching the industry grow over the years, if there are details of one’s personal association with the industry – as to how it developed and changed over time – that may of interest to readers. This may be added with generalisation of the market.

Invitation for contributions

Needless to say, it is a massive project – it has to be collaborative. We need the support of scholars, authors, stakeholders – those who have been practising, teaching, consulting or regulating securitization over the years. Hence, if you are one such contributor, or you know one who may be such a contributor, your contribution/assistance is most welcome.

For interest in contribution to the anthology, please do write to timothy@vinodkothari.com. Please indicate your background, proposed contents, length of the article, etc. After hearing from us positively, you may start writing your article, for submissions by end of August, 2020.

Sponsoring/advertising opportunities

From our side, this project is completely non-pecuniary. We just felt that we can steer this effort which may be valuable for a long time.

However, this project will involve massive research effort, editing, and production. Hence, there may be substantial expense.

If you want to sponsor in any manner, or want to put up a befitting advertisement about your company/products, the same is welcome. Please feel free to discuss with finserv@vinodkothari.com.

Timeline for publication

Tentatively, we may put the e-publication in public domain by November, 2020.

High Level Forum (EU) makes recommendations to further boost securitisation market

Data shows that the European securitisation market never rebounded after the 2008 crisis, even after the implementation of STS framework. Securitisation however, plays a key role in boosting the capital markets. This role has been recognised by the High Level Forum (EU) in its final report released on 10th June, 2019.

Seven recommendations were made by the HLF with respect to securitisation. The intent is to ultimately boost securitisation markets and help it pick up in the years to come.

In this write up, the author attempts to explain in brief the recommendations with respect to securitisation of the High Level Forum.

Read more

Draft Guidelines on Securitisation & Sale of Loans with respect to RMBS transactions

Presentation on Draft Directions on Securitisation of Standard Assets

Our related research on the similar topics may be viewed here –

  1. New regime for securitisation and sale of financial assets;
  2. Originated to transfer- new RBI regime on loan sales permits risk transfers;
  3. Comparison of the Draft Securitisation Framework with existing guidelines and committee recommendations;
  4. Comparison of the Draft Framework for sale of loans with existing guidelines and task force recommendations;
  5. Inherent inconsistencies in quantitative conditions for capital relief;
  6. Presentation on Draft Directions Sale of Loans;
  7. YouTube video of the webinar held on June 12, 2020.

Presentation on Draft Directions on Sale of Loans

Our related research on similar topics can be viewed here –

  1. New regime for securitisation and sale of financial assets;
  2. Originated to transfer- new RBI regime on loan sales permits risk transfers
  3. Comparison of the Draft Securitisation Framework with existing guidelines and committee recommendations;
  4. Comparison of the Draft Framework for sale of loans with existing guidelines and task force recommendations;
  5. Inherent inconsistencies in quantitative conditions for capital relief;
  6. Presentation on Draft Directions on Securitisation of Standard Assets;
  7. YouTube video of the webinar held on June 12, 2020.

Inherent inconsistencies in quantitative conditions for capital relief

Abhirup Ghosh

abhirup@vinodkothari.com

– Updated as on 16th June, 2020

On 8th June, 2020, RBI issued the Draft Framework for Securitisation of Standard Assets taking into account existing guidelines, Basel III norms on securitisation by the Basel Committee on Banking Supervision as well the Report of the Committee on the Development of Housing Finance Securitisation Market chaired by Dr. Harsh Vardhan.

With this, one of the main areas of concern happens to be capital relief for securitisation. The concerns arise not just for new exposures but also existing securitisation exposures, as Chapter VI (dealing with Capital Requirements) shall come into immediate effect, even for the existing securitisation exposures.

Earlier, due to the implementation of Ind-AS, concerns arose with respect to capital relief treatment as most of the securitisation exposures did not qualify for derecognition under Ind-AS. However, on March 13, 2020, RBI came out with Guidance on implementation of Ind-AS, which clarified the issue by stating that securitised assets not qualifying for derecognition under Ind AS due to credit enhancement given by the originating NBFC on such assets shall be risk weighted at zero percent. However, the NBFC shall reduce 50 per cent of the amount of credit enhancement given from Tier I capital and the balance from Tier II capital.

Once again, the issue of capital relief arises as the draft guidelines may cause an increase in capital requirements for existing exposures.

Capital requirement under the Draft Framework

The Draft Framework lays down qualitative as well as quantitative criteria for determining capital requirements. As per Para 70, lenders are required to maintain capital against all securitisation exposure amounts, including those arising from the provision of credit risk mitigants to a securitisation transaction, investments in ABS or MBS, retention of a subordinated tranche, and extension of a liquidity facility or credit enhancement. For the purpose of capital computation, repurchased securitisation exposures must be treated as retained securitisation exposures.

The general provisions for measuring exposure amount of off-balance sheet exposures are laid down under para 71-78 of the Draft Framework.

The quantitative conditions are however, laid down in paragraphs 79 (a) and (b). The intention here is to delve into the impact of the quantitative conditions only, keeping aside the qualitative conditions for the time being.

Substantial transfer of credit risk:

The first condition (79(a)) is that significant credit risk associated with the underlying exposures of the securities issued by the SPE has been transferred to third parties. Here, significant credit risk will be treated as having transferred if the following conditions are satisfied:

  1. If there are at least three tranches, risk-weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk-weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation;
  2. In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions.

Taking each of the two points at a time.

The first clause contemplates a securitisation structure with at least three tranches – the senior, the mezzanine and the equity. Despite the presence of three tranches, the condition for risk transfer has been pegged with the mezzanine tranche only, however, nothing has been discussed with respect to the thickness of the mezzanine tranche (though the draft Directions has prescribed a minimum thickness for the first loss tranche).

If the language of the draft Directions is retained as is, qualifying for capital relief will become very easy. This can be explained with the help of the following example.

Suppose a securitisation transaction has three tranches, the composition and proportion of which has been provided below:

Tranche Rating Proportion as a part of the total pool Retention by the Originator Effective retention of interest by the Originator
Senior Tranche – A AAA 85% 0% 0%
Mezzanine Tranche – B AA+ 5% 50% 2.5%
Equity/ First Loss Tranche – C Unrated 10% 100% 10%
        12.5%

As may be noticed, both the senior and mezzanine are fairly highly rated as the junior most tranche has a considerable amount of thickness and represents a first loss coverage of 10%. Additionally, it also retains 50% of the Mezzanine tranche. Therefore, effectively, the Originator retains 12.5% of the total pool, yet it will qualify for the capital relief, by virtue of holding upto 50% of the Mezzanine tranche, despite retaining 10% in the form of first loss support.

The second clause contemplates a situation where there are only two tranches – that is, the senior tranche and the equity tranche. The clause says that in absence of a mezzanine tranche, the retention of first loss by the Originator should not be more than 20% of the total first loss tranche.

Given the current market conditions, it will be practically impossible to find an investor for the first loss tranche, hence, the entire amount will have to be retained by the Originator. Also, it is very common to provide over-collateral or cash collateral as first loss supports in case of securitisation transactions, even in such cases a third party’s participation in the first loss piece is technically impossible.

Also, there is a clear conflict between this condition and para 16 of the draft Directions, which gives an impression that the first loss tranche has to be retained by the originator itself, in the form of minimum risk retention.

Therefore, in Indian context, if one were to take a holistic view on the conditions, they are two different extremes. While, in the first case, capital relief is achievable, but in the second case, the availing capital relief is practically impossible. This will make the second condition almost redundant.

In order to understand the rationale behind these conditions, please refer to the discussion on EU Guidelines on SRT below.

Impact on the existing transactions

As noted earlier, this part of the draft Directions shall be applicable on the existing transactions as well. Here it is important to note that currently, most of the transaction structures in India either have only one or two tranches of securities, and only a fraction would have a mezzanine tranche. In all such cases, the entire first loss support comes from the Originator. Therefore, almost none of the transactions will qualify for the capital relief.

In the hindsight, the originators have committed a crime which they were not even aware of, and will now have to pay a price.

The moment, the Directions are finalised, the loans will have to be risk-weighted and capital will have to be provided for.

This will have a considerable impact on the regulatory capital, especially for the NBFCs, which are required to maintain a capital of 15%, instead of 9% for banks.

Thickness of the first loss support:

This requirement states that the minimum first loss tranche should be the product of (a) exposure (b) weighted maturity in years and (c) the average slippage ratio over the last one year.

The slippage ratio is a term often used by banks in India to mean the ratio of standard assets slipping to substandard category. So, if, say 2% of the performing loans in the past 1 year have slipped into NPA category, and the weighted average life of the loans in the pool is, say, 2.5 years (say, based on average maturity of loans to be 5 years), the minimum first loss tranche should be [2% * 2.5%] = 5% of the pool value.

In India, currently the thickness of the first loss support depends on the recommendations of the credit rating agencies (CRAs). Typically, the thresholds prescribed by the CRAs are thick enough, and we don’t foresee any challenge to be faced by the financial institutions with respect to compliance with this point.

EU’s Guidelines on Significant Risk Transfer

The guidelines for evidencing significant risk transfer, as provided in the draft Guidelines, are inspired from the EU’s Guidelines on Significant Risk Transfer. The EU Guidelines emphasizes on significant risk transfer for capital relief and states that a high level, the capital relief to the originator, post securitisation, should commensurate the extent of risk transferred by it in the transaction. One such way of examining whether the risk weights assigned to the retained portions commensurate with the risk transferred or not is by comparing it with the risk weights it would have provided to the exposure, had it acquired the same from a third party.

Where the Regulatory Authority is convinced that the risk weights assigned to the retained interests do not commensurate with the extent of risk transferred, it can deny the capital relief to the originator.

Under three circumstances, a transaction is deemed to have achieved SRT and they are:

  1. Where there is a mezzanine tranche involved in the structure: the originator does not retain more than 50% of the risk weighted exposure amounts of mezzanine securitisation positions, where these are:
  • positions to which a risk weight lower than 1,250% applies; and
  • more junior than the most senior position in the securitisation and more junior than any position in the securitisation rated Credit Quality Step 1 or 2.
  1. Where there is no mezzanine tranche involved in the structure: the originator does not hold more than 20% of the exposure values of securitisation positions that are subject to a deduction or 1,250% risk weight and where the originator can demonstrate that the exposure value of such securitisation positions exceeds a reasoned estimate of the expected loss on the securitised exposures by a substantial margin.
  2. The competent authority may grant permission to an originator to make its own assessment if it is satisfied that the originator can meet certain requirements.

In case, the originator wishes to achieve SRT with the help of 1 & 2, the same has to be notified to the regulator. If as per the regulator, the risk weights assigned by the originator does not commensurate with the risks transferred, the firms will not be able to avail the reduced risk weights.

Underlying assumptions behind the SRT conditions

The underlying assumptions behind the SRT conditions have been elucidated in the EU’s Discussion Paper on Significant Risk Transfer in Securitisation.

  1. Mezzanine test: This is applicable where the transaction has a mezzanine tranche. Usually the first loss tranches are meant to cover up the expected losses in a pool and the mezzanine tranches are meant for covering up the unexpected losses, irrespective of whether the equity/ first loss tranche is retained by the originator or sold off to a third party. The mezzanine test is indifferent with regard to the retention or transfer to third parties of securitisation positions mainly or exclusively covering the EL — given potential losses on these tranches are already completely anticipated through the CET1 deduction/application of 1250% risk weight if they are retained.
  2. First loss test: This is applicable where the transaction does not have a mezzanine tranche. In such a situation, the first loss tranche is expected to cover up the entire expected and unexpected losses. This is clear from the language of the EU SRT guidelines which states, that the securitisation exposure in the first loss tranche must be substantially higher than the expected losses on the securitisation exposure. In this case, due to the pari passu allocation of the actual losses to holders of the securitisation positions that are subject to CET1 deduction/1250% risk weight (irrespective of whether these losses relate to the EL or UL), the first loss test may effectively require the originator to transfer also parts of the EL, depending on the specific structure of the transaction and, in particular, on which portion of the UL is actually covered by the positions subject to CET1 deduction/1250% risk weight

The following graphics will illustrate the conditions better:

In figure 1, the mezzanine tranche is thick enough to cover the entire unexpected losses. If in the present case, 50% of the total unexpected losses are transferred to a third party, then the transaction shall qualify for capital relief.

 

 

 

 

 

 

Unlike in case of figure 1, in figure 2, the mezzanine tranche does not capture the entire unexpected losses. The thickness of the tranche is much less than what it should have been, and the remaining amount of unexpected losses have been included in the first loss tranche itself.

In the present case, even if the mezzanine tranche does not commensurate with the unexpected losses, the transaction will still qualify for capital relief, because, if the first loss tranche is retained by the originator, it will have to be either deducted from CET1/ assign risk weights of 1250%

 

 

 

In figure 3, there is no mezzanine tranche. In the present case, the first loss tranche covers the entire expected as well as the unexpected losses. In order to demonstrate a significant risk transfer, the originator can retain a maximum of 20% of the securitisation exposure.

 

 

 

 

Conclusion

Currently, the draft Directions do not provide any logic behind the conditions it inserted for the purpose of capital relief, neither are they as elaborate as the ones under EU Guidelines. Some explicit clarity in this regard in the final Directions will provide the necessary clarity.

Also, with respect the mezzanine test, in the Indian context, the condition should be coupled with a condition that the first loss tranche, when retained by the originator, must attract 1250% risk weights or be deducted from CET 1. Only then, the desired objective of transferring significant risks of unexpected losses, will be achieved.

Further, as pointed out earlier in the note, there is a clear conflict in the conditions laid down in the para 16 and that in the first loss test in para 79, which must be resolved.