Ever wonder why your mortgage has so many restrictions and requirements/conditions? Why does your lender require provisions for prepayment penalties, restrictions on subsequent encumbrances (such as no second mortgages), title insurance and opinions, the mortgage becomes due on sale or due on encumbrance, the lender can assign the mortgage without the borrower’s permission, etc…? Believe it or not, its not because the lenders are inflexible, but more so because the lenders need to package up thousands if not hundreds of thousands of these mortgages into mortgage backed securities in order to obtain more cash to re-loan and continue business in the mortgage industry.
Asset securitization provides an additional basis of funding. Securitization is one of many tools available for risk and capital purposes. One of the most significant classes of assets securitized in Canada is residential mortgages. These residential mortgages, until recently (given the economic meltdown of last), are also characterized as one of the safest classes of assets available from a credit quality and an underlying asset contingency point of view. For any conventional residential mortgage has an embedded buffer because of the standard loan-to-value restrictions legalized in Canada when granting a mortgage. Unless insured, a conventional mortgage requires 20% owner’s equity, and up-to 80% mortgage money. As a first mortgage, it is this 20% that should be available to cover:
- Any market downturns in the real estate value of the property should it be foreclosed or sold under power of sale;
- Extra costs associated with recovery, such as legals and selling commissions;
- Condominium common area expenses or maintenance fees, or liens thereof;
- Arrears in property back taxes; and
- Interest owed on the said mortgage loan.
And thus, it is these basic parameters in eligibility for a conventional first mortgage loan, that further reduces the risk of using mortgages in securitization as asset backed securities:
- the mortgage must follow the CMHC (Canada Mortgage Housing Corporation) guidelines;
- the LTV (Loan To Value) of the mortgage must not exceed 80%;
- the mortgage is a first mortgage on residential property;
- no mortgages may exceed $500,000 (if they are to be used in securitization as part of the pool in an asset backed security);
- a certain minimum spread over funding cost must be achieved (ie. high enough interest rate if the mortgage is to be used in a securitization);
- the maximum term of a mortgage must not exceed 5 years;
- the property must be within the geographic diversification requirements of the securitization portfolio; and
- prepayment provisions must compensate for the loss of the spread (for securitization purposes, the prepayment provision must protect the securitization/asset backed security, from having to re-lend mortgage monies that have been prepaid back at a time when the market rates are lower. Hence the asset backed security has to maintain a rate of return for its investors, and can’t afford to be backed by mortgages that don’t collect interest at the same rate they were securitized at and for the same term they were committed to.)
The concept of securitization is relatively uncomplicated. For instance, a corporation inflates/obtains cash by selling some of its assets, leases, loans, licenses, goodwill, or other receivables, (ie. illiquid assets) to a special purpose vehicle (SPV). The SPV will in turn securitize into financial instruments/units (ie. securities) for investors in capital markets. These securities are structured in a way that allows rating agencies to analyze them and grade its investment quality, hence increasing their marketability. As a result, investors are able to see the cash flows of the illiquid assets (such as the receivables now owned by the SPV), being paid into the SPV to repay their securities. Investors are, likewise, willing to provide funds to the SPV, by purchasing its securities (ie. units) at relatively favorable rates, and the original corporation is able to indirectly access capital/cash at a low cost from the capital markets.
However, just like any securitization endeavor to choose the assets to back against, the gap between risk and opportunity should be met by providing due diligence, risk management and specialist training services to help organizations negotiate risks and perform in the dynamic and challenging market environment specific to that asset being backed. Financial institutions reach ever further into emerging and developing markets facilitating growth through capital raising, lending, and advisory activities. The major investment banks value their reputation and standing, and as such seek to ensure that the relationships into which they are entering are free from reputation risk through thorough research.
Most transactions, the level of required diligence depends on the situation of the deal. The due diligence to be implemented is broader when an entire loan or an anguished loan is being purchased as compared to the due diligence performed when a partial interest of loan is being purchased especially if the seller keeps hold of an interest and provides representations and warranties as to the asset being acquired by the SPV. The range of due diligence usually includes a review of the loan documents of the mortgages making up the asset pool backed in the securitization. It focuses on the commercial terms and the more significant provisions such as prepayment rights, prohibition of subordinate security (ie. second and third mortgages), due-on-sale, due-on-encumbrance, limited recourse clauses, cross-defaults, and assign-ability by the lender. Normally, the review of title insurance or title opinions is taken into consideration. If a lender’s policy of title insurance was initially obtained, then a new assigned endorsement in support of the buyer (the SPV) as well as the date of the existing policy should be considered.
Oftentimes, initial due diligence also involves the sub-search of title to confirm ownership, priority, subsequent mortgages or construction liens, assignments of mortgage, partial discharges, and registered renewals or amendments of the mortgages in the asset pool. Personal property searches confirm the continued effectiveness of prior registrations and any required renewals and amendments. Typically, bankruptcy, execution, and realty tax searches are normally undertaken as well. As you can imagine, the securitization of thousands of mortgages requires an immense amount of work, that can be reduced so long as the original lenders maintain the restrictions, conditions and requirements mentioned above, in each and every mortgage they give out.
When a single large loan in default is being acquired, the due diligence involved will most likely require complete and extensive supporting papers of the property secured by the loan. The loan will not be repaid in full if the reason of the default is that the original cash flow does not sustain the debt payments. The value of a defaulted loan is not a function of the outstanding balance, but rather depends on the proceeds from enforcement and collection after the deductions of all costs; not to mention the risks of delay and frustration inherent in the enforcement process.
In performing due diligence on the loan documents and re-endorsing the property subject to a loan, the purchase of a non-performing loan would usually require a review on the actions taken by the lender and borrower prior to and during the period that the loan has been in default. Any actions that will endow with a valid protection to enforcement are tremendously important. All waivers, amendments, or correspondence would need to be cautiously reviewed.
Another essential factor in determining the level of due diligence is the time afforded for the task. Due diligence may be shortened if the seller/lender has a need to sell without delay. This would result to an extent in a lower purchase price to account for the additional risk taken by the buyer (the SPV and Unit buyers). In addition, a more complete and precise set of representations and warranties may be required from the seller/lender.
Although this article is not necessarily for the individual borrower, it is for the individual lender, lender syndicate or the lending institution. To seriously engage in the securitization of your mortgages contact the lawyers at Levy Zavet PC.