Critical Ingredient to Identify Healthy Mortgage-Backed Securities

What you will learn:

• How liquidity is created in the secondary market
• How the FICO® Score can help investors better model cash flows
• Next steps for increasing value and liquidity

Though the origination of a mortgage may not be the most exciting event to some, to a renter buying a first house or a family finding their dream home, a new mortgage can be as thrilling as life comes. Origination is just the initial phase of the long and complex mortgage lifecycle, which begins with a lender qualifying a borrower and then providing the funds used to purchase a new property or refinance an existing property. The lender then holds the mortgage on its balance sheet or sells the mortgage on the secondary market to investors.

The secondary market plays a critical role in making capital available to lenders, so they have the funds to continue to offer borrowers competitively priced mortgages. In this blog, I will explore how the secondary market values mortgage loans, the importance of FICO®Scores in that valuation, and how essential it is to have consistent and universal credit standards to accurately compare loans across time and lenders.

Role of Secondary Market

After their origination by lenders, mortgages are bought on the vast secondary market by investors ranging from banks to insurance companies, to hedge funds. One key part of the secondary market involves the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac buy and guarantee mortgage loans that conform to their lending standards and advance their mission to make housing more affordable, creating a powerful market incentive for lenders to issue loans that meet these high standards.

Investors, such as Fannie Mae and Freddie Mac purchase mortgages in bulk and then bundle them together to create mortgage-backed securities (MBS) (a single lender can also issue its own MBS). Just as the quality of any item – a cup of coffee, a precision time piece, a grand piano - depends upon the quality of its materials or ingredients, the value of the MBS depends on attributes of its underlying mortgages. Some indicators of value are empirical in nature, such as loan-to-value ratio, debt-to-income ratio, and the unpaid principal balance, and each of these attributes has a unique charge-off and pre-payment curve associated with it that adjusts when these attributes are combined. But no MBS can be properly valued without an underlying FICO® Score, the key piece of information that informs investors whether they are making a sound investment or simply rolling the dice.

Importance of FICO Score

It should come as no surprise that investors in MBS first and foremost want to minimize the risk of losing some or all of their investment. Mortgages with higher FICO® Scores tend to be more valuable to investors since they represent lower risk and more predictable charge-offs, yielding more stable cash flows. Often lower FICO Scores mean lower pre-payment risk, yet higher risk of default, with a higher likelihood of leading to a charge-off. This is a stable cash flow model is so important in valuing mortgages on the secondary market.

Mortgage lenders adhere to credit guidelines and standards to ensure that the loans they originate meet the “buy-box” of potential investors of MBS in the secondary market. These credit guidelines and standards are used to evaluate a borrower’s risk level and ability to repay the loan. A uniform credit standard, which includes the FICO® Score, ensures that the loans lenders originate and ultimately securitize are universally comparable across time and with other lenders, helping drive market liquidity.

A universal standard credit evaluation process used across time and lenders allows investors to know they are comparing apples to apples, which is critical for the functioning of the secondary market. The FICO® Score allows investors to evaluate risk associated with loans they purchase as part of the MBS, and it provides a common framework for evaluating the quality of the underlying loans in the security. In short, the more predictive and reliable the credit score as a standard of creditworthiness is over time, the easier it is for investors to have faith that their investments will produce the anticipated cashflows. This, in turn, increases the overall value of the MBS as an investment instrument.

Remember, there are risks associated with the sale of mortgage loans in MBS on the secondary market. One is repurchase risk-- the risk a lender may be required to buy back a loan from an investor due to breaches in the loan's representations and warranties (Rep and Warrant). This can occur when the borrower defaults or when there are issues with the loan documentation or attributes used to document the loan.

Rep and Warrant exposure refers to the potential losses a lender may incur if they are required to repurchase loans due to breaches of these Rep and Warrants.  All of this leads to the necessity of using the most predictive credit score possible to help project investor cash flows. That credit score continues to be the FICO® Score. With the latest score version, FICO® Score 10 T being the most predictive FICO® Score on the market, projecting an incremental 5% approval rate over scores most commonly used in the market today.

Remember, a more predictive score could equate to a better valuation of MBS. For on-GSE loans in the marketplace, lenders, investors, rating agencies, and others should all start to consider how to upgrade the value chain to create more valuable securities with FICO® Score 10 T.

To learn more about FICO Score 10 T, visit the FICO mortgage migration center.