Digital Risk In The News

Fraud Seen Playing Large Role in Loan Contract Breaches

June 13, 2008
By Bonnie Sinnock
NATIONAL MORTGAGE NEWS ONLINE

Risk mitigation firm Digital Risk LLC, Maitland, Fla., has found 50% to 60% of the subprime and alternative-A mortgages from the last few years that it has examined due to contract breaches contain significant misrepresentation or fraud, according to Bruce Miller, who was recently named to head the company's New York-based structured finance consultancy practice.

Mr. Miller, the former founder of Credit Suisse's conduit and credit products group, said traditional methods of analyzing such loans have proved insufficient and he has come to believe that every subprime/alt-A loan originated in the past few years should get a third-party review. Information on original loan "tapes" for these mortgages cannot be counted on, he said, adding that he feels rating agencies, as well as other market participants, have largely been "defrauded" when it comes to this information.

Payment histories that were once commonly seen as a good way to size up loan quality are no longer enough because they may, for example, show a borrower has a fairly good track record and only one 30-day delinquency on its loan while hiding the fact that the same borrower owns five other properties he has been flipping, Mr. Miller said.

Automation valuation models at the ZIP code/metropolitan statistical area level also may be insufficient ways to size up such loans, which really need to be analyzed in terms of the individual property as well as in terms of whether a pattern of fraud has been detected in the region if one wants to derive any value from them, said Mr. Miller. "Everything revolves around getting as granular as possible. Otherwise it's the classic 'garbage in, garbage out.'"

While it has been a challenge to find value in problematic alt-A and subprime loans, Mr. Miller said Digital Risk's clients have told the company that by using more granular analytic techniques they can produce higher internal rates of return on their whole loan investments. He said the firm's clients are typically "anyone who is long mortgage risk as a guarantor or cash owner."

While liquidity appears to be improving and many resources have been lined up to buy assets, it is still a challenge and in that there is "a big gulf" between buyers' and sellers' expectations, Mr. Miller said. "We have a ways to go," he said, noting that the bid-offer spread has been about 25%-30% recently, with some improvement over time in that the spreads have been closer to 20%-25% as opposed to 25%-30%. But he noted that this is based on a very limited number of whole loan trades. Also, there is not a lot of price discovery in these trades as most transactions have been private deals.

Mr. Miller also noted that a lot of the money lined up by buyers, largely hedge funds, still has not been "deployed."

He said he believes consulting firms can help narrow spreads because he believes those reflect "an information gap" that advisory companies can help fill.

Mr. Miller also noted that due diligence firms' role has changed dramatically since the days when he founded the Credit Suisse conduit and credit products unit. "It's not just due diligence on the inbound/new origination [business], it's a very different role," he said, noting also that demand for advisory/consulting work of this nature has grown notably in the last 18-24 months.

Although the recent credit crisis has changed many aspects of the business, Mr. Miller believes past experience like his own still is valuable if it is adapted correctly. "In financing a lot of different mortgage warehouses and loan pools over the years, I was acutely aware of and concerned about credit issues and have used analytics and due diligence firms in the past," said Mr. Miller, who most recently was group head at ING Capital Markets, and previous to his Credit Suisse post was head of securitization at Daiwa Bank Ltd. "I understand what is valuable to market participants who own risk ... and bring an understanding of markets, credit issues and participants to the job."

The market has been "very uncomfortable" with mortgages recently, but he is confident the asset class will recover. "Mortgages need to be financed and investors want to invest in credit, not be stuck in Treasuries for the rest of their lives," he said.