Is Mortgage Quality Deteriorating Again? Already?

This sounds like pretty grim news. Just yesterday, we wrote that the commercial mortgage industry is beginning to come back to life, thanks in large part to commercial mortgage-backed securities market finding its footing. It seems that the return of mortgage securitization is also bringing back poor underwriting practices, however. This is either very bad or completely irrelevant.

First, here's the claim, via Jody Shenn at Bloomberg:

"There's some crap getting done," David Jacob, an executive managing director at credit-rating company S&P, said today during a panel discussion at the American Securitization Forum trade group's annual meeting in Orlando, Florida. "It's surprising to me this early in the cycle that some of that could be happening."

And he's not the only one making the claim. The article continues:

It's been surprising how quickly investors have returned to accepting transactions with numerous AAA rated classes, said Blewitt, co-head of securitized assets at BlackRock, the world's largest money manager. Some bond buyers may not be scrutinizing offering documents closely enough to find "hidden" dangers, he said.

"I don't think we're going back to the Ponzi finance excesses that we had in 2006 and 2007 just yet, but when I get a little bit scared is when I see the old game of, 'These are not your droids, look over there, not over here,' " Blewitt said, referring to a scene in the original "Star Wars" movie involving a so-called Jedi Mind Trick to evade detection.

This raises a few questions.

First, we've got a guy from S&P -- one of the very rating agencies that was blamed for incorrectly rating mortgage-backed deals prior to the financial crisis -- making this claim. If this rating agency is aware of the problem either a) they're not doing anything to prevent it (again). or b) they have re-worked their assumptions to rate the deals accordingly so that they can withstand the "crap" that's getting into them.

If the latter is true, then the return of some bad mortgages getting slipped into securitization deals probably isn't a huge deal. If the loss cushion within these transaction is big enough, you can have some garbage in there without it affecting the investors' cash flows. Of course, if S&P and others haven't sufficiently changed their methodology and are rating these bonds anyway, then that's very bad.

Then, there's the investor perspective. Again, one of two things is happening here. Either a) investors are failing to scrutinize these deals, just like they did before and endured big losses as a result, or b) they are closely examining these deals and the occasional bad loans they find don't bother them, because there's plenty of cushion to absorb losses.

Just like before, the second of these possibilities would mean that this news isn't that important. Some bad loans can make it into a securitization without killing the entire deal if you've got enough loss cushion. But if investors haven't learned their lesson and still aren't doing enough due diligence, then they could suffer big losses again in coming years.

The Jedi mind tricks that Blewitt refers to simply shouldn't be possible with securitization. Investors should not invest in these bonds if they aren't fully comfortable with the assets they're backed by, which means they should have been provided sufficient, accurate information about the quality of the loans. That way they can do the modeling themselves and use their own assumptions to determine the value of the bonds. You don't need to wield the Power of The Force to do that; you just need some conservative market expectations, accurate information, and a good knowledge of financial modeling. Unless banks are misrepresenting assets, securitization should work when investors are doing their homework.