DBRS Morningstar Requests Comments on Proposed Mortgage Insurance Appendices to RMBS Insight 1.3: U.S. RMBS Model and Rating Methodology and Operational Risk Assessment for U.S. RMBS Originators

DBRS, Inc. (DBRS Morningstar) is requesting comments on the following proposed new:

(1) Appendix 8: Expected Mortgage Insurance Payments to the existing DBRS Morningstar “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology.” The proposed appendix provides an analytical framework for reviewing mortgage insurance (MI)-linked note transactions. The update also includes the implementation of a minimum asset correlation in the U.S. RMBS Insight model with respect to pools with large loan counts, typically agency pools for government-sponsored enterprise (GSE) credit risk transfers (CRTs) or MI-linked notes.

(2) Exhibit II – Sample Operational Risk Questions for U.S. Mortgage Insurers in the existing DBRS Morningstar “Operational Risk Assessment for U.S. RMBS Originators” methodology.

INTRODUCTION
Since 2017, various MI companies have set up programs to issue MI-linked notes. These programs aim to transfer a portion of the risk related to MI claims on a reference pool of loans to the investors of the MI-linked notes. In these transactions, investors’ risk increases with higher MI payouts.

TYPES OF MORTGAGE INSURANCE
There are two types of MI: borrower-paid MI (BPMI), with insurance premiums paid by the borrower, and lender-paid MI (LPMI), with premiums paid by the lender.

BPMI can be terminated or canceled under various conditions, but such termination is typically only applicable to mortgages secured by single-unit primary residences or second homes. LPMI generally cannot be canceled.

BPMI will be automatically terminated if (1) the unpaid principal balance (UPB) is reduced to 78% of the property value at origination and (2) the borrower is current on the mortgage payment. Borrowers can also initiate termination based on the original or current property value of the homes, provided they meet certain loan-to-value (LTV), seasoning and payment history criteria. To qualify for cancellation, a current valuation in the form of a broker price opinion, value certification or new appraisal is typically required.

TYPES OF CLAIM SETTLEMENT
When a loan defaults and incurs losses, the mortgage insurer pays the claim as per its contractual obligation.

There are typically three claim settlement types for the mortgage insurer:
(1) A coverage percentage option,
(2) A pre-approved sale and
(3) The acquisition of the property.

For the coverage percentage option, the mortgage insurer pays out the claim amount times the MI coverage percentage. The claim amount is the sum of (1) the UPB, (2) delinquent interest and (3) reasonable expenses. The second settlement type is a pre-approved sale where the mortgage insurer can elect to pay up to the difference between the claim amount and the proceeds from the sale of the property. The last settlement type is the acquisition of the property where the mortgage insurer takes possession of the property and pays the claim amount.

EXPECTED MI PAYMENTS ANALYSIS
Generally, the process of calculating MI payments follows the loan-level default and loss calculation process consistent with non-MI loans, with additional logic applied, as described below:

(1) Calculate expected probability of default,
(2) Calculate expected loss and
(3) Calculate expected MI payments.

Although the processes for default and loss calculations are the same as for non-MI loans, some additional conditions may apply during the application of MI payment calculations, such as capping the amount of predicted delinquent interest, since master MI policies typically do not allow for payouts in excess of 36 months.

DBRS Morningstar uses the estimated state-by-state timelines, previously described in the related “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology,” which are further capped at 36 months to calculate delinquent interest. In addition, DBRS Morningstar uses expenses derived from agency data for the MI payment calculation.

In RMBS Insight 1.3, the amount paid out by the MI insurer is calculated as the minimum of:
(1) Claim * MI Coverage Percentage and
(2) Claim less net sale proceeds from the sale of the property.

This is calculated for each period in the forecast, using the model’s native default and loss forecasts, plus the MI coverage logic. If the MI coverage is estimated to be terminated based on scheduled payments, the payout amount is calculated to be 0.

MI TERMINATION
Cancellation of policies removes the insurer’s exposure on the mortgage loan and therefore reduces the risk to the transaction. As such, for the purpose of MI-linked notes transactions, DBRS Morningstar assumes only the automatic termination of BPMI insurance and not borrower-initiated BPMI terminations. Automatic termination occurs when the loan’s UPB drops to 78% of the original property value. Although home price increases may reduce LTV ratios, allowing for a borrower in certain instances to initialize early cancellation, this must be triggered by a borrower request and is therefore not contemplated in the DBRS Morningstar analysis.

MINIMUM ASSET CORRELATIONS
In conjunction with the expected MI payment appendix, DBRS Morningstar also implements a minimum asset correlation in U.S. RMBS Insight with respect to pools with large loan counts, typically agency pools for GSE CRT or MI-linked notes transactions. This update is deemed to be a material change to the existing DBRS Morningstar “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology” and is expected to be more significant for seasoned GSE CRT transactions with strong credit attributes and collateral performance.

In its U.S. RMBS Insight model, DBRS Morningstar’s approach to ratings categories includes two components: one based on identifiable risks and the other based on unidentifiable risks. Unidentifiable risk refers to causes of variation that are not captured by the independent variables in the model. For unidentifiable risks, the variation is quantified by estimating an asset correlation.

The asset correlation model is a parametric function of geographic concentration, loan size concentration and credit quality. Asset correlation increases with concentration and decreases with credit quality. As a corollary, correlation decreases with loan size concentration, but remains positive because of broader economic correlations at the regional and national levels. In pools with very high loan counts, the loan diversity benefits can result in low correlation calculations and gaps between any rating categories can be compressed and potentially subject to rating volatility.

To mitigate this risk while maintaining appropriate rating scalability for pools of different credit quality, DBRS Morningstar implements minimum asset correlations in its U.S. RMBS Insight model to effectively capture pool risks. This represents a change from DBRS Morningstar’s earlier approach of enforcing minimum spacing between each rating category for pools with very high loan counts.

OPERATIONAL RISK QUESTIONS FOR MORTGAGE INSURERS
DBRS Morningstar also updated its “Operational Risk Assessment for U.S. RMBS Originators” methodology to include a new Sample Operational Risk Questions for U.S. Mortgage Insurers exhibit.

IMPACT ANALYSIS
The appendices address only the analytics of expected MI payments for MI-linked notes and do not affect any other asset types covered in DBRS Morningstar’s “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology.” To date, DBRS Morningstar has not rated any MI-linked notes. Accordingly, no rating impact analysis has been performed for the newly proposed appendix.

The implementation of the minimum asset correlation is expected to affect 12 outstanding GSE CRT transactions rated by DBRS Morningstar. A preliminary impact analysis indicates that the potential rating actions on these transactions are expected to be confirmations or upgrades.

GSE CRT AND MI-LINKED NOTES TRANSACTIONS PLACED UNDER REVIEW
As a result of the adoption of DBRS Morningstar’s “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology” for GSE CRT and MI-linked notes transactions, Morningstar Credit Ratings, LLC (MCR) has placed all 32 outstanding transactions and 660 outstanding classes Under Review – Analytical Integration Review. The rating actions on such ratings were taken in relation to the future combination of MCR and DBRS into one single U.S. registration. Upon the finalization of the RFC, such classes of debt are expected to subsequently be assigned new DBRS Morningstar ratings. Due to the material change proposed for GSE CRT transactions, DBRS Morningstar has placed all 12 outstanding transactions and 316 outstanding classes Under Review with Positive Implications.

For more information related to the rating actions taken on the GSE CRT and MI-linked notes asset classes, please see the following press releases:

<a href="https://ratingagency.morningstar.com/PublicDocDisplay.aspx?i=UhDPTGjvZoc%3d&m=i0Pyc%2bx7qZZ4%2bsXnymazBA%3d%3d&s=LviRtUKXqs8kml5dHt7FTeE2SZmY0Fvqd4iX49Mk%2f9UapyiFTEO6TA%3d%3d" target="_blank">"Morningstar Credit Ratings Places Ratings on GSE CRT and MI-Linked Notes Asset Classes Under Review"</a>

<a href="https://www.dbrs.com/research/353170/" target="_blank">"DBRS Morningstar Places 12 GSE CRT Transactions Under Review with Positive Implications"</a>

Comments should be received on or before December 22, 2019. Please submit your comments to the following email address:
Structured.Finance.Comments@dbrs.com.

DBRS Morningstar publishes on its website all comments received, except in cases where confidentiality is requested by the respondent.

Notes:
DBRS Morningstar methodologies are publicly available on its website www.dbrs.com under Methodologies & Criteria.

For more information on this methodology or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.

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