Structured Securities - TheRapid Growth of Principal & Work at Home

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1 Structured Securities Processing Challenges A White Paper on the processing challenges posed by Collateralized Mortgage Obligations and other Asset-Backed Securities June 2006

2 Table of Contents Executive Summary Introduction The Structured Securities Market Challenges of CMO/ABS Processing Accuracy Timeliness Reasons for Post-Payable Revisions CMO/ABS Asset-Servicing Model Accomplishments to Date Action Steps for

3 Executive Summary 2 The rapid growth of structured securities including collateralized mortgage obligations (CMOs) and asset-backed securities (ABS) shows no signs of slowing down. The average distribution of principal and interest on the 25th of the month by The Depository Trust Company (DTC), a subsidiary of The Depository Trust & Clearing Corporation (DTCC), has gone from $9.5 billion in 2001 to $52.5 billion in With this growth, however, comes an increasing number of processing challenges, and late and inaccurate notifications of payment rates continue to be major concerns. This paper: Identifies the inherent structural challenges for the processing of principal and income payments for CMOs and ABS; Proposes specific steps to improve and expedite processing capabilities in 2006; Calls on industry participants to work together, and with DTCC, to develop and support additional initiatives to foster processing efficiencies for these structured securities. The challenges of processing structured securities have existed since the inception of the market. Although DTC and paying agents have developed automation and process improvements and made some progress on timeliness of information during the past several years, little progress has been achieved in improving the accuracy of CMO/ABS principal and interest (P&I) payment processing. This suggests that there may be a structural discontinuity in the servicing terms of CMO/ABS that contributes to inefficiencies. Thousands of transactions fail to be processed in an accurate and timely manner each year. In 2005 alone, 5,345 CMO or ABS transactions had to be adjusted or reversed, representing a 0.54% postpayable date adjustment rate. This is in contrast to a 0.20% post-payable date adjustment rate for all other issue types processed by DTC. Also in 2005, more than 14% of payable rates were unknown to DTC at the close of business the day prior to payable date. The figure drops to 1.7% by 3 p.m. on payable date but this last-minute information continues to create uncertainties within the industry for DTC, participants and their customers. In 2005, DTC and the Association of Global Custodians identified opportunities to improve structured securities processing. DTC has now begun working with The Bond Market Association and the American Securitization Forum to bring together all interested parties including the Association of Global Custodians and industry participants underwriters, paying agents, servicers and issuers to map out a strategy that will help define accountability, set time parameters and develop actions to spur improved performance across the board. Working with the industry, DTC will: Host an industry roundtable with The Bond Market Association and the American Securitization Forum in the second quarter of 2006 and form a committee that will make industry-wide recommendations on CMO/ABS processing as well as monitor their implementation. Expand the distribution of monthly agent performance Report Cards beyond the agent community. Currently, DTC works directly with major paying agents who provide DTC with detailed payment information for CMO/ABS processing and together they use the report cards to examine processing and performance problems. The data in these report cards can be used to create similar report cards for service providers in other industry segments to help them improve efficiencies and meet new regulatory requirements. Create a time limit for post-payable adjustments. Implement financial disincentives for failure to comply with established DTCC requirements and industry standards for accuracy and timeliness. Explore other recommendations to improve timeliness and accuracy.

4 Introduction In the three years since The Depository Trust & Clearing Corporation (DTCC) released its white paper entitled Examining the Growth of the Collateralized Mortgage Obligation Market, there has been continued growth in the issuance of structured securities 1 such as collateralized mortgage obligations (CMOs) and other asset-backed securities (ABS). This growth has resulted in record increases in the volume of principal and interest payments processed by DTC. CMO/ABS issues now represent 25% of all principal and income (P&I) payments made by DTC. Late and inaccurate notifications of payment rates for these issues continue to pose a major problem. Despite significant efforts by DTC and paying agents who must make these payments, the high percentage of payment rate revisions following payable date revisions that require adjustments in the actual payments made to participants and their beneficial owner customers (post-payable date adjustments) 2 remains virtually unchanged since CMO/ABS deal structures continue to have inherent limitations with stringent time frames for information reporting and significant interdependencies among servicers, trustees, paying agents, DTC, broker/dealers, custodians and beneficial owners. Although the recent adoption of Regulation AB by the Securities and Exchange Commission (SEC) may provide some regulatory impetus to focus on reporting responsibilities, 3 inconsistencies remain present. The failure to make progress in the timeliness and accuracy of rate information, combined with the above-average growth in CMO/ABS volume, is causing the absolute level of late payments to end investors and the volume of exception processing for financial intermediaries to continue to grow. The problem can neither be solely attributed to a lack of automation nor corrected by process improvements by paying agents and DTC. Part of the problem appears to be structural and can only be solved through a concerted industry effort to change the terms of the deal structures and the time available for the various parties in the information chain to add their particular value to the end result. The purpose of this paper is to provide an update on progress made since 2002, to outline DTC s next steps and to call upon the industry to help resolve this difficult and growing problem once and for all. 1 A structured security is a financial instrument created by combining other financial assets that can include credit cards, mortgages, and bank loans as well other assets and then marketing them to investors. 2 In a post-payable date adjustment, payment has been made to the participant on the asset, and the participant has credited these proceeds to the beneficial owner, but subsequently the rate is changed, necessitating additional payment or causing all or a portion of the payment to be reversed. 3 As of January 1, 2006 Regulation AB provides the disclosure and periodic reporting requirements related to asset-backed securities that are registered with the SEC. Item 1122 of the regulation, Compliance with Applicable Servicing Criteria, potentially impacts the ongoing periodic reporting of almost every entity (servicers, issuers, master servicers, bond administrators, trustees, and underwriters) involved with publicly registered mortgage-backed or asset backed securities that are the subject of registered offerings beginning after December 31, Item 1122 requires assessments of compliance with servicing criteria from each party participating in the servicing function including cash collection and administration, and investor remittances and reporting and an attestation of such compliance from a registered public accounting firm. These assessments of compliance and attestations must be filed as exhibits to an annual report or Form 10-K. For more detailed information on Regulation AB, go to the SEC Web site at 3

5 The Structured Securities Market The CMO is a multi-class bond backed by a pool of mortgage loans. CMOs are issued by various organizations, including Fannie Mae, Freddie Mac, investment banks, mortgage originators, and insurance companies. The issuer or servicer collects the monthly payments from individual homeowners and begins the process of passing the cash flow through to the investors or holders of the CMO issues. The CMO issuer pays a coupon rate of interest to the holders along with scheduled and unscheduled principal payments. While the CMO coupon rate is standard, the principal is variable resulting in unpredictable payment obligations from the issuer to the end-holder of the CMO. This variability also creates an additional process step for servicers by introducing the possibility for errors. The vast majority of CMOs pay principal on a passthrough basis that is, with each holder receiving a pro rata share of the principal paid during a period. The remaining issues pay the principal in the form of a partial call that is, with some holders having their securities called and principal returned, and others unaffected. CMOs pay principal and interest on various days throughout the month with the majority paying on the 25th. Asset-backed securities are structured bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. ABS differ from most other kinds of bonds in that their creditworthiness (which is at the triple-a level for more than 90% of outstanding issues) derives from sources other than the paying ability of the originator of the underlying assets. Like CMOs, ABS share the same unpredictability of the timing of principal payments from the issuer to the end-holder of the security. The Mortgage Bankers Association reported that domestic commercial mortgage lending increased by a record $328 billion or 14% in 2005, to an all-time high of nearly $2.6 trillion. The Bond Market Association reported that total bond issuance reached $5.52 trillion in 2005, up from the $5.49 trillion in 2004, while asset-backed issuances increased by $200 billion, or 20%, reaching $1.10 trillion in 2005, breaking the previous record of $901.5 billion set in DTC s overall CMO/ABS activity mirrors this volume growth. As depicted below, there has been and continues to be significant growth in the volume of CMO/ABS securities that underwriters have distributed via DTC s book-entry settlement system over the past five years, with the largest percentage increase in Over the last five years, the total number of CMO CUSIPs increased 2.5 times while the number of ABS CUSIPs has more than tripled. Consequently, the average distribution of principal and interest on the 25th day of the month has gone from $9.5 billion in 2001 to $52.5 billion in 2005, with a record daily high of $61.7 billion on October 25, These CMO CMO ABS ABS YEAR CUSIPs ISSUES CUSIPs ISSUES , , , ,635 1, ,703 1,090 6,744 1, ,104 1,293 9,806 1, ,296 1,662 14,014 2,443 data quantify the dramatic growth in CMO/ABS issuances that DTC has seen and will serve as the backdrop to address the structural issues associated with these securities. 4 Bond Markets News Desk, News Bulletin: Asset-Backed Issuance Tops $1 Trillion, New all time High, Released Wednesday, February 22, 2006, News Highlight for the week of February 20,

6 Challenges of CMO/ABS Processing ACCURACY PROBLEM During 2005, DTC allocated 983,424 individual CMO/ABS payments to its participants and subsequently adjusted 5,345 of those, reflecting a 0.54% post-payable date adjustment rate. For all other issue types combined, 5 DTC allocated 2,987,748 individual payments, with 5,825 adjustments, reflecting a 0.20% post-payable date adjustment rate. Thus, the CMO post-payable date adjustment rate is nearly three times greater than that for all other issue types combined. Since CMO/ABS now represent 25% of all payments made by DTC, up from 18% in 2002, the problem will only grow larger unless a solution is developed. CMO/ABS All Others Year Payments % All Adj. Adj. Rate Payments % All Adj. Adj. Rate , % 3, % 2,702, % 5, % , % 3, % 2,545, % 5, % , % 4, % 2,607, % 5, % , % 5, % 2,987, % 5, % As the table above shows, while there were some modest improvements in 2005 during a year of tremendous growth, there has been no net improvement in the past four years despite the best efforts of paying agents and DTC. The gap between CMO/ABS adjustments and all other instrument types remains constant. Thus, the three-year focus on CMO/ABS payment rate accuracy has simply allowed the industry to tread water while significantly increasing volumes have raised the water level. 5 All other issues include corporate bonds, municipal bonds, UITs/equity and Variable Rate Demand Obligations (VRDOs). 5

7 The CMO/ABS Asset Class Presents Industry Challenges CMO/ABS adjustments account for 47% of all post-payable adjustments 6,000 5,000 4,000 3,000 2,000 1,000 0 Post-Payable Adjustments by Products x x x x x CMO/ABS Corporate Bonds Municipal Bonds UITs/Equities VRDOs CMO/ABS & All Other Issue Types Adjustments ,000 5,000 4,000 3,000 2,000 1, CMO Adjustments All Other Issue Types Adjustments As the graphs above demonstrate, CMO/ABS generate by far the largest number of postpayable adjustments made on an annual basis compared to all security products and these adjustments tend to be made well after payable date. On average, 45% of post-payable rate changes are disclosed to DTC by the paying agents more than 30 days after the payable date. Thus, nearly half the adjustments are made after the next scheduled payment date with over half of those being made after three or more payment dates have passed. This forces custodian banks and broker/dealers to adjust investors accounts and, in many cases, take back funds from clients while crediting them with funds on the same security for a separate payment date. This practice causes obvious customer service challenges. Despite the extensive effort that has gone into correcting this accuracy problem during the past five years, little progress has been achieved. DTC believes that there may be a structural discontinuity in the servicing terms of CMO/ABS that causes this payment rate accuracy problem. TIMELINESS PROBLEM Timely receipt of rate information is also a significant problem. The structure of CMO/ABS issues, and the disparate number of players involved in setting and communicating payment rate information, result in an unacceptably large number of issues that do not have their rates communicated to DTC and on to investors by the close of business the day prior to payable date. The result is that DTC participants and their customers do not know how much will be paid the next day. This creates a mad scramble across the industry on payable date in order to: Capture the rate information, Load it into allocation systems, Report it to clients, Use it to maximize cash management, and ultimately, Get payments made to the end investor. On average in 2005, more than 14% of rates were unknown to DTC at the close of business the day prior to payable date. And while that figure shrank to 1.7% by 3 p.m. on payable date, this last-minute receipt and allocation of payments presented significant challenges to 6

8 DTC s participants and their customers, including end investors. Negative effects include financial losses due to payments not made to investors on payable date, as well as the lower reinvestment rates investors receive on a significant portion of the proceeds they received on payable date, but were not expecting. While collective efforts have reduced the number of payments with missing information from 25% several years ago to14.63% currently as of the opening of payable date and from 2% to 1.7% at 3 p.m. on payable date, our data show a significant growth in the annual number of payments processed from 608,428 to 983,424. Therefore, despite the industry s best efforts, the absolute number of issues unannounced on payable date has grown. As with the accuracy issue, DTC believes that the inability to eliminate these delays suggests that there may be a structural discontinuity in the servicing terms of CMO/ABS that causes this payment rate timeliness problem. One might believe that there is a trade-off between timeliness and accuracy in these instances, and that moving faster causes mistakes. The data, however, do not support this. In two years the industry has improved the day prior to payable date timeliness by 40% while accuracy in 2005 was virtually the same as in

9 Reasons for Post-Payable Revisions/Fragmented Process Agents revise payment rates for a variety of reasons ranging from inaccurate security set-up to calculation errors. The most common reason involves the servicer updating the underlying collateral data, which may be the actual collection data or involve delinquent payments after initial reporting to the agent. There are also classic processing errors in which a particular loan included as collateral for the CMO or ABS may be paid off but the proceeds are applied to the wrong account. There are many other errors associated with manual entry. Any of these can result in inaccurate or delayed reporting of principal and interest to holders. But the main drivers of late rate production/dissemination are the structural terms of CMO/ABS issues combined with a fragmented process involving many parties touching payment data and creating dependencies on each other s accuracy, timeliness and overall performance. The principal players in this aspect of the CMO/ABS market include Servicers 6, Master Servicers 7, Paying Agents, DTC and DTC Participants (broker/dealers and custodians). Servicers collect and pool principal, interest and escrow payments and then pass on the proceeds. Servicers also monitor and deal with delinquencies, handle foreclosures, liquidations, and perform loan payment, follow-up and analysis. In some cases, there are intermediaries referred to as Master Servicers who typically have overall responsibility for overseeing the reporting, loan accounting and default administration activities of a variety of Servicers for the loans aggregated in a particular CMO or ABS portfolio. Master Servicers, Trustees and the Paying Agents are responsible for liaising with Investment Banks, Underwriters, Issuers and others during the securitization process. Paying Agents act on behalf of Issuers, passing detailed payment information onto bondholders and distributing the interest and any principal on payment date. DTC is typically the registered holder and, as such, receives the detailed payment information, which it immediately makes available to its Participants who in turn make it available to investors or to other financial intermediaries who pass it on to investors. On payment date, DTC Participants credit their client accounts with the interest and principal DTC has released. (See Asset- Servicing Model on following page.) DTC continues to receive the payment information in a compressed time period with a significant amount of the information subsequently changing. These changes and the related payment adjustments they often require continue to be problematic due to the increasing volumes and value of payments requiring adjustment. Paying Agents share DTC's concern with increased volumes and cite frustration at not receiving timely payment information from the multiple servicers, and at the short window they have to process the information once it is received. There is varying quality among each of the identified players with some performing better than others on a regular basis. 6 A Servicer is responsible for taking in the mortgage payments and determines prepayments, payoffs, refinances, etc. 7 A Master Servicer is responsible for loan servicing and bond administration; the bond administrator calculates the numbers to determine the factor for payment. Not all CMOs roll up to a Master Servicer. 8

10 CMO/ABS Asset-Servicing Model Borrower 1 Borrower 2 Borrower 3 Borrower X Issuer Underwriter (Divide into various bond classes and sell them to investors.) Asset (Pools) Paying Agent (DDA) Loan Servicers: Calculation agent, accounting for borrowers payments (principal, interest and escrow), rate adjustments, delinquency and defaults Payoffs The Depository Trust Company Receives payment on behalf of holders Participants (Brokers and Custodians) Participants (Brokers and Custodians) Participants (Brokers and Custodians) Participants (Brokers and Custodians) Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders Beneficial Holders 9

11 Accomplishments to Date Much has been accomplished since the publication of the first white paper in 2003, and the joint efforts of DTC and paying agents have resulted in major improvements in process flows. Wherever feasible, DTC has incorporated automated data collection, data sourcing and balancing techniques to reduce processing errors. Working with The Bond Market Association and the agent community to automate the process, a standardized file layout was created and adopted by the major agents handling these issues. As a result, 91% of the rates are now received in that format. Additionally, DTC incorporated new logic techniques to check rates coming in on the file (whether new or updates of a previous factor) against prior factor information in DTC s records to ensure they are consistent. If the rates are not consistent, they are flagged and researched prior to release. Through root-cause analysis, process changes were implemented by DTC reducing internal errors and eliminating their reoccurrence. Similarly a BEO (Book-Entry Only) comparison was instituted, where DTC calculates the scheduled payment and then compares the result to the wire details received from the agent. Differences are flagged and researched prior to release. For statements received in certain PDF formats, DTC utilizes software to read the statement, extract information from the statement and export it to a spreadsheet. The spreadsheet is then uploaded for processing, eliminating the manual keying of hundreds of rates. All post-payable adjustments and rate changes are centralized at DTC. Old and new rates and positions are entered into a spreadsheet to calculate differences and expedite adjustments. A central mailbox was established for all adjustments from paying agents. Reports were also created to note potential problems to ensure early intervention and to flag all unidentified payments exceeding $5,000 on the business day following the payable date. DTC continues to work directly with the major paying agents, tracking performance and generating monthly report cards. Together, DTC and the agents perform rootcause analysis and hold monthly conference calls to address issues. In addition, DTC holds internal cross-functional team meetings to continually improve the process and implement best practices. While DTC and agents will continue to work together on improvements, the challenge now is beyond the control of these parties. The industry as a whole must deal with the CMO/ABS challenge and realize that the issue may be inherent in the structuring of these securities. 10

12 Action Steps for 2006 DTC will take certain steps on its own and in conjunction with agents to find solutions. Planned action steps for 2006 include: Expand distribution of agent performance Report Cards beyond the agent community. It is anticipated that agents will use the data on their report cards to create similar report cards for servicers that pass information to them. Both levels of scorecards may be helpful to agents and servicers in meeting the requirements in Regulation AB and for management assertion as to their compliance with servicing criteria set forth in the Regulation. Create a time limit for post-payable adjustments. After that limit, DTC would decline to make adjustments. Implement financial disincentives for failure to comply with established standards for timeliness and accuracy. The party who should incur these disincentives has not yet been determined. It should be noted, however, that investors are already bearing an economic cost through late payments, less than maximal cash management and higher P&I processing fees that DTC charges participants for CMO/ABS than for other types of instruments. While these steps would help improve performance incrementally, the industry must come together to make the breakthroughs necessary to enable continued growth of the CMO/ABS business without significantly decreased service levels to investors. Accordingly, DTC is partnering with The Bond Market Association and the American Securitization Forum to bring together representatives from all parts of the information production/dissemination chain to recommend structural improvements to CMO/ABS issues. Additional recommendations the group may consider include: Establishing new payable date standards such as moving the payment date on future CMOs and ABS forward two business days, yet keeping the same accrual period allowing servicers/agents additional time to establish accurate and timely rates. Establishing best practices for standard service level agreements between all parties in the chain that include clearly defined accountability and time parameters. Requiring that any adjustments proposed after the DTC time limit for post-payable adjustments be factored into the next payment. These are just some of the plans under consideration and are illustrative of the types of actions that need to be considered (including determining any adverse impacts) to solve the timeliness and accuracy problems. Many more will enter the industry discussion as it moves forward on CMO/ABS processing. 11

13 Please send questions and comments to: James Balbo Managing Director The Depository Trust & Clearing Corporation 212/ OR Peter Gleeson Vice President The Depository Trust & Clearing Corporation 212/

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