ABS Commentary: Evaluating the Role of Representations and Warranties in Marketplace-Lending Securitization

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1 ABS Commentary: Evaluating the Role of Representations and Warranties in Marketplace-Lending Securitization September 2015 Author: Diana Lande Vice President, Asset-Backed Securities Morningstar Perspective The perceived deficiency in representations and warranties offering transparency around credit quality, origination, and servicing is an often-mentioned barrier to mainstream rated marketplace-lending securitization. While some marketplace lenders may lack incentives to provide standard ABS representations and warranties for sponsor securitizations, and newer players in the market may not be prepared or adequately capitalized to provide the necessary representations and warranties outlined in this article, Morningstar Credit Ratings, LLC (Morningstar) does not consider the relative strength of representations and warranties alone to be a major barrier to ratability. Positive results from originator and servicer operational assessments and third-party due-diligence reviews coupled with appropriately robust credit enhancement can help mitigate concerns over the strength of ABS representations and warranties in marketplace-lending securitizations. Approximately 250 marketplace lenders 1 are in operation, according to Asset-Backed Alert, but securitization of loans originated through these platforms has been limited to the largest originators 2 (including CAN Capital, Inc., SoFi Lending Corp., On Deck Capital, Inc., Prosper Marketplace, Inc., and Lending Club Corp.), and only a handful have been publicly rated. Rated securitizations can provide access to a large investor base with a conservative risk profile and offer economical long-term industry funding, but most marketplace-lending securitizations have so far been unrated private placements. While marketplace-lending originators planning to securitize loans by issuing rated notes must provide basic representations and warranties related to loan eligibility, enforceability, accuracy of information, compliance with internal procedures and law, and legal integrity of the ABS structure that 1 Initially investors in online peer-to-peer lending platforms were mostly individual investors. Nowadays, institutional investors, including hedge funds and pension funds, purchase many loans originated online. As a result, the industry prefers the term marketplace lending over peer-to-peer lending to better reflect the industry players, and this evolving term is sometimes used broadly to also include nonbank automated online lenders that fund loans directly. 2 Many marketplace lenders do not directly originate loans, but instead partner with federally insured banks for origination and service the loans for a fee. For purposes of this article, we include these platforms in our references to originator. Sponsors that purchase marketplace loan pools and hold the assets before securitizing may also need to make some representations and warranties required of originators. and is registered with the U.S. Securities and Exchange Commission as a nationally recognized statistical rating organization (NRSRO). Morningstar

2 are, with some exceptions, standard across the universe of ABS deals, these representations and warranties constitute just one of many risk factors in evaluating marketplace-lending ABS. Significance of Representations and Warranties Representations and warranties in debt documentation are statements by a borrower, sponsor, issuer, or originator that as of a particular date, certain information is true. In credit analysis, representations and warranties are important because they support the integrity and transparency of information that an originator provides about a deal s collateral and borrowers who owe payments on that collateral. They also form the basis for key assumptions related to enforceability of legal rights in collateral as well as legal structural features and asset transfers that are fundamental to structured finance. While other analytical tools, such as operational reviews of the servicer and originator, are valuable in ensuring the integrity of the data used to assess the credit quality of an ABS deal, a set of basic representations and warranties common in ABS deal documents is a necessary complement. In addition to providing information and transparency, representations and warranties are important because debt documentation can protect investors if a representation or warranty is incorrect as of the date made. In the context of a marketplace-lending securitization, remedies for a breach could include an obligation of the originator to repurchase, at the original sale price adjusted for any payments received by the issuer. The originator may also be required to indemnify the securitization issuer from losses incurred resulting from the inaccuracy of a representation. Morningstar evaluates representations and warranties in assigning ratings, but gives minimal credit to the repurchase obligation of a non-investment-grade originator in investment-grade rating scenarios, and does not rely solely upon representations and warranties to support the integrity of a rating higher than that of an originator. These financial obligations linked to breached representations and warranties remain indispensable, however, in aligning the interests of the loan seller with those of the ABS deal s noteholders and deterring that seller s fraud or negligence. Characteristics of Eligible Loans The most important representations and warranties covering the characteristics of loans eligible to be included in the securitized pool are those that would be difficult to verify independently. For example, the originator and any intermediate purchaser or sponsor selling loans to the securitization must represent that in choosing which loans to sell, no selection procedures were used to negatively affect the buyer of the loans or to select loans less valuable or desirable than other loans available for sale. A representation that the full contracted amount of the loan has been paid to the borrower is similarly important. 2

3 Additional eligibility information would be relevant in modeling cash flows because, in addition to reviewing the results of thirdparty due diligence, we assume that pooled loan characteristics conform to representations and warranties. For example, representations regarding payment history on the loans, who can be a borrower with respect to any loans (whether individuals or some types of businesses), how interest payments on the loans are calculated, the operation of prepayment provisions, and whether the loans are term or revolving loans are relevant to cash flow model inputs. Representations that the borrower s billing address and accounts used to make loan payments via Automated Clearing House transfers are located in the United States and that loans are denominated only in U.S. dollars eliminate foreign exchange and sovereign risks. The absence of these types of representations can be mitigated with information provided in a third-party due-diligence report and our independent review of standard form loan documents, underwriting criteria, and servicing guidelines. Deals with a revolving structure or prefunding mechanism should feature additional representations and warranties regarding eligibility, which would be used to analyze any subsequent asset additions to the pool. They should include information like the permissible ranges of interest rates on the loans, remaining and original payment periods until loan maturity, and original and outstanding principal balances. The originator should also provide bounds on the minimum FICO score and internal rating, which many marketplace lenders calculate at origination using a formula or algorithm to score borrower applicants on default risk and determine the loan s interest rate. Morningstar may address some gaps in representations and warranties related to postclosing asset additions with stress runs based off the marketplace originator s underwriting criteria for all loans it originates. Enforceability of Loans and Accuracy of Information Some of the fundamental representations and warranties that marketplace loan originators must provide are statements that the financial contracts evidencing the loans are in full effect, the loans have the terms reflected in loan documentation, and that those documented terms are legally enforceable. Deal documents should clearly state that each borrower is legally obligated to make loan payments and that information describing the loans is accurate. These are basic representations and warranties that confirm legal rights to payment on collateral and accuracy of information incorporated in our analysis. Enforceability representations include statements that the loan seller has done nothing to invalidate the loan, and that nothing has been signed releasing, subordinating, or canceling any loan. Other essential elements of enforceability include that no terms or conditions of the loan have been waived or changed except as disclosed or allowed in the loan documents, and the borrower has not asserted, and does not have, any defenses, counterclaims, or setoff rights. The marketplace lender also must represent that there is no litigation related to any of the loans being securitized. Because the marketplace lender, as originator and loan servicer, is 3

4 responsible for loan documentation and monitoring, only it has sufficient knowledge to provide information covered by these necessary representations. It must therefore be financially incentivized to be diligent and truthful about these facts. The recent holding in Madden v. Midland Funding, LLC highlights the importance of enforceability representations. In this case, the Second Circuit decided that the purchaser or assignee of a loan cannot rely on federal preemption of state usury laws to charge interest rates that the originating bank could legally charge in its home state. While the states subject to this holding are limited to New York, Connecticut and Vermont, a subsequent Supreme Court decision or similar successful lawsuits in other circuits could eventually require nonbank marketplace lenders to comply with all state usury laws or risk usury defenses to loan payment, undermining enforceability of legal rights to payment on marketplace loans. When a loan is made to a borrower at an interest rate higher than the maximum legal rate, or usury limit, allowed by the state in which the borrower resides, a nonbank marketplace lender that partnered with a bank to originate the loan and then acquired it from the bank may be unable to enforce payment of the full stated interest rate, or any payment at all if the loan is voided under that state s usury regime. The Second Circuit denied a petition to rehear the case on Aug. 12, 2015, and previously remanded the case to the district court to decide whether Delaware or New York law should apply. In light of this development and related legal uncertainties, it is important that deals include comprehensive enforceability representations tied to repurchase or indemnification to align the loan originator s interests with those of ABS noteholders by incentivizing the originator to address and minimize the risk of defenses to loan repayment. Representations should also confirm the accuracy of information upon which Morningstar relies in assigning ratings. These cover information the marketplace lender provides about any loan or borrower, and may to some extent be confirmed through third-party due diligence. If a marketplace lender uses an internal rating, it usually provides a key representation unique to that marketplace lender that confirms accuracy in calculating its internal rating for each loan. Even with this representation, Morningstar gives varying and possibly limited weight to a marketplace lender s internal ratings, depending on the depth and length of historical performance data. We seek to supplement analysis with traditional FICO-based assumptions used for other consumer lending ABS to derive cumulative net loss assumptions. Accuracy representations supported by repurchase or indemnification obligations are still important in showing the originator stands behind information it provides and will absorb losses resulting from related errors. 4

5 Related to accuracy of information, and given that the application process for marketplace loans occurs entirely online, the originator must also represent that it took steps to ensure each loan was not obtained fraudulently or using a stolen identity. A representation regarding absence of fraud in loan origination is standard in consumer ABS, but one tailored to the originator s responsibility to take preventative steps according to established internal procedure is especially important for marketplace lending because the possibility of fraud is greater. A servicer report showing loan seasoning and payment history can also help keep fraudulently obtained loans out of the pool; those borrowing via stolen identity are unlikely to make consistent, timely payments. Compliance with Applicable Law and Internal Procedures One of the major challenges confronting the marketplace-lending industry is a shifting and uncertain regulatory landscape. In addition to the potential impact of the Madden case, the Treasury Department recently requested comment on possible measures to regulate the industry, including requiring risk retention for marketplace lenders. Deal documentation, as for all ABS deals, must confirm the originator s and servicer s diligence in keeping up with existing and emerging laws and regulations to provide assurance that all loans are originated and serviced, and all collection actions are taken, in accordance with the law. The originator s written policies and procedures as well as historical practice should be covered in this set of representations, which also support representations related to loan enforceability. Some of the existing statutes with which a marketplace originator would be expected to verify compliance in loan origination and administration include the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Federal Trade Commission Act, the FTC Privacy Act, the Fair Credit Reporting Act, the Electronic Signatures in Global and National Commerce Act, and the Electronic Fund Transfer Act. An originator would also need to provide representations regarding adherence to its detailed internal written guidelines and procedures, including form loan documentation, underwriting criteria, servicing guidelines and collection policies. In an operational review of the servicer and originator, Morningstar would independently assess the actual implementation of underwriting guidelines, servicing automation, ease of transferability to a backup servicer, information transparency, effectiveness of guidelines for servicing delinquent and defaulted loans, and thoroughness and sophistication of reporting to better understand underwriting standards and factors affecting underwriting and servicing behavior. Additionally, third-party diligence can confirm that loans being securitized meet underwriting standards. Similar to enforceability representations, those related to compliance with law and internal procedures are necessary to align the interests of the loan originator with the securitization noteholders. It would be difficult, if not impossible, for Morningstar to independently verify a marketplace lender s compliance with the universe of regulation or adherence to all of its guidelines on a 5

6 day-to-day basis, and so Morningstar relies on the incentives this representation creates when supported by a duty to repurchase or indemnify. Collateral Rights and Structural Integrity: Security Interest and True Sale Representations and warranties establish the necessary legal components for a true sale of assets to the securitization and the security interest in the ABS issuer s assets, which are essential because they protect the rights of holders of ABS notes to payments made on the collateral. Some of the representations an originator must provide in selling the loans confirm that it has full ownership rights to the loans at the time of sale. The loan seller should also represent it has not previously transferred ownership in any of the assets or granted any security interest in them, and that it is unaware of any competing liens on, or claims to, any of the loans. In addition, Morningstar reviews legal opinions that provide a legal analysis of the effectiveness of these representations and warranties in upholding the integrity of these fundamental ABS structural features. Implications Representations and warranties in ABS deal documentation offer valuable information for credit analysis, but are always considered in conjunction with other integral analytical tools. In addition to evaluating the sufficiency of representations and warranties, Morningstar considers other factors in rating a marketplace securitization such as cash flow modeling and stress runs, servicing quality, origination standards, risk of servicing disruption, results of any third-party diligence reports and other rating considerations as described in our ABS methodology, found at Diana Lande, J.D., is involved in the rating process and the development of criteria for ABS ratings. DISCLAIMER The content and analysis contained herein are solely statements of opinion and not statements of fact, legal advice or recommendations to purchase, hold, or sell any securities or make any other investment decisions. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MORNINGSTAR IN ANY FORM OR MANNER WHATSOEVER. To reprint, translate, or use the data or information other than as provided herein, contact Michelle Weiss ( ) or by to: Michelle.Weiss@morningstar.com. 6