Each depositor insured to at least $250,000 per insured bank

Reps and Warranties
by Penelope Moreland-Gunn, Peter J. Elmer and Timothy J. Curry*

Representations and warranties (R&Ws) are legally binding statements primarily made by sellers assuring buyers that certain minimum asset quality requirements are met. These minimum quality guarantees are commonly given in all types of asset sales, ranging from consumer products to whole loans. The guarantees may extend for only a few months or for the life of the asset.

R&Ws on loan sales are especially interesting because banks and thrifts have increased sales dramatically in the 1990s and each sale tends to create new R&W liabilities that remain long after the sale is completed. Moreover, these liabilities are almost never tracked, recognized in accounting statements, or reserved for with specific reserves. As such, they are a largely unacknowledged source of risk that remains long after the related assets have disappeared from a seller's books.

R&W risk can be significant for institutions that actively purchase and sell loans, because R&W risk exposure increases each time a purchase or sale is made. The act of selling loans increases the seller's liability to honor R&W obligations it issues as part of the sale. Buyers also increase risk due to the possibility that sellers may not honor the R&Ws they issue. Understanding and controlling these risks are prerequisites for effective risk management of any institution that actively purchases or sells loans.

The early difficulties of the Resolution Trust Corporation (RTC) in trying to sell assets without R&Ws are discussed in the first section of this paper. This is followed by a discussion of the "lemons principle" that suggests that the offering of R&Ws is likely to be beneficial. R&Ws commonly made by market participants are then discussed in detail. This is followed by an analysis of the RTC's claims experience with R&Ws, and a comparison of the estimated costs and benefits of granting R&Ws. Conclusions and caveats are presented in the final section.
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A $200 Billion Example

R&Ws, which have been granted for as long as sale contracts have existed, are used in all types of sales ranging from toasters to corporations. Sellers are often willing to give R&Ws because the risk of loss appears small as long as they are confident that they are well-managed and their product is of high quality. Buyers demand R&Ws because the potential problems may be difficult or costly to research, especially if they are numerous and data are not readily available to assess their risk. Buyers may be suspicious of products with no R&Ws due to a fear that a seller's unwillingness to offer them signals a higher risk of problems.

Figure 1 documents the explosion in sales of single-family mortgages that occurred during the 1980s. Because R&Ws are given in virtually all sales, including those to the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA), it is safe to assume that R&W liabilities grew in lockstep with sales activity. The success of the single-family market in the 1980s spread to other loan markets in the 1990s, as trading increased dramatically for all types of loans ranging from commercial mortgages to nonperforming consumer loans. R&Ws have necessarily also increased, especially for products that encounter more varied risks than single-family mortgages, such as commercial loans.

The experience of the RTC with R&Ws exemplifies the problems encountered by many market participants. The RTC was formed in August of 1989 with no sales experience and no policy for giving R&Ws. Initially, the RTC made several efforts to limit R&W liabilities created from the sales of loans and servicing rights. One approach granted R&Ws only from the receiverships created from the dissolved savings-and-loan associations (S&Ls), thereby limiting R&W liabilities to the receiverships. Other approaches included the granting of only very limited R&Ws and replacing R&Ws with rights to put back assets to the RTC in the event of problems.

Under the initial R&W policy, the RTC experienced great difficulty in selling its assets. The process was slow, prices were low, and buyers often resisted doing business with the RTC based on the terms it tried to dictate to the market. Buyers were highly suspicious of the credit quality of receiverships. In some cases, buyers required a portion of the sale proceeds to be placed in escrow to ensure that R&Ws issued by insolvent S&Ls could be honored. The limiting of R&Ws caused buyers to demand extensive reviews of loan and servicing files ("due diligence"), which were costly, time-consuming, and cumbersome to administer.

The RTC experimented with the sale of whole institutions and giving buyers rights to put back assets to the RTC after the sale and after they had been given a chance to research the loans. However, bidder interest showed little improvement and assets were often returned to the RTC. Also, the buyers of S&Ls and banks began teaming with Wall Street experts to buy whole S&Ls, then "flipping" (immediately reselling) the loans to the Wall Street partners, who in turn either securitized or otherwise resold the loans with R&Ws for a profit.

The RTC researched the costs and benefits of adopting more common sales practices, that is, performing due diligence prior to a sale and giving R&Ws. In May 1990, the RTC's Board of Directors approved the first policy permitting the use of R&Ws in loan and servicing rights sales. This policy expanded the R&Ws given and allowed the RTC in its corporate capacity to give R&Ws instead of only giving them from receiverships. However, the policy established several key restrictions, such as limiting R&Ws to a maximum of five years and indemnifying investors only in the event of an actual loss. As will be discussed later, these restrictions are more than is customary in the market because many situations require long-term indemnification and/or the repurchase of assets. Therefore, investors remained concerned about the risk of buying assets from the RTC.

In August 1990, the RTC's Board of Directors responded to market pressures by expanding its R&Ws to those customary or normal in the marketplace. In particular, R&W coverage was extended to cover the life of the loan and the RTC was permitted to resolve problems by repurchasing assets and/or substituting replacement loans. These revisions conformed RTC policy with market practices, thereby clearing the path for high-volume loan sales that competed directly with other loan sales in the market. It also helped to open the door to the development of securitization, a process that aimed to sell loans for higher prices than those achieved by selling loans directly to buyers as whole loans. 1 Indeed, R&Ws have since facilitated the sale of over $200 billion of loans and loan servicing for a vast array of loan types, many of which had never been sold in volume.

Although the expansion of R&Ws cleared the path for high-volume loan sales, it also increased the RTC's exposure to the risk of losses on R&W claims. Therefore, a R&W claims administration department was created to oversee related issues and to establish reserves to cover R&W claims costs. As will be discussed later, the experience of the RTC provides a rare example of the likelihood and magnitude of R&W claims and costs.

The Lemons Principle

Analysts unfamiliar with the whole-loan market occasionally claim that market efficiency will cause the financial benefit of higher prices on the sales of loans with R&Ws to equal the cost of granting R&Ws. This theory suggests that buyer competition will cause the price of loans with R&Ws to exceed the price of loans without R&Ws by an amount equal to the sellers' expected cost of granting the R&Ws. However, a classic principle of economics, known as the "lemons principle," suggests an alternative view, that the value of granting R&Ws should be greater than their cost.

The lemons principle is a response by Akerloff (1970) to the observation that the value of a new automobile declines significantly as soon as it is driven off the showroom floor. Akerloff explained this as a result of the fact that information relating to the quality of the automobile is not the same for the buyer as it is for the seller. That is, information is asymmetric in the sense that the seller is more likely than the buyer to be aware of the auto's problems and limitations, that is, better able to identify the auto as a "lemon." In the absence of complete information, buyers assume the worst and price the auto as if it were a lemon, even though it may in fact be in perfect running condition.

Information on the quality of a loan is as difficult (costly) to assess as information on the quality of an automobile. While recent payment history and loan characteristics are typically available from the servicer on, for example, a magnetic tape, it is always possible that the tape information is incorrect. More importantly, the tape will normally not show information about a host of potential problems such as underwriting equirements, policies used to obtain appraisals, sources of credit histories, mistakes made in originating or servicing the loans, and legal problems that either have or have not been identified. Fraud in any of these areas is always a possibility as well.

Buyers are acutely aware of the risks arising from the lack of information in a pool of loans. They control the risks by either: 1) requesting that the seller give R&Ws, 2) requesting that the seller perform extensive due diligence and make it available to bidders prior to the sale, or 3) bearing the cost of performing their own due diligence.

The experience of the RTC was that many whole-loan buyers would not even consider buying loans that did not have R&Ws customarily given in the market. Some buyers would consider loans with limited R&Ws, but only after performing extensive due diligence. Many buyers did not wish to bear the cost of their own due diligence and they were fearful that it would not address all risks. The final result was that the offering of loans with either no or limited R&Ws reduced the number of potential buyers significantly and complicated the sale with due diligence-related issues. Buyers that took the added risk and participated in the sales consequently discounted prices heavily based on the presumption of problems.

Discussions with financial advisors suggested that limiting R&Ws can cause price reductions of two percent to three percent for relatively clean portfolios of single-family mortgages. Higher discounts are likely for loans that are not as widely traded as single-family mortgages and for loans with documentation, underwriting, or servicing problems. The lemons principle suggests that these price discounts should exceed the cost of granting R&Ws and the payment of related claims. Actual RTC R&W claim costs shown below are consistent with this view. However, a comparison of R&W costs and benefits is reserved for later in this study, following a more detailed discussion of the nature of common loan-related R&Ws.

Common Representations and Warranties

R&Ws fall into two categories: 1) institutional, which deal with the legal authority of a firm to sell loans, and 2) loan-related, which deal with risks arising directly from the loans being sold. Most R&Ws are loan-related because the most likely source of problems are loan characteristics such as documentation, underwriting standards, and delinquency status. R&Ws cover a wide range of issues, from innocuous guarantees given in almost every sale to specialized guarantees used only for unique circumstances.

Institutional R&Ws are small in number and can often be used for many types of loan sales. As shown in section A of Table 1, these R&Ws focus on the nature of the institutional seller and its right to sell the assets. While they are found in many types of sale agreements, claims on institutional R&Ws are rare because sellers normally have full authority to execute sales and their obligations are valid and binding. Nevertheless, buyers consider them indispensable because a violation can result in extensive losses and/or litigation. For example, a buyer can seek to return all assets, and sue for return of its funds, if a seller does not have legal authority to sell a package of loans.

Loan R&Ws are used in many types of loan sales, but many must either be tailored, or written precisely, to meet the needs of each type of loan. Section B of Table 1 lists a number of R&Ws common to sales of most types of mortgages. Items B-1 and B-2 are seemingly obvious guarantees that may be given by most sellers with little risk of subsequent claims. In fact, they are found in almost all contracts and result in claims only in unusual situations. For example, they became an issue in the RTC's sale of "participation" loans, that is, loans owned by two or more participants. Documentation on joint ownership for these loans was not always complete or available. Ownership guarantees greatly enhanced the ability to sell the loans because they relieved all parties of the need to find all documentation and resolve all ownership issues prior to sale.

Servicing-related issues, such as items B-3 and B-6 are most likely to result in claims. Because a host of loan characteristics change each month, incorrect information can be easily transmitted to a buyer. The loan balance or coupon could be incorrectly recorded on the seller's computer system or not received prior to transfer. The rate on an adjustable-rate loan may be tied to the wrong index or otherwise reset incorrectly. Mortgage insurance coverage may have lapsed due to failure to make timely payments. Real-estate taxes may not have been paid.

Table 1
Sample of Common Loan Reps and Warranties

A. Institutional

1. Seller has taken action to authorize the execution, delivery, and performance of the sale agreement.

2. All obligations of the seller are legal, valid, and binding.

3. Obligations will not conflict with any provisions of any law.

4. No action, suit or proceeding is pending against the seller that would materially affect the ability of the seller to carry out the transaction.

B. Found in Many Types of Mortgage Sales

1. Seller is sole owner and holder of the mortgage loan.

2. Seller has full right and authority to sell mortgage loan.

3. Mortgage loan schedule information is correct in all material respects.

4. The related note, mortgage and other agreements executed in connection therewith are genuine and each is a legal, valid and binding obligation of the maker enforceable except by limitations of bankruptcy, insolvency, reorganization or other similar laws.

5. Seller is transferring the loan free and clear of any and all liens, pledges, charges or security interests of any nature encumbering the loan.

6. All taxes, governmental assessments, insurance and utilities that came due prior to the closing date have been paid or an escrow account has been established.

7. The related mortgaged property is free of mechanics' and materialmen's liens.

8. There are no proceedings pending related to the property, and property is in good repair and free and clear of any damage.

C. Single-Family Mortgage Sales

1. Mortgage loan is secured by a mortgage on a 1-4 family residential real property or a condominium unit or a unit in a planned unit development or is a co-op loan.

2. Each mortgage loan was underwritten generally in accordance with FNMA or Federal Home Loan Mortgage Corporation (FHLMC) standards in effect at the time of origination except that 1) the original principal balance may exceed FNMA/FHLMC limits.

3. Each mortgage loan with a loan-to-value ratio (LTV) greater than 80 percent is covered by a primary mortgage, FHA, or VA insurance policy. Such policy is in full force and effect and insures the excess over a 75 percent LTV, and such policy shall remain in effect until the unpaid principal balance is reduced below 80 percent LTV.

4. Loan is serviced in accordance with the terms of the note.

D. Commercial Mortgage Sales

1. Borrower possesses all valid licenses, permits and other authorizations necessary to conduct business.

2. If required, seller has inspected or caused to be inspected property within the past 12 months.

3. Credit file includes environmental assessment that does not disclose any disqualifying conditions. If a disqualifying condition exists, remediated cost should be equal to or less than $10,000.

4. Seller represents that, as of the sale closing date, property does not contain hazardous materials such that the mortgage loan would be ineligible for purchase by FNMA (assuming that the loan were otherwise eligible for purchase). In the event of a breach of this representation, the seller will cure such breach or repurchase the affected mortgage loan.

E. Vehicle Loan Sales

1. Seller has not and does not make any representations, warrants or covenants regarding financial condition or status of obligor.

2. Seller has not transferred its interest in and to the vehicles to any other person. Seller has the right to sell its interest in and to the vehicles in accordance with the terms of the contract and free of liens.

3. Purchaser waives any claims or cause of action it might have against the seller for any loss, damage or expense caused by or to any vehicle.

4. Purchaser is a sophisticated buyer of contracts and loans similar to loans in package.

The wide variety of servicing problems implies that there is no single rule or procedure for dealing with them. Some can be easily identified and resolved soon after the sale is completed, either as a result of servicing the loans or a post-sale audit or reconciliation. Claims generated at this stage tend to relate to performing loans for which delinquency and default-related losses are not an issue. Claims generated at later stages are more likely to arise after a loan defaults and a careful check is made of the loan file. Incorrect real-estate tax payments and title problems are often caught at this point because back taxes must be paid and a title check made in order to complete the foreclosure process. Because delinquency and foreclosure may not occur until many years following a sale, R&W claims may not be made for a similar period. Thus, it is not surprising that buyers often require R&Ws for the life of the loan.

Section C of Table 1 contains a sample of R&Ws specific to single-family mortgage sales. This loan market is made unique by the widespread influence of the FHLMC and the FNMA. Firms that sell directly to the FHLMC and the FNMA must agree to voluminous R&W origination and servicing requirements stated in lengthy volumes published by the two agencies. Aside from these requirements providing the agencies with R&W protection, their wide publication and acceptance enable other mortgage market participants to adopt similar R&W requirements easily. As shown in item C-2, a simple R&W extends FHLMC and FNMA underwriting requirements to mortgage sales that do not involve either agency. Item C-3 is also a FHLMC and FNMA requirement even though it does not directly reference them by name.

Commercial-mortgage R&Ws differ significantly from those of single-family mortgages because the loan and underwriting characteristics are different and there is far less standardization of the origination and servicing functions. Also, the FHLMC and the FNMA are not permitted by their charters to purchase commercial mortgages, so standardized R&W guidelines and benchmarks are not as common as for single-family mortgages.

The unique aspects of commercial mortgages are evident in the four R&Ws listed in Section D of Table 1. Because commercial-mortgage borrowers are usually corporations, they may be required to have and maintain various licenses and authorizations required to conduct business. Servicers are often required to inspect periodically commercial properties and monitor the borrower's financial health by reviewing financial records. Environmental problems are a major issue, as suggested by items D-3 and D-4. Item D-4 is especially important because the cost of environmental clean-up can be very high and the requirement places this cost on the seller, even if the problem is unknown to anyone at the time of sale. In some cases the environmental clean-up costs exceed the value of the loan and may involve years of litigation to resolve.

The final sample of R&Ws applies to a group of loans unrelated to mortgages, namely, vehicle loans. Because these loans have relatively low balances and are collateralized by automobiles, lenders place much less reliance on the security gained from foreclosure and the subsequent sale of the underlying collateral. Extended or costly litigation between the borrower and the lender is unusual. These attributes combine to greatly simplify the types of R&Ws given. For example, one requirement might be that the seller guarantees its ownership or right to sell the loans (item E-2) in order to prevent fraud. Given the changed nature of product risk, sellers may be as likely as buyers to request R&Ws. Specifically, sellers may ask buyers to give R&Ws to the effect that they are sophisticated and capable of understanding the risks of the loans being sold (items E-3 and E-4).

Claims Trends

A consequence of the RTC's unprecedented sales volume is that it provides the large-scale R&W claims experience needed to gauge the likelihood of problems that normally have only a low likelihood of occurrence. The large program size also caused the creation of a claims administration department and a database of claims losses. These data provide one of the largest records of R&W claims costs and trends ever created.