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
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.
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
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
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
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
1. Seller has taken action to authorize the execution, delivery, and performance of the sale
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
2. If required, seller has inspected or caused to be inspected property within the past 12
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
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
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.
Many interesting characteristics of the data can be observed by examining the claims experience of
a sample of deals. Tables 2a and 2b provide such a sample for fixed-rate and adjustable-rate
mortgage sales that occurred relatively early in the RTC's history (1991). 2 The sales chosen were five securitizations, three containing
single-family mortgages (1991-11, -12, and -14) and two with multi-family mortgages (1991-M1
and -M5). Early securitizations provide convenient examples because their collateral
characteristics are well-documented and claims experience is seasoned. A review of other sales
around the same time found that the sample chosen was reasonably representative.
Table 2a Rep and Warranty Claims Statistics For a Sample of RTC Sales
Initial Sale Data Cured Claims Claims Approved Claims
Mortgage Sale UPB Number Average Average Average
Sale Date $Mil Loans Type Number $000s Number $000s Number
(Security) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
1991-11 10/91 $888 16,826 FX 28 $2 1 $ 32 29 $ 3
1991-12 10/91 527 2,330 ARM 9 2 0 0 9 2
1991-14 11/91 545 7,126 ARM 176 2 0 0 176 2
1991-M1 8/91 373 218 ARM 0 0 6 5,960 6 5,960
1991-M5 11/91 386 548 FX 0 0 1 1,536 1 1,536
Note: Data reflect all RTC R&W claims filed as of December 31, 1994, for all R&Ws contracted
by the RTC at the corporate level. The UPB in column 2 is unpaid principal balance of collateral
placed in trust as of the starting date of the security. The average claims figures in columns 6, 8,
and 10 are computed by dividing total claims costs by the number of claims shown in columns 5,
7, and 9, respectively (rounded to $000s).
The initial sale data in columns 1-4 of Table 2a provide a snapshot of the sample. The loans were
sold into security trusts between August and November 1991. These start dates imply three to
four years of R&W claims experience prior to the 1994 database cutoff used for this study.
The securities were mid-sized offerings in the $300-900 million range that contained considerable
Columns 5-10 of Table 2a break total approved claims into two components, cured and
repurchased. A limitation of the data is that the costs of cured claims are recorded as the actual
cost of curing the claims, whereas the cost of repurchases is recorded as the entire unpaid
principal balance (UPB) of the repurchased loan. 3 The cost
of curing a repurchase is not tracked because repurchased loans may be resold in a number of
ways that create problems for tracking losses. For example, a repurchased delinquent loan might
later have the delinquency cured and be included in a package of several thousand loans, none of
which are priced separately when the securitization is completed. The important point is that the
recorded cost of repurchases is many times larger than the cost of cures, and the two numbers
should not be compared directly as a measure of claims costs.
In spite of data limitations, several points can be noted from the approved claims data in Table 2a.
First, on the single-family mortgage side, the average claim for all three sales shown was only
$2,000. This is because R&W problems for single-family mortgages tend to relate to
relatively solvable and inexpensive problems such as tax penalties and incorrect payment
adjustments. Second, on the multi-family mortgage side, all claims are repurchases. 4 Multi-family claims are more likely to relate to environmental
or other problems that are not as easily solved as single-family problems. Repurchase may be
required because the problems are either too costly or troublesome to resolve. Multi-family
problems are aggravated further by large loan balances ($5,960,000 average balance for the six
claims in 1991-M1 and $1,536,000 for the one claim in 1991-M5).
Table 2b Rep and Warranty Claims Statistics For a Sample of RTC Sales (continued)
Total Claims Claim Filing Date Claim Processing Time
Approved Claims Denied/Other Claims
Mortgage Average Average
Sale Number $000 Number $000 0-1 Yr 1-2 Yr >2 Yrs 0-2 Mo 2-4 Mo >4 Mo
(Security) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
1991-11 29 $3 133 $15 1 26 135 65 29 68
1991-12 9 2 8 23 7 4 6 15 2 0
1991-14 176 2 165 25 44 57 240 44 108 189
1991-M1 6 $5,960 8 429 4 4 6 1 0 13
1991-M5 1 $1,536 6 3,090 2 1 4 6 1 0
Note: Data reflect all RTC R&W claims filed as of December 31, 1994, for all R&Ws contracted
by the RTC at the corporate level for the five securities listed.
Table 2b begins by comparing approved claims to those either denied or subject to some other
resolution status. 5 Relatively large percentages of the
claims were denied or otherwise not approved. For example, in three sales (1991-12, 1991-14,
and 1991-M1) approximately 50 percent of all claims were denied, while the remaining two sales
had approximately 80 percent of all claims denied. Moreover, the average approved claim tended
to cost considerably less than the average denied claim. Combining these statistics suggests that
substantial savings accrue to reviewing claims carefully.
The remainder of Table 2b deals with the time required to file and process claims. The most
interesting points are that large numbers of claims may be made several years after the loans are
sold and a review of these claims may take considerable time and/or resources. In all
of the cases shown the largest number of claims occurred in the longest filing date category (over
two years) while the shortest category (up to one year) contained either the lowest or almost the
lowest number of claims. This trend primarily results from the fact that RTC securities provide an
indemnity against loss, which implies that claims are more likely to occur several years after the
securities are created and after the loans have had time to default. In contrast, the RTC's
non-securities sales generally did not indemnify against losses and their claims tended to occur in
the first year following sale. This trend can be seen in Figure 2, which shows that R&W claims
for sales consummated in 1991 peaked in 1992 and declined thereafter for every class of RTC
sales except securities. Therefore, the likelihood of 1991 sales claims occurring in 1995 or later is
low for all of the classes of RTC assets shown in Figure 2, with the exception of securities.
Compounding the filing time problems is the fact that substantial numbers of claims required a
long period (over four months) to process, that is, to approve, deny, or otherwise conclude. The
long processing times reinforce the notion that significant resources and costs may be required to
administer claims even apart from the direct cost of curing claims and repurchasing loans.
Table 3 RTC Claims Losses by Product Type
Claims Claims UPB Losses Losses Estimated
UPB Losses Losses Repurchased Repurchases Reperchases Total
Product $Bil $Mil as % UPB $ Mil $ Mil as % UPB $ Mil as % UPB
(1) (2) (3) (4) (5) (6) (7) (8)
Servicing Rights $ 139 B $ 69 M 0.05% $ 44 M $ 0-7 M 0-0.01% $69-76 M 0.05-0.06%
Securitizations 23 27 0.12 83 0-13 0-0.06 27-40 0.12-0.18
Securitizations 20 40 0.20 134 0-33 0-0.17 40-73 0.20-0.37
Whole Loans 25 12 0.05 178 0-27 0-0.11 12-39 0.05-0.16
Other 19 17 0.09 64 0-10 0-0.05 17-27 0.09-0.14
Total $ / Average % $226 B $165 M 0.07% $503 M $ 0-90 M 0-0.04% $165-255 M 0.07-0.11%
Note: Data reflect all RTC R&W claims paid as of December 31, 1994, for all R&Ws contracted
by the RTC at the corporate level. Estimated losses in columns 5 and 6 are calculated as the
likely range of losses on loans repurchased by the RTC to cure R&W deficiencies. These ranges
assume a minimum loss of zero for all categories of loans. The maximum loss is 15 percent of
UPB repurchased for all categories of loans except multi/commercial/other securitizations, and 25
percent of UPB repurchased for multi/commercial/other securitizations.
Costs vs. Benefits
An advantage of the RTC's experience is that its claims and sales data may be combined to
compare the financial costs and benefits of granting R&Ws. That is, the data may be used to
perform a cost/benefit analysis of the economic efficiency of granting R&Ws.
The cumulative claims loss experience for the RTC's R&Ws is shown in Table 3. These data
include claims paid for all R&W agreements made by the RTC in its corporate capacity as of
December 31, 1994. As such, they include the seasoned claims experience arising from
sales completed in 1990 and 1991, as well as only recent claims experience from sales completed
Column 1 of Table 3 displays the RTC's R&Ws by type of sale. Of the total $226 billion UPB
covered by R&Ws, the largest component, $139 billion, or approximately 62 percent of the total,
was given on sales of servicing rights. 6 The remaining 38
percent were from four similar-sized categories of loan sales: single-family securitizations,
multi-family/commercial securitizations, whole loans, and "other" loan sales.
Claims losses for each sale type are shown in columns 2-8 of Table 3. The UPB of all loans
covered by RTC corporate R&Ws is shown in column 1 in order to provide a benchmark for
gauging the magnitude of the losses. The UPB is a useful benchmark because it reflects
the maximum potential R&W loss in most circumstances. Losses are normally below the UPB
because lenders may opt not to foreclose on properties with projected losses greater than the
UPB. While it is possible for legal or environmental problems to cause losses to exceed
the UPB, these situations are rare.
The most easily tracked costs are for cures, which equaled $165 million, or 0.07 percent (seven
basis points) of the $226 billion UPB benchmark. The claims loss rate in column 3 was highest
securitizations (20 basis points) due to a higher likelihood of
complicating factors such as environmental problems. The remaining claims loss rates ranged
from five basis points for whole loans and servicing rights to 12 basis points for single-family
securitizations. Whole-loan loss rates were the lowest because most RTC whole-loan sales were
limited to either unusually clean packages of loans or loans with extensive due diligence.
As noted earlier, the cost of R&W claims resulting in repurchases was not tracked by the RTC.
The fact that many repurchases cause either no or only small losses complicates matters. For
example, a repurchase of high-quality adjustable-rate mortgages may be required because
they were sold into a security containing only fixed-rate mortgages.
The problems of calculating losses on repurchases are dealt with by estimating potential losses as
ranges (see columns 5 and 6) based on the UPB of loans repurchased, as shown in column 4. The
range for each product has a lower limit of zero and an upper limit of 15 percent of the UPB of
loans repurchased for all types of loans except multi-family and commercial loans. A 25 percent
upper bound is used for multi-family and commercial loans due to their higher risk. The 15
percent and 25 percent upper bounds are chosen based on the authors' best estimates of
higher-than-expected or "conservative" estimates of the average loss on repurchases. 7 Given the range estimates in column 5, column 6 estimates
that repurchases add an upper limit of between one basis point and 17 basis points to the
estimated R&W losses of the various product classes. The average upper limit loss across all
products is four basis points.
The costs of granting R&Ws can now be directly compared to the benefits for a key asset class,
single-family mortgages. As noted, financial advisers and early RTC experience estimated the
benefit of granting R&Ws on single-family mortgages in the range of two percent to three
percent (200 to 300 basis points) of the UPB sold. That is, single-family mortgages sold with
R&Ws can be expected to sell for 200 to 300 basis points more than if they are sold without
A 200-to-300 basis point financial benefit for single-family mortgages compares very favorably
with total R&W costs in columns 7 and 8 of Table 3. The cost category most directly applicable
to single-family sales is single-family securitizations. Column 8 shows the cost of single-family
securitizations as 12 to 18 basis points. However, because Figure 2 suggests that securitization
claims may continue in the future, an adjustment needs to be made to recognize the possibility of
future claims. If we project future single-family securitization R&W claims costs to equal all
costs incurred through December 31, 1994, then the projected R&W cost implied by past
securitization claims equals 24 to 36 basis points. 8 Thus,
the cost of single-family mortgage R&Ws is only a small fraction of the 200-to-300 basis point
benefit that accrues from granting them in single-family mortgage sales.
The dramatic excess of financial benefits over costs suggests that sellers of single-family
mortgages are well-advised to grant R&Ws in spite of the expectation of some claims-related
costs. Indeed, the excess may help to explain the RTC's experience that it is customary for sellers
to grant R&Ws, and why sellers who do not grant R&Ws are viewed with suspicion by buyers
who willingly pay a price premium to avoid the risk of purchasing a "lemon."
But does the cost/benefit analysis of the the RTC's single-family mortgage experience extend to
sales of other types of financial assets, such as commercial mortgages or "other" loans? Three
points suggest that the RTC's experience applies to many other types of assets. First, the R&W
cost statistics in Table 3 are of the same order of magnitude for all types of assets. While the costs
vary by product, all column 8 estimates are far below the 200-to-300 basis point range found for
single-family mortgages. 9 Second, all types of loans are
characterized by information problems similar to those of single-family mortgages. Moreover, the
RTC's initial policy of limiting R&Ws resulted in the same liquidity and bidder interest problems
regardless of the types of loan-related assets sold. Finally, it is a widespread market practice for
sellers to give, and for buyers to request, R&Ws for all types of financial assets.
The weight of evidence points to the conclusion that it is cost-effective to grant R&Ws in many
types of loan sales. Given the lemons principle, we expect that the excess of benefits over costs
increases as the quality or availability of risk-related information declines.
A number of interesting lessons may be drawn from the RTC's extensive R&W experience. First,
R&Ws may represent significant risk because considerable expense may be required to cover
claims costs and claims may continue for several years after the loans are sold. The risk may be a
problem especially for firms that actively sell loans to the secondary markets because R&W
liabilities grow with each sale. Second, administrative costs exacerbate the risk because claims
may require additional expenses in the form of file reviews, the repurchase of assets, legal advice,
and other problems. Finally, in spite of the likely costs and administrative problems, the
experience of the RTC suggests that it is financially efficient for firms to grant R&Ws. R&W
claims costs for single-family mortgages sold by the RTC were dramatically less than the financial
benefits estimated to accrue from higher market prices on loans sold with R&Ws. The evidence
points to a similar conclusion for many other types of assets as well.
Two caveats should be kept in mind regarding the RTC's experience relative to that of other
institutions. First, the bulk of the RTC's claims experience occurred in a relatively favorable
economic environment between 1992 and 1994. If this had been an extended period of
unfavorable economic conditions, then claims-related losses could have been higher, especially for
the default-sensitive portion of claims found in RTC securitizations. Similarly, an economic
downturn could cause future claims experience, for the default-sensitive portion of the claims, to
compare unfavorably from that documented in this paper. Second, the RTC's experience is made
distinct by the fact that the S&Ls it took over, and whose assets it sold, were highly distressed.
Therefore, the RTC may have been more likely to encounter R&W claims problems than, for
example, healthy firms, and this may have affected both the benefits and the costs of granting
R&Ws. While the net effect of these factors is difficult to quantify, the RTC's R&W claims
experience nevertheless seems to provide a useful guide to projecting potential claims costs and
trends, especially for firms that actively sell loans to the secondary markets.
Akerloff, George. "The Market for Lemons: Quality Uncertainty and the Market Mechanism."
Quarterly Journal of Economics
(August 1970): 488-500.
Resolution Trust Corporation. Sketchbook of RTC Securities. Washington, DC:
Resolution Trust Corporation, December 1994.