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» VISIT US ONLINE @ DSNEWS.COM 17 We'll also look at the collateral—we look at the values, we'll also examine where the col- lateral's located and the condition. A signifi- cant factor is the leverage of the borrower, so we look at their LTV. Many macroeconomic factors go into our analysis, like interest rates and house prices. If it's a new asset, we'll look at historical performance data and see how the asset or the borrower performed in good times and in bad times. And if there's no data, we'll look at similar types of assets and try to triangulate how we think the asset is going to perform. en, we also look at the originator for these types of pools of loans and their under- writing process. How did the financial crisis impact this process? We built the entire rating process from the ground up after the crisis trying to address things that we learned. For example, today's models contain a lot more data. We have data going through the recession, but our analysts also scrutinize those model results because we learned through the crisis that you can't just rely on a model. ere's a whole bunch of things outside the model that you need to look for, like different risks and other factors that weren't really in the scope when Morningstar developed the model. Compliance with regulations and policies, many of which developed post-crisis, is also part of our focus. We have a new set of inter- nal controls that we've built into our process, and it helps us comply with all the rules. What safeguards are in place that allow you to mitigate for economic downturns? e internal controls I just mentioned are designed to protect us and to make sure we're doing the right thing. We've also built the rating framework to address different economic scenarios. For example, when we rate a bond single B, we expect it to survive a benign economic environment. And then we defined our single A to survive the worst economic experience that we have in the data, which is usually the recent recession. We're trying to build our criteria so it's transparent in the bonds we rate and what kind of economic scenario they can survive. How did Morningstar get involved with looking at single-family rental securities? e single-family rental (SFR) market came from the vast foreclosure inventory after the recession. Around 2010, some investors started buying up as much distressed inventory as they could get, usually through auctions. By 2012, they were talking about obtaining financing through the capital markets, and they looked to us because securitization was one of the options. e Morningstar RMBS team was really in its infancy, but I hired a deep bench of seasoned analysts who were curious and eager to analyze a new asset type. We also had the advantage of being a historically commercial mortgage-backed securities (CMBS) rating agency, and so we had CMBS analysts sitting right next to us. We started analyzing these deals, and we saw that most of the risks were either similar to RMBS or residential or multi-family CMBS. We began publishing thought leadership commentaries and became sort of the go-to rating agency for the market. How does Morningstar approach rating SFR securities? e methodology breaks down two key factors, which are property value and net cash flow. We haircut property values based on the type of property, location, and different rating stresses, as well as various economic simulations and then we also underwrite our net cash flow based on a forecast of the manager's performance on things like vacancies, expenses, and cap ex. We base our value projection on the RMBS framework and our net cash flow underwriting on the CMBS multi-family underwriting. Has Fannie Mae's and Freddie Mac's recent launches into the SFR space impacted your rating process? One thing that Fannie Mae specifically added to their deal was this concept of substitution, the property manager could substitute properties into the pool, and the Fannie deal allowed for that flexibility. So that's starting to creep into deals that we rate. ere's only been one Fannie deal to-date, and if this model were to take off, it would affect our volume, as they are probably not going to need ratings. If the Freddie type of model takes off, then where they're financing the multi-borrower multi- loan type of deals, they could utilize ratings to transfer some of the risks like they would with the STACR CRT deals or the K series multi- family deals. What has Morningstar's activity been in the re-performing loan and non- performing loan space? We've been pretty active in that space. After the financial crisis, many borrowers who were struggling had their loans modified, and then these loans either re-defaulted or became current. Now, we are starting to securitize those re-performing loans, which is how this new market arose. Eventually, the market will shrink as the number of non-performing borrowers left over from the crisis declines and house prices increase, which reduces the number of borrowers that are underwater. e current pools are pretty varied across shelves or issuers. Some pools are made up of borrowers that are mostly underwater, and other pools have different loan types like sec- ond liens or manufactured housing. We do a loan level analysis on all our RMBS securities, and our loan level access becomes important in RPL deals because we can really differentiate risks associated with individual loans, which lets us distinguish individual issuers and deals. "Our whole idea and why we're here is to be very flexible and very responsive. Usually, we get to see different asset types first, and we're always intellectually curious. The goal here is really to solve problems and identify risks, and that's what we love to do."

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