Recourse, holdbacks and credit enhancements from originators

Portfolio purchases rarely transfer all the risk cleanly. Originators commonly give the refinance company recourse for defaulted loans, an obligation to repurchase loans that breach eligibility warranties, a holdback (part of the price withheld and paid later net of losses), first-loss protection, or mortgage insurance attached to the loans. Each feature changes what the buyer has actually acquired. At one extreme, full recourse for credit losses means the originator has kept substantially all the risks and rewards: the originator cannot derecognise the loans, and the buyer does not hold mortgages at all, it holds a receivable from the originator. At the other, a limited holdback is a separate liability of the buyer that absorbs losses. Whether an enhancement is integral to the loans' contractual terms decides whether it reduces ECL or is recognised separately.

Does the originator bear credit losses on the portfolio beyond a small first-loss amount, through recourse, guarantees, swaps or a deferred price, so that it retains substantially all risks and rewards? If so, has the buyer recognised a financing receivable from the originator rather than the mortgage loans? Is part of the purchase price held back, and what are the terms for its release and reduction? Are eligibility warranties and repurchase obligations limited to defects existing at sale (documentation, eligibility) or do they cover later credit performance? Is the credit enhancement (mortgage insurance, borrower-level guarantee, originator first-loss) part of the contractual terms of the loans or a separate contract, and was it transferred with the loans? Is the enhancement provider's own credit risk considered?

1. Analyse the transfer from the originator's side first: if the originator retains substantially all the risks and rewards (for example full recourse for credit losses, or a total return arrangement), the transfer fails derecognition.
2. In that case the buyer does not recognise the mortgage loans; it recognises a receivable from the originator for the cash paid, measured at amortised cost, with the originator's credit risk (and the mortgages as collateral) driving ECL.
3. If the originator has transferred substantially all risks and rewards, the buyer recognises the loans (BANK-089).
4. Holdback: recognise the full loan portfolio and a financial liability to the originator for the amount withheld; when losses reduce the holdback under its terms, reduce the liability, with the credit to profit or loss, while ECL and write-offs on the loans are recognised gross.
5. Repurchase obligations for breach of eligibility warranties: these give the buyer a right to put defective loans back at par; recognise any claim when a breach is identified and recovery is supported, and consider it in measuring expected losses on the affected loans only if the right is integral to them.
6. Credit enhancements: include cash flows from collateral and other credit enhancements that are part of the contractual terms of the loans and not recognised separately (for example a mortgage insurance policy that transfers with the loan) in measuring ECL; enhancements that are separate contracts, not integral to the loans, do not reduce ECL and are recognised separately when the buyer has a right to reimbursement.
7. Reflect the enhancement provider's ability to pay in any amount included.

Failed transfer: receivable from originator at the cash paid plus transaction costs, at amortised cost, with ECL driven by the originator's probability of default and the mortgages as collateral. Holdback liability: initially at the amount withheld (discounted if the deferral is long and the effect material); subsequently reduced by losses absorbed and by payments to the originator, with expected changes in the amount payable reflected as revisions to its estimated cash flows. Integral credit enhancements: included in the ECL cash flow estimate, net of the provider's own expected default. Non-integral enhancements: no reduction in ECL; any reimbursement right is recognised as a separate asset under the policy the company has chosen and disclosed.

Disclose: (1) the nature of credit enhancements, recourse, holdbacks and repurchase rights obtained from originators; (2) the effect of collateral and other credit enhancements on the amounts arising from ECL, and the maximum exposure to credit risk without taking them into account; (3) the carrying amount of holdback liabilities and receivables from originators; (4) significant judgments on whether purchased portfolios are recognised as loans or as financing receivables from originators, and on whether enhancements are integral; (5) concentration of credit risk on individual originators and enhancement providers.

• Recognising mortgage loans bought with full recourse to the originator, when the originator has kept substantially all the risks and rewards
• netting the holdback against the loan balance
• reducing ECL for an originator guarantee given under a separate agreement that is not integral to the loans
• ignoring the originator's own credit risk when relying on its recourse
• treating eligibility repurchase rights as protection against later credit losses
• recognising the release of a holdback to the originator as an expense instead of settlement of a liability