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Mortgage asset quality holds up better than auto loans and credit cards

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Historic house price increases are shoring up residential mortgage-backed securities (RMBS), but auto and credit card loans face the prospect of deterioration, say analysts.

Currently, there are record amounts of home equity, and homeowners are locked into very low mortgage rates. So residential mortgage asset quality performance is going to perform very well, according to Warren Kornfeld, senior vice president at Moody's Investors Service. "We expect residential mortgages to perform the best of all major asset classes, whether consumer or business credit, in the next 12 to 24 months," he said.

A January 2024 Moody's report on the largest U.S. retail banks' quarterly consumer loan performance said that residential mortgage delinquencies and charge-offs are low and likely to remain so. Aggregate mortgage balances at the large banks were flat in Q4 2023 on a year-over-year basis, the report said.

Looking more closely into RMBS, not all vintages in the aggregate $13 trillion U.S. residential mortgage market are equal. While most are expected to perform very well, a Fitch Ratings report warns of weaker collateral for the non-qualifying mortgage (QM)/non-prime 2023 RMBS vintage, where delinquency performance is weaker than for the 2022 vintage.

Interest rates for these mortgages are higher, and in some markets house prices have dropped, along with the level of home equity. Another factor is the "FICO inflation" of the COVID years, which temporarily raised certain borrowers' credit scores. Those borrowers would now be considered sub-prime, Kornfeld noted.

However, the increase in home equity that cushions the debt load of longer-term homeowners isn't available to renters, who might also have taken on credit card and auto debt, based on weak underwriting and credit inflation. Unlike homeowners with low-rate, fixed mortgages, renters saw huge increases in rents in 2021 and 2022, Kornfeld said. Auto loans are also suffering from the decline of used car prices in the last 18 months.

"So, if you have a default, the severity of losses to the lender are much higher," Kornfeld said.

Fitch has a deteriorating outlook for the performance of credit card and auto loan ABS assets in 2024 relative to 2023. "The impact on borrowers will continue to be uneven with lower-income households being squeezed through higher prices and elevated interest rates," said Margaret Rowe, a senior director of asset-backed securities research at Fitch. "But just modest increases in delinquency and losses above pre-pandemic levels are expected for ABS platforms focusing on higher-income prime borrowers."

Mike Nowakowski, head of structured products at Conning, sees two mitigating factors for auto loan and credit card performance. One is that inflation-adjusted earnings have turned positive as inflation has moderated, leaving more money in consumers' pockets. The second is that underwriting standards have tightened meaningfully since the second half of 2022. "One lesson we learned from the global financial crisis is that consumers will prioritize the payment of their automobiles above most obligations, and we think that sentiment has only become stronger, given the rise in the gig-economy," Nowakowski said. Owning a car is integral to being able to earn income in the gig economy.

With low-rate existing mortgage loans making first lien cash-out financing uneconomical, Kornfeld expects a relatively modest level of housing activity over the next year, and not much of an increase in residential mortgage balances. This will be slightly offset by home equity extraction, mostly of second lien cash-outs. Moody's expects credit card balance growth to slow somewhat, while weak affordability keeps auto loan and mortgage growth very modest.

"HELOCs and CES (Closed End Second) mortgages will increase as a way to tap built up home equity while holding onto existing low mortgage rates," said Ed Reardon, managing director at Deutsche Bank. "The normal strategy for borrowers is to [opt for] cash out refinance, but they won't want to do that with low locked-in rates."

Deutsche Bank's advice for investors is to add current coupon agency MBS over non-QM new issue AAA. This is because the broad rally across new issue credit types which occurred in November 2023, tightened spreads for non-QM AAA to T+145 basis points, bringing it closer to agency MBS (132 basis points). With such a low spread advantage, investors should prefer the liquidity of agency MBS, Deutsche Bank advised in a report.

Credit risk transfer for mortgages is the preferred area of investment for Greg Handler, head of mortgage and consumer credit at Western Asset Management Company. In particular, Handler is interested in borrowers who took mortgages at the high rates of 2023.

"For these, there will be a significant opportunity to refinance into lower rate loans as the Fed's cutting cycle takes hold," he said. "We do like taking credit risk on the higher rate 7+% mortgages that were issued last year, as we would expect those to see rapid de-leveraging and prepayment activity. Here, we like taking select credit risk in the non-QM and credit risk transfer markets."

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