Non-QM stayed strong in 1H, but the road ahead could be bumpy

Capital market volatility in the first half of 2022 did not affect the performance of non-qualified mortgage securitizations, but investors should not remain complacent, a DBRS Morningstar report said.

No visible signs of cracks in the non-QM ecosystem have appeared — "yet," said the report from analysts Youriy Koudinov, Ronik Malhotra and Quincy Tang.

"Although voluntary prepayment rates declined, the share of delinquent loans remains modest, new delinquency rates low, serious delinquency cure rates robust, liquidations infrequent, loss severity rates low, and losses near zero," the report said. "[But] DBRS Morningstar expects performance of non-QM RMBS to be tested in the month to come, as voluntary prepayment rates may fall further and the rise in home prices may moderate, slowing the buildup of non-QM borrowers' equity." 

Duration or extension risk — loans not paying off at expected speeds at issuance — is a rising problem with non-QM securitizations, Standard & Poor's previously noted.

Meanwhile, delinquencies are likely to rise if both interest rates and inflation continue their upward movements.

Still, in the first half, non-QM loan performance improved from the end of last year, with just approximately 4% of mortgages delinquent at the end of the period, down from 5% in December 2021 and well lower than the pandemic-era peak of 18.8% in July 2020.

"Similarly, the share of seriously delinquent borrowers (those who were delinquent for 60 or more days under the Mortgage Bankers Association method) declined to 2.4% from 3.1% [in December 2021] and 13.5% [in July 2022]," the report said.

DBRS Morningstar remains bullish on non-QM. These transactions are "well poised" during the economic slowdown because the associated credit enhancement for rated transactions rose since they were issued due to robust prepayment speeds and low collateral losses.

And unlike during the financial crisis, borrowers today have built significant equity in their properties and are not underwater, largely because of rising prices. That gives them an incentive to preserve their homeownership. If any loans were to go into foreclosure, increased equity helps cushion investor losses when properties backing seriously delinquent loans are sold off.

However, the rapid rise in rates that caught most non-QM lenders with lower rate originations on their books at the end of the first quarter, making them difficult to securitize, could take some time to work out, affecting the pace of newer deals coming to market. Observers attribute the recent closures of Sprout Mortgage and First Guaranty Mortgage to pricing difficulties for non-QM loans, with a mismatch existing between the primary and secondary market impacting issuances, said Gunes Kulaligil, structured finance co-lead at investment banking firm Stout.

"Originators and aggregators with lower-rate loans on the books are faced with having to sell those loans at a discount or securitize them with lower returns to free up capital," DBRS Morningstar said. "As a result, issuance of non-QM RMBS is likely to be challenged until the volatility of rates and spreads subsides and the overhang of lower-rate loans clears."

But credit quality of new non-QM securitizations has remained strong.

The weighted-average credit score of the deals rated by DBRS Morningstar that were issued from March to July, 732, was about the same as those of the deals rated in January to February at 736 and higher than the 729 of those rated in the second half of 2021. At the same time, the original cumulative loan-to-value ratio of 70.6% for the March to July deals was similar for those in January to February, also 70.6%, and slightly higher than the second half of 2021 at 69.9%.