What Investors Need to Know About the New Nonprime RMBS
Mortgage lending to borrowers with spotty credit, underway for several years, appears poised to take off in 2017.
Banks are still steering clear of this market; instead, most of the lending is being done by affiliates of private equity firms and other kinds of asset managers including Angel Oak, Ellington Management Group, Invictus Capital, Lone Star Funds, and Varde Partners.
Most gained an understanding of this market by acquiring portfolios of loans that went bad during the financial crisis. As the housing market recovered, they sensed an opportunity to make new loans to consumers shut out of the mortgage market.
“After the financial crisis, nonprime origination dropped literally to zero,” said John Hsu, head of capital markets at Angel Oak Capital. “I’m not saying we have to get to $1.3 trillion, but [nonprime has] got to exist in some form. There are some good credits left out with production at zero.”
Taking advantage of this opportunity required significant investment. Some investment funds acquired operating companies with an existing infrastructure for loan originations, while others formed aggregator platforms that make bulk loan purchases.
They’ve also had to invest in educating potential borrowers and mortgage brokers and correspondents, not to mention investors in mortgage bonds, which ultimately fund lending. Since early 2015, five sponsors have issued more than $1.3 billion of mortgage bonds in 10 deals [[update 12 deals].
Most of these early deals have been unrated, but three firms, Caliber Home Loans (controlled by Lone Star), Invictus Capital and Angel Oak, have issued deals with credit ratings, seeking to broaden their investor base and boost liquidity.
Fitch Ratings expects as many as nine more issuers to follow suit this year. “Every potential non-QM [qualified mortgage] issuer we’ve spoken to seems interested in getting a rating at some point, in 2017 or 2018,” said Grant Bailey a managing director at the rating agency.
Kroll Bond Rating Agency also expects to see more rated deals, though not necessarily right away. “There’s probably some price discovery going on to determine the value of issuing rated transactions,” said managing director Jack Kahan. “Once that is determined, I think we might see a pickup” in rated issuance, he said.
This could create virtuous circle, as less expensive funding provided by selling rated mortgage bonds allows lenders to offer lower interest rates, which in turn boosts lending. Caliber, which completed three rated deals last year, appears to have passed along some of the savings. The average coupon on loans used as collateral for a December deal was 6.4%, down from 7% for its first rated deal, completed in June, and 7.4% on the collateral for an unrated deal completed in 2015, according to data published by Fitch.
And higher lending volume would allow sponsors to issue mortgage bonds market more frequently, in larger deals, a key to attracting some investors who have yet to jump into the market.
“There have been fits and starts, with various people trying to bring a non-QM product to market. Yet not in the size or scope or breadth we would have thought,” said Greg Parsons, chief executive officer of Semper Capital Management, one such investor.
“From our perspective, it’s been staggered,” Parsons said. “There are very small deals, but no one has really built a sustainable engine. The ones that have come out have seemed like a one-off, as opposed to a product shift.”
A number of legislative and regulatory changes have established new lending standards and increase liability for lenders that make poor quality loans. And changes to market practice, such as preventing loan officers from communicating with appraisers help mitigate conflicts of interest in lending.
No Easy AAAs
That doesn’t mean every mortgage bond offering is structured so as to obtain top ratings, however. Fitch Ratings, one of only two rating agencies hired to rate nonprime mortgage bonds to date, has said that the relatively recent entry of a number of market participants, not to mention the heightened risk of the sector, will prevent some issuers from obtaining an AAA, at least for now.
“It’s the lack of track record of the aggregators and visibility into the originators,” Bailey said.
“If you’ve just started in the past two or three years, and you’re buying from a lender we don’t know anything about, that combination is not likely to get you to AAA, even with 100% due diligence.”
It doesn’t necessarily take too long for the rating agency to achieve a level of comfort, however. It assigned an A to the senior tranche of Caliber’s first two deals, but the sponsor’s third deal, completed the same year, achieved an AAA.
Avoiding Layering of Risk
Some notable “new” risks for nonprime mortgages include a large number of loans that rely on bank statements to document income, which most lenders offer only to self-employed borrowers. They generally require 24 months of statements, although some lenders reviewed by Fitch use only 12 months of statements, and one lender allows a one-month statement to document income for prime-quality borrowers.
And of course, many borrowers are getting loans from nonprime lenders because they have experienced a prior credit event, such as a bankruptcy, short sale, or deed-in-lieu of foreclosure, that disqualifies them from getting a loan that can be sold to Fannie Mae or Freddie Mac.
While performance data for borrowers that had a recent credit event is limited, Fitch says early data indicate a 20% greater likelihood of default on their new mortgage compared to the entire population of new mortgage borrowers, after controlling for credit score. And that performance difference was observed in a benign economic environment, rather than a stressed one. The rating agency currently increases base-case and stressed default projections by 20% for borrowers with prior credit events after controlling for all other attributes.
Other kinds of collateral include loans are not eligible to be purchased by Fannie Mae or Freddie Mac because they are for business purposes or to foreign nationals.
On a positive note, Jack Kahan, a managing director at Kroll Bond Rating Agency, noted that the initial issuers in this space are trying to reduce any layering of risks.
“Before the financial crisis, losses meaningfully increased as originators started producing loans with weaker credit, such as loans with limited income documentation that possessed both higher DTIs [debt-to-income ratios] and LTVs [loan-to-value ratios],” he said.
“For more recent non-prime originations, if an issuer is going to take on more risk for a given credit attribute, such as income documentation, they will generally compensate by seeking more favorable metrics and require lower LTVs and/or higher FICO scores. If they dial up a risk for one characteristic, they generally dial down others.”
Large Loans, High Geographic Concentration
Other risks in nonprime mortgage bonds are similar to those in prime jumbo mortgage bonds, such as a high geographic concentration of loans and a few large loans.
For example, the $145 million transaction that Invictus completed in February featured a heavy concentration of loans in California (57.9%) and to loans greater than $1 million (29%). KBRA, which rated the deal, assessed increased losses to account for the large loan exposure in the Invictus deal.
“It was a combination of the loans being large and the pool being small,” Kahan said. “However, the size of the loan itself is not, in and of itself, a risk. We see this in prime jumbo deals as well, that for larger balance loans there tend to be more conservative LTVs. The LTV on the largest loan in this deal is less than 50%.”
Prepayment Speeds are High
Early performance has been similar to that of historical prime averages, than what was known as Alt-A or subprime averages, according to Fitch.
“While acknowledging that the economic environment has been very supportive, the early delinquency trends are reassuring and appear to be consistent with loans originated with solid operational controls. finds reassuring,” the rating agency stated in a January report.
One of the most notable performance trends, according to both Fitch and KBRA, is that prepayment speeds are quite high, something both rating agencies attribute to borrowers refinancing into less expensive loans after they “cure” their credit by making regular, timely payments. Fitch says prepayments are as high as 40% on an annualized basis, and tend to increase as deals season.
Hsu acknowledges that prepayments “are generally higher than most originators, or investors, want them to be.” But he does not expect this to last. “Keep in mind that we’re still developing this product … early on, the coupons were quite high. We just didn’t know if could get leverage or would have to hold them. As more entrants come in, there’s been more price competition. As coupons settle into a level, we’ll see prepayments slow.”
Hsu also acknowledged that “we can get a better bang for our buck by not asking investors to analyze multiple programs [in a single deal].”
For now, he said “we’re looking to source good credits. When the volume is there, the market more recovered, and [potential borrowers] know these mortgages are available to them, we will then be able to pick a part of our balance sheet to securitize in order to get more efficient execution,” he said.
“If you could get an all bank statement program or an all-prime-ish program, you’d have a lot of interest, though I don’t know if we’ll see that this year.”