Let’s start with a flashback. The advent of the subprime bond crisis, in January 2007, triggered a price decline on various ABX index tranches that would continue for the next two years. By early 2009, shortly after the nadir of the Great Financial Crisis (GFC), the price of the ABX 07-1 “AAA” tranche bottomed at $25. It slowly recovered to the high $60’s over a five-year span, but prices on the “AA”, “A”, and “BBB” tranches fared worse — bottoming below $10, never to recover. Not fun for investors who sold protection or owned the underlying cash bond constituents. But this crisis may be different (and better) for non-agency mortgage bondholders. Why? Many reasons — mostly boiling down to improvements in underwriting, structuring, and trading. Below we highlight our top ten reasons (counted down in Late Show style) as to why this time may in fact, be different:
10. Generous Forbearance Programs – While the Federal program (as part of the CARES Act) is directed at mortgages held in GSE pools, virtually all states have forbearance and deferral options, which include mortgages held in non-agency pools. These programs typically do not require borrowers to be in a delinquency status or to make-up missed payments upon exit. By allowing a forborne borrower to either amortize payments for the remaining life of the loan or extend the loan’s final maturity, servicers avoid inciting a delinquency on the boundary. During the GFC, government attempts at forbearance were untimely and punitive, with their fees and stipulations, so they never got off the ground. Fortunately, they learned from their mistakes and were ready with more borrower friendly programs this time around.
9. More Experienced Servicers – During the GFC, few servicers had expertise in helping distressed borrowers avoid foreclosure simply because serious delinquencies had been so scarce in the preceding years. So when 70,000+ non-agency securities revealed waves of distress, the special servicing operations simply couldn’t keep up. Today, servicers have much larger special servicing operations with years of experience in handling the vicissitudes of borrowers. This has led to improvements across a variety of metrics, including transition, recidivism, and foreclosure rates, and should translate into lower collateral losses over time.
8. Both Borrower and Appraisal Matter – Prior to the GFC, the industry had little empirical evidence on the behavior of non-prime borrowers in a soft housing market. Instead the structures (and ratings) disproportionately relied on the perceived strength of the collateral’s aggregate appraisal value. Then the GFC produced reams of data on how the full housing cycle influences borrower behavior. This has since been used to formulate a “belt and suspenders” approach to underwriting — borrower circumstances are tied to loan-to-value such that additional credit protections may be afforded if necessary.
7. Holdings in Stronger Hands – Prior to the GFC, a large portion of higher rated non-agency RMBS was held by downgrade and impairment sensitive accounts. As the GFC progressed, the severity of the cycle necessitated mass downgrades to junk and even default (in the event that one or more dollars of principal were expected to be lost). Forced sellers exacerbated the already weak market technicals, creating a vicious cycle of price suppression and illiquidity that lasted for years. Today’s market has significantly more sponsorship by money managers and hedge funds, which should mitigate any forced selling if downgrades do occur.
6. No More Affordability Products – We now know that Negative Amortization, Interest Only, and Teaser-Rate mortgages were more prone to go into distress when the monthly mortgage payments spike higher. These mortgages were explicitly designed to allow homebuyers to borrow more, and, in hindsight, borrow beyond their means. Fortunately these products have been wiped from the landscape by government legislation passed in the wake of the GFC. Now the vast majority of mortgage applicants receive amortizing, level-pay mortgages, thereby promoting monthly home equity contributions and long-term household financial stability.
5. Conservative Rating Agencies – Because their reputations were so damaged by the GFC’s RMBS meltdown, the Rating Agencies take far more conservative approaches to rating private label securitized products today. Risk layering, especially prevalent in pre-GFC Alt-A collateral (including the infamous NINJA loans – loans held by borrowers with no incomes, no jobs, or verifiable assets) has been all but eliminated from securitizations. For example, today’s “limited documentation” borrowers (e.g. no W-2 statement) are required to have higher credit scores and larger down payments in order to hedge the risk that they lose their income source.
4. GSEs Largely on the Side-Lines – Fannie and Freddie offered increasingly aggressive product line-ups backed by the benefit of government subsidies in the run-up to the GFC. This nudged private lenders into their own rapid and reckless expansion of credit inclusions in an effort to protect their turf. The result was a lot of corner cutting at the origination level – including the pervasiveness of “liar loans”. Now that the GSEs have retreated under conservatorship, the private market is competing and growing in a more measured and prudent manner.
3. CDO Machine Halted – the slice-and-dice risk machine was shut down during the GFC and has yet to return. Subordinated tranches are now placed with end accounts rather than reapportioned into new “AAA” securities via the “mathematical magic” of Collateralized Debt Obligations. This type of sausage making was intended to diversify the riskiest tranches, but in hindsight, concentrated mortgage credit risk in more complex and correlated ways.
2. Market Tilted Back to Cash Bonds – Synthetic ABX contracts ceased trading near the end of 2015, which slowed the transfer of risk and largely eliminated the means for investors to short mortgage credit. But the absence of credit derivatives has kept price volatility across the sector relatively tame this time around. Although the GSE’s Credit Risk Transfer (CRT) program is a new form of synthetic mortgage credit, these tranches are CUSIP bearing and unlevered, which has, so far, insulated their challenged liquidity and technicals from the rest of the non-agency RMBS market.
And the number one reason this crisis will not inflict GFC-level carnage on non-agency RMBS (Anton Fig drumroll please!)…
1. Increased Credit Enhancement– In the wake of the crisis, investors and rating agencies required both higher levels of subordination and lower aggregate LTVs as a pre-requisite to version 2.0 of non-agency issuance. Now the largest and most liquid senior tranches must have far more enhancement in order to receive “AAA” ratings. This is critical – without a “AAA” endorsement on a deal’s most liquid and subscribed tranche, the economics of structuring are prohibitive. For example, prior to the GFC, the “AAA” senior tranches off Jumbo Prime collateral had 7% enhancement. Today, the senior tranches backed by that same collateral have 12-15% enhancement. Prior to the GFC, “AAA” seniors off Alt-A collateral had 10-15% enhancement. Today, the “AAA” seniors off non-QM collateral have 30+% enhancement.
So that wraps up our whirlwind view on the evolving non-agency RMBS market. At IR+M, we steered clear of subprime in the lead up to the GFC, but believe that the modest percentage of non-agencies we hold in our Core strategies today will be safely insulated from fundamental deterioration during this crisis. The technical bumps will come — likely from headlines — but we do not see a systemic chain-reaction of technical events triggering a mortgage bond meltdown this time. As always, we are happy to discuss the topic further. Thank you and good night!
Sources: https://www.nber.org/ and Bloomberg Barclays. Data as of 6/12/2020. Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. Copyright © 2020, S&P Global Market Intelligence. Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.