Adding convexity with investor loans in non-QM
admin | February 7, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Prepayment risk continues to be a prevailing concern among non-QM investors. Targeting specific collateral profiles can potentially afford investors with significantly more prepayment protection. Similar to the agency space, loans backed by investor properties tend to have flatter s-curves than owner occupied ones. A wrinkle particular to non-QM is that investors can pick up additional convexity associated with features such as alternative documentation and prepayment penalties.
Leveling the prepayment playing field
Non-QM deals almost by definition are backed by a mix of loans that fall outside the purview of the QM rules for a host of different reasons. Risk-based pricing on these loans can vary significantly and any prepayment analysis needs to control for a borrower’s propensity to prepay given equivalent refinancing incentives net of any additional spread from risk-based pricing or spread at origination (SATO). After controlling for each loan’s spread over the prime rate at point of origination, the analysis shows that while s-curves are surprisingly flat across owner occupied, investor and second homes in non-QM deals, the absolute level of prepayments is significantly lower in loans backed by investor properties. Higher out-of-the-money speeds in owner occupied loans are likely driven by a larger percentage of borrowers’ whose credit has cured since origination, potentially increasing their refinancing incentive absent a move in interest rates. This phenomenon seems less prevalent in loans backed by investor properties. (Exhibit 1)
Exhibit 1: Investor loans with the same refinancing incentive have prepaid slower
The population of investor loans backing non-QM trusts can be further screened for loan features such as alternative documentation and prepayment penalties. Loans backed by investment properties are by definition commercial purpose loans which fall outside the purview of the Qualified Mortgage rules set by the Consumer Financial Protection Bureau (CFPB). The distinction is an important one: while the CFPB does not allow originators to apply prepayment penalties to consumer mortgage loans, those backed by commercial purpose real estate can still carry prepayment penalties. This adds a potentially meaningful source of prepayment protection to non-QM trusts backed by investor loans with penalties. An additional wrinkle to investor loans is that they are often underwritten using the property’s projected rental income in lieu of the borrower’s income. This type of debt service coverage based underwriting is becoming more prevalent in non-QM lending. Based on conversations with originators, this type of underwriting potentially eases some of the burden associated with manually underwriting each non-Qualified mortgage loan. As a result the population of these loans should continue to increase in non-QM trusts going forward.
Comparing prepayment S-curves across full and limited documentation investor loans in non-QM trusts – again controlling for refinancing incentive net of risk-based pricing – shows that investor loans underwritten using alternative documentation have an extremely flat S-curve and prepay slower given equivalent incentive than fully documented ones. This is likely attributable to the more limited menu of refinancing options available to alternative documentation investors. While these types of loans could become more prevalent in non-QM trusts, its unlikely to be broad based enough to materially increase the channels these borrowers have to refinance these loans. (Exhibit 2)
Exhibit 2: Limited documentation investor loans have prepaid slower in non-QM trusts
Drilling down further, unsurprisingly, both full doc and DSCR loans with prepayment penalties tend to prepay slower than similar investor loans without penalties. Separating investor loans into four buckets, DSCR loans with and without penalties and other investor loans with and without penalties, shows that DSCR loans with penalties have prepaid the slowest of any cohort by a fairly wide margin over the past two years. Other investor loans with prepayment penalties have not afforded investors the same absolute level of protection as DSCR loans, but by and large have prepaid slower than comparable investor loans without penalties with similar coupons. Additionally, given the relatively novel nature of the product, earlier spikes in prepays on loans with prepayment penalties are generally a byproduct of a small sample of observations, and all flavors of loans with penalties are expected to offer attractive prepayment protection to non-QM investors going forward. (Exhibit 3)
Exhibit 3: DSCR loans with penalties can offer attractive prepayment protection
Scanning the universe of non-QM trusts to try to find concentrated exposures to these types of loans shows that nearly 90% of the collateral backing certain Invictus trusts are DSCR loans with prepayment penalties attached to them. In addition to the Invictus VERUS trusts, Oaktree’s Bunker Hill (BHLD) deals have meaningful concentrations of investor loans with prepayment penalties. (Exhibit 4) Ultimately, investors in these trusts are short call options which allow the issuers to collapse the trust at par at either a specified date or when the collateral balance hits a certain threshold. Collateral selection can by and large do little to mitigate that call risk. That said, investors can try to insulate themselves from elevated prepayment speeds prior to issuer calls by adding convexity through certain types of investor loans.
Exhibit 4: Scanning the universe for prepayment penalty investor loans