Signs of resilience in non-QM loan credit
admin | October 2, 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.
Delinquency rates continued to fall across mortgage credit in September with rates in non-QM loans down notably. The drop in non-QM delinquencies has come in part from loans underwritten using limited documentation and debt service coverage ratios, loans largely untested before this spring. Improving borrower performance across these types of loans may help provide a springboard to renewed non-QM issuance.
Borrower performance continued to improve across all sectors of mortgage credit in September. Not all sectors performed uniformly as prime jumbo delinquency rates remained relatively elevated, although at low absolute levels, while seasoned RPLs and non-QM have seen the steepest declines from their peak delinquency rates in the spring. Delinquency and forbearance-related modifications have fallen from 23.9% in June to just over 16% in September across all non-QM trusts (Exhibit 1)
Exhibit 1: Improved credit performance led by non-QM loan and RPLs
Looking broadly across borrower attributes and loan underwriting, nearly all flavors of non-QM loans have contributed to the decline in delinquency rates. Riskier non-QM loans, such as lower FICO and higher LTV loans, still have exhibited relatively higher delinquency rates. One notable exception is loans with an original combined LTV greater than 90, which exhibit some of the lowest delinquency rates in the sector, likely driven by material compensating credit characteristics on those higher LTV loans.
Concerns about underwriting standards of non-QM loans may be abating as delinquency rates on limited documentation loans have fallen to roughly in line with rates in full documentation loans. Delinquency rates on limited documentation loans came in just above 16% in September with rates on full documentation less than 1% lower. Somewhat surprisingly, the rebound in performance in limited documentation loans has been most pronounced in later vintages where arguably underwriting standards on limited documentation loans were substantially looser than in earlier years. (Exhibit 2)
Exhibit 2: Performance rebounding in later vintage limited doc non-QM loans
There are still underlying concerns about limited documentation loans in non-QM trusts. The potentially largest issue facing the non-QM market is the largely untested Ability to Repay (ATR) standard under the Qualified Mortgage rules. As some of these limited documentation borrowers ultimately default, there will likely be future ATR challenges where borrowers will attempt to demonstrate that the originator did not properly underwrite the loan and verify the borrowers’ ability to pay off the loan. Where a borrower makes a successful ATR claim, either affirmative or defensive, it mitigates the lender’s ability to foreclose on the borrower. Concerns about a potential ATR claims may prompt servicers of non-QM loans to preemptively offer generous permanent loan modification terms to limited documentation borrowers. Conversely, a slew of potential ATR challenges should help establish as statutory framework for the ATR standard and provide lenders with more clarity on what constitutes Ability to Repay going forward.
Other potential areas of concern for the non-QM market appear to be rebounding as well. Investor properties, particularly those underwritten using the property’s rental income rather than the borrower’s income were a significant source of concern for the non-QM market in the spring. This type of underwriting based on debt service coverage had not been done historically in the private label RMBS market and remains largely untested. Broadly, delinquency rates on investor loans in non-QM trusts were roughly 2.5 points lower than those of owner-occupied loans in September at 14.5% and 17.1% respectively, likely a function generally lower LTVs and other compensating credit characteristics in investor loans. Loans underwritten without the borrower’s income are performing slightly better than all other flavors of non-QM lending. Delinquency and modification rates on loans underwritten to a debt service coverage ratio, which were higher than other forms of non-QM lending in June have fallen 40% in the span of three months from over 24% to just over 14% in the September remittance. The marked improvement in performance is especially encouraging in light of large scale eviction moratoriums that may have provided a headwind to rental performance. Other forms of no income verification, specifically loans underwritten using asset depletion underwriting have experienced a far more modest rebound in performance over the past quarter with delinquency rates falling roughly 17% since June. (Exhibit 3)
Exhibit 3: Performance of DSCR loans has improved materially
One potential headwind to the non-QM aggregator model is weaker performance of loans originated through broker and wholesale channels relative to those originated through retail channels by sponsors with captive origination networks. Peak delinquency rates on retail originations were far more modest than those of loans originated through broker or wholesale channels and dropped below 10% in September. Peak delinquency rates on broker originations were nearly double those of retail loans and are still markedly higher than retail and wholesale originations. (Exhibit 4) Elevated delinquency rates across broker originations were prevalent in ARMs relative to fixed rate originations at 22 and 14% respectively. Performance of limited documentation loans originated by brokers appears to be consistent with fully documented underwriting as both forms of originations exhibited delinquency rates just above 14% in September.
Exhibit 4: Retail originations outperforming broker and wholesale loans
Ultimately, improving performance should provide a reasonable tailwind to non-QM originations in the coming months. As borrowers cure the sector will likely continue to attract capital from mortgage credit investors. In addition to improving fundamentals, additional statutory clarity around the Ability to Repay standard should provide momentum for increased non-QM originations. Furthermore, capital allocations to the sector may increasingly come in the form of equity investments in originators with retail origination networks as investors looking to gain exposure to the asset class will likely not only want exposure to the asset class but some control over how loans are both originated, and potentially more importantly, serviced especially in light of the idiosyncrasies observed in servicer behavior across the private label market in recent months.