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Playing a mixed recovery in mortgage credit

admin | December 4, 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. This material does not constitute research.

Delinquencies have continued declining in non-QM and certain areas of the seasoned RPL markets in recent months, and prepayments are on the rise. In other areas of private-label MBS, not so much. A lift in RPL speeds should help shorten average lives, tighten spreads and deleverage these structures. Falling delinquencies and faster prepayments should only add to the negative convexity of non-QM trusts, however. And while other sectors look set for persistent delinquencies and slow speeds, that ultimately could be a positive for interest-only profiles in legacy MBS.

A mixed recovery

The November remittance cycle showed a continued plateau in delinquencies across most sectors of mortgage credit, although non-QM continues to decline. Plateauing delinquency rates are of somewhat greater concern in legacy MBS cohorts, as they did not exhibit as steep a decline from peak levels as other sectors. Non-QM continues to show a steady though modest decline in delinquencies as outstanding overdue balances fell roughly 100 bp month-over-month and are down over 40% from the peak experienced in June (Exhibit 1).

Exhibit 1: Borrower performance plateaus in most cohorts

Source: CoreLogic, Amherst Pierpont Securities

Consistently elevated delinquencies can be a function of an existing delinquency pipeline rolling to later stage delinquency. Delinquencies can remain elevated until some portion of those borrowers ultimately default and liquidate or some borrowers curing. Delinquencies also can get boosted by new borrowers rolling from current-pay to an early stage delinquency. In the case of legacy subprime and option ARMs, it appears that a substantial amount of previously current-pay loans were rolling into early stage delinquency as of the November remittance. After accounting for both capitalization modifications and loans being marked as current but reported as in forbearance, 9.5% of previously current-pay loans in the subprime cohort and 7.5% of those loans in the option ARM cohort fell 30-days past due in the November remittance cycle. These roll rates are substantially elevated relative to most other legacy and post-crisis cohorts with the exception of the legacy Alt-A cohort, where roll rates are elevated as well (Exhibit 2).

Exhibit 2: Elevated rates driven by new delinquencies in subprime, POA

Source: CoreLogic, Amherst Pierpont Securities

Elevated roll rates in the three legacy cohorts are likely driven by larger populations of previously modified loans that are showing higher roll rates in the wake of the pandemic. Comparing roll rates on previously modified loans against those that had not experienced a modification shows that roll rates on modified loans came in roughly 1.75 times to 3.25 times those of non-modified loans across various legacy and re-performing cohorts (Exhibit 3). The 1-month observation is broadly consistent with 6-month average roll rates across the various cohorts.

Exhibit 3: Previously modified loans exhibit higher roll rates

Source: CoreLogic, Amherst Pierpont Securities

To date, post-crisis re-performing loan securitizations have exhibited some of the strongest recoveries in terms of borrower performance. However, higher roll rates on modified loans may suggest that post-crisis RPLs may be subject to elevated delinquency rates going forward if the recent trend holds. Looking across major RPL shelves, overall delinquency rates and the trajectory of those rates vary significantly by issuer. Overall delinquency rates are highest on New Residential’s NRZT shelf and remain near peak levels observed in the spring. The contrast in performance of the NRZT shelf relative to others is likely a function of the collateral; in many cases it is sourced by calling outstanding legacy securitizations and re-securitizing the loans, putting the performance of that collateral more in-line with comparable legacy collateral. Conversely, performance has been better on the Towd Point and Mill City shelves, where the collateral has been sourced from commercial bank and GSE portfolios; these portfolios have likely seen less frequent and lighter-touch modifications. Despite higher roll rates on modified loans, delinquency rates on the Towd Point shelf fell every month since June prior to flattening out between the October and November remittance cycles. A similar trend held in the Mill City shelf until this month when delinquency rates rose by roughly 80 bp compared to the October remittance cycle (Exhibit 4).

Exhibit 4: RPL performance varies significantly by shelf

Source: CoreLogic, Amherst Pierpont Securities

Not all bad news

Despite the overall flattening in delinquency rates, there are some collateral profiles that continue to see delinquencies decline. Delinquencies continue to fall in the non-QM sector and loans with certain attributes are even outperforming the broader trend. Investor loans in particular have exhibited stronger credit performance than owner-occupied loans to date (Exhibit 5). These loans not only have exhibited stronger performance, given the fact they are commercial purpose loans and not subject to the Qualified Mortgage rules it seems plausible that there may be less frequent or lighter-touch modifications on these loans as borrowers cannot bring Ability to Repay (ATR) challenges against originators of these loans as the risk of ATR exposure may provide incentive for originators and servicers of low-documentation owner-occupied loans to offer more significant loan modifications.

Exhibit 5: Delinquency rates lower in non-QM investor loans

Source: CoreLogic, Amherst Pierpont Securities

The intersection of credit and prepayments

Elevated delinquency rates are consistent with slower prepayments, and falling delinquencies push speeds higher. An uptick in overall prepayments in the non-QM and RPL sectors has been commensurate with the decline in overall delinquencies in those cohorts for the most part. The increase in prepayment rates is a positive for the RPL market given the sequential structures. Deleveraging of those structures allow investors to roll down the spread curve, providing a valuable source of total return. As delinquency rates peaked on RPLs in June, average prepayment rates fell below 10 CRR. As of the November remittance, average prepayment rates have increased by roughly 50% to 15 CRR for the cohort. Given this, investment grade mezzanine tranches of RPL deals backed by cleaner collateral pools may outperform next year as they should continue to deleverage and roll down the curve.

The uptick in speeds in the non-QM cohort should increase negative convexity in these deals. The overall improvement in credit performance in non-QM trusts may serve to not only increase the negative convexity of these deals through faster prepayments but also as a result of the potentially growing incentive for sponsors to exercise short-dated call options on these trusts as more loans re-perform. As a result, the majority of the capital structure in non-QM may be more of a short-term carry investment than a source of total return. With that said, deals backed in whole or in large part by non-QM investor loans may limit negative convexity from prepayments to some extent. Despite exhibiting better credit performance than owner occupied loans, non-QM investor loans continue to prepay slower. On average, owner-occupied non-QM loans prepaid at nearly 33 CRR in November while investor loans paid roughly 12 CRR slower, potentially providing investors looking for short duration options in mortgage a more stable profile than bonds backed mostly by owner occupied loans.

Conversely, slower prepayments and elevated delinquency rates in certain sectors of the legacy market should benefit IO profiles, specifically IOs backed by option ARM collateral. IOs backed by option ARM collateral, particularly loans in judicial states with long foreclosure timelines may provide investors with an attractive source of carry into next year.

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