Lessons learned in private-label MBS in 2021

Chris Helwig | December 17, 2021

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.

Investors in private-label MBS can glean some valuable lessons from the past year. It was somewhat of a transformational year for mortgage credit as the market navigated some uncharted waters. Originators, issuers and investors had to adapt to rapidly changing policy mandates from the GSEs, which transformed both the size and nature of private-label supply. Investors also gained valuable insight about borrower performance in the wake of long-dated payment deferrals. The market over the past year also tested novel forms of expanded credit lending, and performance has remained strong. Lessons learned from the past year show the relative resilience of the private-label mortgage market and should create a strong foundation for it going forward.

#1 Policy risk weighs heavily on mortgage credit issuance

Originators, sponsors of private-label securitizations and investors were exposed to extraordinary amounts of volatility this year. Impending and eventual turnover at the top of the house at the Federal Housing Finance Agency led to wide swings in the role of the GSEs in mortgage lending and in the distribution of mortgage credit risk. The imposition and subsequent removal of caps on purchases of non-owner-occupied loans tested originators ability to nimbly switch from selling those loans to the GSEs to finding alternates sources of liquidity. Those that were able to navigate the rapidly changing landscape have implemented channels to allow best execution of any loan that may flow to GSE or private-label channels.

The nomination of Sandra Thompson as permanent director of FHFA should stem some of the policy volatility of the past year. However, there is likely still some degree of uncertainty around how the GSEs may change risk-based pricing on certain types of loans. Higher balance loans and those backed by investment properties may be targets for increased LLPAs, and originators who have already made substantive investments in execution away from the GSEs should be able to better navigate any policy changes enacted under the Thompson administration. Best execution will likely be a front-and-center issue, especially for larger, publicly traded originators that need to protect revenue against the backdrop of higher interest rates, lower volumes and less profitable GSE refinances.

The market also learned that in addition to limits on GSE liquidity and best execution, other factors influence originators to choose private-label execution. The flow of loans to private-label channels will also likely depend on the value of base servicing in private securitization. Variable servicing compensation structures have become increasingly prevalent in the private-label market, and they allow originators to assign nominal valuations to the servicing associated with performing loans. This feature is valuable to both banks and non-banks. Given the current low level of interest rates, current coupon IO multiples, especially those on what are viewed to be more positively convex investor loans, are substantial and will only expand given a back-up in rates. The amount of up-front capital that an originator would have to post against a 25 bp strip is substantial, likely close to five times the coupon currently and will only increase as rates sell off potentially creating additional incentives for originators to choose private-label execution.

Policy change at FHFA also weighed on the flow of mortgage credit risk from the enterprises. One potential modest surprise this year is that the disruption in CRT issuance from Fannie Mae did little to sour investor demand for the product when they ultimately returned to the market. Given that one of the widely held advantages of CRT over other forms of credit risk is that it provides a stable, relatively liquid and homogeneous exposure to residential mortgage credit, the pause in issuance could have diminished that view amongst the investor base and diverted private capital away. While CRT spreads have widened in the fourth quarter, that has likely been a function of a confluence of factors. Investors have had to grapple with both an increase in supply and meaningful structural change as the enterprises look to potentially push incremental risk to the investor base while reducing the long-term costs of insuring risk transferred.

#2 Forbearance doesn’t equate to foreclosure

The other major lesson investors likely gleaned from this year that diverged materially from past experience is that a disruption in a borrowers’ payments may have little impact on borrowers’ ability to ultimately re-perform. Despite the extension of forbearance plans to as much as 18 months, the performance of borrowers in forbearance continues to improve as these plans ultimately come to term. Cure rates on borrowers referenced in GSE CRT transactions that were seriously delinquent last summer have shown steady improvement and are above 80% for both agencies as of their most recent remittance. Delinquency rates for borrowers in non-QM trusts have fallen from upwards of 25% last summer have fallen by roughly 80% as well and are currently sitting at roughly 5.0% at the cohort level as of the November remittance. Delinquency rates on loans in prime private-label transactions have also seen elevated cure rates and are currently just above 1.0% at the cohort level.

As a corollary to this, the market likely distilled the value of deferral modifications as a tool to re-perform borrowers after forbearance. While capitalizing delinquent arrearages has historically been a tool that servicers could use to re-perform borrowers, the arrearages were generally appended to the balance of the loan while continuing to accrue at the loan’s note rate. In the case of recent large scale forbearance plans, borrowers, in many cases, have had the ability to defer those arrearages in non-accrual status, thus lowering the threshold to re-performing. It appears that the move to append delinquent arrearages without the burden of paying interest on that balance has led to improved re-performance rates. However, an assumption that this somewhat subtle change to servicer actions is the sole driver of better borrower performance is likely flawed. Prior spikes in delinquency rates were generally coupled with overinflated and subsequent falling home valuations along with limited demand for a growing housing stock of available housing, clearly a stark difference from the current paradigm. Any future disruptions in borrower performance will have to be weighed against broader housing and consumer balance sheet fundamentals. Applying recent borrower behavior against weaker housing and consumer fundamentals would likely overstate potential borrower performance.

#3 Novel forms of non-QM lending survive the pandemic

One additional insight the market has likely gleaned in the past year is evaluating performance of novel forms of lending against the backdrop of high delinquencies and a material slowdown in payment velocity in cohorts such as investment properties underwritten using a property’s rental income. Given that this type of underwriting was previously untested for residential lending, concerns arose about how these loans would perform as disruptions in rental income threatened to hurt borrowers’ ability to make payments. These concerns ultimately were largely unfounded as delinquency rates on DSCR loans currently run lower than those of full documentation or owner-occupied loans. They are broadly consistent with lower delinquency rates on limited documentation and investment property loans, likely a result of strong compensating credit characteristics.

Chris Helwig