By the Numbers
ARMs and other angles drive prepayments in non-QM MBS
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.
Adjustable-rate loans have provided investors in non-QM trusts with relatively fast prepayments, helping limit duration and providing upside in discounted cash flows pulling to par. But higher prepayments have depleted the remaining supply of ARMs in non-QM trusts and investors will likely have to screen for other loan attributes that may provide prepayment upside. Investors have a good set of choices on that front.
Investors looking for a path to faster prepayments in discount collateral cohorts should look for the following:
- Larger concentrations of high balance loans
- Higher concentrations of second homes and seasoned investor loans
- Shelves such as DRMT and STAR that have posted fast speeds on discount loans
- Deals with that still have higher concentrations of ARMs
The re-steepening of the yield curve over the past 12 months has driven elevated prepayments across ARMs collateralizing non-QM trusts. To date, ARMs have made up more than half of total non-QM prepayments despite making up less than 30% of over $300 billion of non-QM collateral analyzed. ARM collateral comprises just over 15% of outstanding non-QM collateral, making it increasingly difficult, and likely more costly, to gain meaningful exposure (Exhibit 1). Prepayments on outstanding hybrid loans appear likely to remain elevated as the WAC on the outstanding population of ARM loans is roughly 20 bp greater than the population of prepaid loans.
Exhibit 1: Non-QM Collateral Attributes – Prepaid versus Outstanding
Source: Santander US Capital Markets, CoreLogic LP
Screening for other collateral attributes that may provide upside to prepayments, loans with higher balances have exhibited faster out-of-the-money speeds than smaller ones. Controlling the population for fixed-rate observations, loans with balances greater than $1 million and -125 bp of refinancing incentive prepaid anywhere from 4.5 CPR to 6.5 CPR faster than other cohorts. Faster observed out-of-the-money speeds on large balance loans are somewhat of an anomaly as they have historically exhibited steeper prepayment S-curves and slower-out-of-the-money speeds than smaller balance loans (Exhibit 2).
Elevated deep-out-of-the-money speeds were more pronounced for loans collateralized by investment properties and second homes where there is likely less lock-in effect as investors may look to extract equity associated with home price appreciation and second homeowners tend to exhibit higher mobility and faster turnover. From a credit perspective, deep credit investors may be able to add large loan exposure, particularly in lower LTV investment properties or second homes where compensating credit characteristics may help to offset exposure to large loan risk.
Exhibit 2: Larger loans exhibit faster-out-of-the-money speeds
Source: Santander US Capital Markets, CoreLogic LP, Observations limited to fixed-rate collateral only with a two-year observation period of June 2022 through May 2024. Refi incentive is SATO adjusted to normalize for risk-based pricing at origination.
Loans backed by second homes have broadly exhibited substantially faster prepayments than those backed by owner-occupied loans or investment properties in recent months. These loans have steadily exhibited faster prepayments than other cohorts over the past two years (Exhibit 3).
Exhibit 3: Loans backed by second homes have prepaid faster than other cohorts
Source: Santander US Capital Markets, CoreLogic LP
Cutting the non-QM first by collateral gross WAC, then by shelf shows that certain shelves have recently exhibited faster speeds on discount loan cohorts than others. Recent prepayment observations on loans with less than 4% gross WACs exhibit limited dispersion across shelves but there are more pronounced differences in other discount WAC bands. Looking across the rest of the universe of discount loans, certain shelves exhibit appreciably faster speeds than others. The DRMT, STAR, COLT and AOMT shelves all have exhibited relatively elevated prepayments over the past year.
Exhibit 4: Stacking up prepayment rates on lower gross WAC Non-QM loans
Source: Santander US Capital Markets, CoreLogic LP
Analyzing potential drivers of elevated prepayments on lower gross WAC loans collateralizing these shelves show some consistent themes. Both the DRMT and STAR shelves last issued transactions in 2022 and as a result, much of the collateral backing these deals has experienced substantial home price and equity appreciation. Additionally, these deals exhibit larger concentrations of investor loans. Substantial home price appreciation appears to have provided a catalyst for investors to unlock that equity via refinancing those loans, particularly loans that are only modestly out-of-the-money. Given this, other seasoned transactions with large concentrations of de-levered investor loans may exhibit faster prepayments on out-of-the-money loans.
Mapping the universe of non-QM trusts suggests that investors can gain substantial exposure to deals with larger concentrations of seasoned investor collateral that may have upside to faster prepayments. Some additional considerations will likely skew whether discount investor loans may be more or less likely to refinance. The most prominent deterrent to refinancing would be the presence and structure of prepayment penalties on investor loans. Loans with hard prepayment penalties and no step-down in the penalty structure will be less likely to refinance absent originators’ ability or willingness to waive those penalties. Conversely, geography and SATO may help drive faster speeds on lower-coupon non-QM investor loans. Loans in areas that have experienced outsized home price appreciation may be more likely to refinance given greater stores of pent-up equity. And seasoned loans with greater SATO originated post-pandemic when risk-based pricing spreads were substantially wider may be able to refinance at tighter spreads, offsetting the increase in benchmark prime mortgage rates to some extent. (Exhibit 5)
Exhibit 5: Mapping the seasoned non-QM universe by investor concentration and SATO
Source: Santander US Capital Markets, CoreLogic LP
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