By the Numbers
Higher delinquencies may lift speeds 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.
Consumer exposures, including auto loans, credit cards and unsecured loans are showing some signs of stress. And mortgage assets have not been immune to a downturn in performance. One consistent theme across all consumer exposures is that lower credit quality borrowers are driving the downtown in performance, generally by an order of magnitude. Unlike other consumer exposures, lower FICO mortgage borrowers generally have low levels of leverage and as a result, abatements of these loans from MBS trusts are more likely to look like a prepayment rather than a liquidation with a loss severity.
FICO Inflation – what goes up must come down?
Weaker performance across consumer exposures has been primarily localized to low-to-moderate credit quality borrowers where pandemic and post-pandemic fiscal policies including mortgage payment forbearance and direct fiscal stimulus translated to upward drift in borrowers’ credit scores. Per studies conducted by the Federal Reserve, the share of borrowers with subprime credit scores fell to the lowest observed levels since the late 1990s, with the share of those borrowers falling from 23% to 18% of total.[1] The Fed’s study defines subprime borrowers as having credit scores of less than 620 with near prime borrowers maintaining a credit score between 620 and 719. Based on this taxonomy, FICO inflation likely had the most meaningful impact in the near prime category where previously subprime consumers had been re-classified.
As the effects of fiscal policies abated and the broader US economy has weakened, fundamental borrower performance in near prime credits has begun to deteriorate. Looking at both serious delinquency rates and rolls of performing loans to early-stage delinquency, lower-tier near prime loans are performing markedly worse than stronger credits. Consistent with the Fed’s analysis, loans in non-QM trusts with FICOs less then 720 are rolling to early stage delinquencies at markedly higher rates than those with scores greater than 720. A similar phenomenon is apparent in 60+ day delinquency rates as well (Exhibit 1).
Exhibit 1: Roll and seriously delinquent rates elevated on near prime Non-QM loans
Source: Santander US Capital Markets, CoreLogic LP Analysis Exclusive to 2019-2023 vintage non-QM transactions
Digging a bit deeper into performance of near prime loans in non-QM trusts shows dispersion in performance based on certain loan attributes. Owner occupied loans exhibit higher roll and delinquency rates than both investor loans and second homes. Somewhat surprisingly, LTV underwritten loans in the form of both no ratio and low DSCR loans exhibit the highest roll and serious delinquency rates relative to other forms of underwriting such as full or alternative documentation loans. While it’s surprising that these loans are exhibiting higher delinquency rates, it is potentially supportive of no loss abatements of these loans given their generally lower ingoing original LTVs relative to other cohorts.
Prepaying out of serious delinquency and foreclosure
While admittedly based on limited observations, there is some evidence of non-QM loans prepaying out of late stage delinquency and foreclosure. Looking at transitions between the June and July remittance, 1.2% of loans more than 60 days past due paid-in-full. Two percent of loans that were greater than 90 days past due in June prepaid in July. Another 2.0% of loans that were in foreclosure in the June remittance cycle prepaid the following month, while the 1.5% of loans that were in foreclosure in June rolled to REO, skewing the proposition to prepay over liquidation albeit to a small degree (Exhibit 2).
Exhibit 2: Near prime loans prepay out of delinquency and foreclosure in July
Source: Santander US Capital Markets, CoreLogic LP Analysis Exclusive to 2019-2023 vintage Non-QM transactions
Screening for optionality to delinquent prepayments
Prepayments from delinquency or foreclosure buckets will obviously have the most material impact on deeply discounted cash flows, consistent with 2020 through early 2022 vintage transactions. The additional benefit of screening for deals with larger cohorts of near prime loans in these vintages is that loans that roll to late-stage delinquency or foreclosure generally have substantial equity cushions in the form of initial paid in equity, home price appreciation and to some extent amortization. Screening for potential optionality to discount abatements involves triangulating a combination of low gross WAC collateral, substantial deleveraging via seasoning and home price appreciation and larger concentrations of near prime borrowers, preferably with an already elevated pipeline of seriously delinquent loans. One example of this profile is a conduit transaction BARC 2021-NQM1. The deal is a 5.86% net WAC with an estimated HPA-adjusted LTV of roughly 50%. At origination, roughly 46% of the loans backing the deal had FICO scores of less than 700 and the deal has a current 60+ day delinquency rate of 8.56%. This deal and others like it may offer investors prepayment optionality if performance in near prime borrowers continues to decline.
[1] John Driscoll, Jessica Flagg, Bradley Katcher, and Kamila Sommer “The Effects of Credit Score Migration on Subprime Auto Loan and Credit Card Delinquencies,” FEDS Notes, Jan. 12, 2024
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