By the Numbers
Layered Risk Continues to Decline 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.
Growth in non-QM mortgage lending this year marks a material departure from prior cycles as it has not been meaningfully fueled by looser underwriting or an expansion of the credit box. In fact, at least when viewed through the lens of layered risk, recent growth has been marked by tighter credit criteria. Loans with more than one risky attribute continue to make up smaller swaths of non-QM trusts.
Meaningful growth in non-QM lending this year has likely left market participants with long enough memories wondering if the rise is analogous to growth of the pre-crisis alt-A market. The answer seems to be a fairly resounding ‘no.’ Median borrower LTVs have remained broadly unchanged despite substantial home price appreciation while borrower FICO jumped as the credit box tightened in 2020 and have taken an additional leg up over the past two years.
With that said, average credit metrics can do a poor job capturing risk. It is often better to focus on layered risk, the population of loans with more than one borrower attribute historically associated with greater risk of delinquency or default. Tail risk, at least for the overwhelming number of cross-dimensioned risk, either continues to decrease year-over-year or is already hovering near zero.
The trajectory of layered risk over time
Loans with layered risk used to make up much more meaningful amounts of collateral backing non-QM trusts. Non-QM lenders have typically had a limited appetite for risk marked by a borrower with a combination of high LTV and low FICO score along with loans where borrowers’ significantly re-lever their existing equity via a high LTV cash out refinancing (Exhibit 1).
Exhibit 1: Layered risks have made up a small amount of non-QM collateral
Note: high LTV = CLTV >= 80, high DTI = DTI > 40, low FICO = FICO < 680.
Source: Santander US Capital Markets, CoreLogic LP
Other exposures have seen a meaningful downturn in recent years. Loans to borrowers with high DTIs and low FICO scores have fallen from nearly 10% of collateral securitized to less than 2% of loans securitized through the first nine months of this year. The presence of loans to high DTI borrowers with high LTVs have fallen substantially as well. They represented 10.2% of loans securitized in non-QM trusts in 2019 and made up less than 3.0% of collateral securitized this year.
The decline in high DTI, high LTV loans should represent a meaningful improvement in the credit profile of the broader cohort. Particularly when looking at the performance of these loans in other exposures to residential mortgage credit. Credit performance of loans referencing GSE credit risk transactions has been relatively pristine with one notable exception. The 2019 high LTV transactions, which were comprised of large populations of high DTI loans, were marked by elevated delinquency rates, particularly when compared to other vintages of high LTV deals that carried substantively smaller populations of high DTI loans.
High DTI cashouts remain elevated
One pocket of layered risk that has seen a decline but remains somewhat elevated is the population of high DTI loans where the borrower re-levered equity in the home through a cash out refinancing. High DTI cash out refinancings comprised 13% of loans securitized in 2019. However, the caveat here is that DTI was the primary metric by which a loan was deemed to fall outside the scope of a ‘Qualified Mortgage’ prior to the adaptation of a rate-based metric in 2021. As such, earlier vintages of non-QM deals will almost definitionally carry larger swaths of high DTI loans.
Exposure to high DTI cashout refinances peaked in 2019, as 13% of loans securitized that year were high DTI cashouts. That cohort represents just 6.7% of collateral backing deals this year but still remains by far the largest exposure to layered risk, 400 bp greater than high DTI, high LTV loans. However, as highlighted in previous analyses, DTI, in isolation, has been a fairly weak predictor of credit performance across the non-QM cohort broadly. Which begs the question ‘Do high DTI cashouts actually pose substantial credit risk?’
In this instance, the answer appears to be ‘yes.’ When isolating the cohort for only cash out refinances and then looking at serious delinquency after bucketing collateral by DTI shows signs of elevated delinquency rates on higher DTI cashouts (Exhibit 2).
Exhibit 2: DTI matters when it comes to cash out refinances
Note: Cash-out refinancings by DTI.
Source: Santander US Capital Markets, CoreLogic LP
While performance when measured by DTI has been somewhat mixed in prior observations, the more recent trend is higher DTI cashout loans are performing worse. These observations are consistent with others we have noted in the non-QM market where it appears elevated debt burdens are driving underperformance across the cohort as borrowers whose increased debt burdens are now making up a more meaningful portion of gross income are underperforming relative to the broader cohort.
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