The non-agency residential mortgage-backed security (RMBS) sector continues to shrink with outstanding debt totaling $843 billion at the end of 2016, down from the peak of $2.7 trillion at the end of 2007. Issuance has yet to return to pre-crisis levels. Issuance in 2016 was at $84.2 billion, compared to $1.3 trillion per year in 2005 and 2006. Despite the non-agency RMBS sector’s inability to meaningfully return to its pre-crisis volume, a number of new post-crisis subsectors have been created by banks and non-bank issuers to try to jump start the sector. I see value in some of these new subsectors, such as post-crisis jumbo prime RMBS (referred to as “2.0”) and re-performing loan (RPL), and have chosen not to participate in others, including single-family rental (SFR), credit risk transfer (CRT), and non-performing loan (NPL). This week’s chart highlights two strong fundamentals in the sector to support interest in housing finance securitizations. Home prices have grown at a 5-year compound annual growth rate (CAGR) of 6.3%, and U.S. household debt as a percentage of gross domestic product (GDP) has decreased at a 5-year CAGR of -1.8%. These metrics bode well for the financial health of the typical U.S. mortgage borrower.
There is distinct reasoning behind the subsectors where we do not see value.
- The SFR subsector is backed by cash flows from rental properties. We currently see little value due to lack of a long-term commitment from large sponsors in the space and performance issues the sector experienced due to vacancies exceeding initial forecasts.
- The CRT space has overcome some of the initial issues in the sector, including new program volatility and National Association of Insurance Commissioners (NAIC) rating discrepancies. However, the tight spreads and short weighted-average lives in this subsector make the yields unremarkable compared to other opportunities.
- The NPL subsector is characterized by professional house flippers, who buy distressed homes on the cheap, remodel, and then sell them for a profit. While this business model works well during times when housing is healthy, these deals tend to come to market without ratings, which reduces liquidity and causes capital charge issues for insurance companies.
On the other hand, we see opportunity in the 2.0 and RPL subsectors. The trailing twelve month (TTM) average conditional prepayment rate (CPR) has averaged 19.6% for 2.0, which is faster than the typical pricing speed of 15%. The TTM average constant default rate (CDR) has averaged one basis point (bps) for 2.0, which supports the typical CDR assumption of zero when modeling 2.0. Additionally, 2.0 is characterized by super-prime borrowers on primarily 30-year fixed mortgages. Due to the relatively lower levels of credit enhancement in 2.0, stress case scenarios typically suggest caution at BBB and lower rated levels in the 2.0 space. The RPL space is currently characterized by a TTM average CPR of 10.4% and TTM average CDR of 19 bps. The credit quality of the underlying borrowers in RPL deals is most definitely weaker than what is found in 2.0. However, the rating agencies have required credit enhancement levels that the market now believes to be excessive in these RPL deals, which provides confidence from a principal protection standpoint.
Key Takeaway:
U.S. housing finance continues to be dominated by agency issuance, as the private sector continues to grapple with how to return to the sector. However, despite their smaller sizes, various post-crisis non-agency RMBS sectors provide good value and are supported by strong economic fundamentals, including strong home price appreciation and declining household debt. We will keep a close eye on interest rate expectations, as speeds could be dampened if the 10-year continues to sell off due to Federal Reserve rate hikes.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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