The coronavirus pandemic’s impact on the U.S. economy has made national headlines as the country shut down in March and is now attempting to reopen. While the major story has been the increase in the unemployment rate from the lowest in decades — 3.5% in February to 14.7% just two months later — the percentage of homeowners delinquent on their mortgage has also risen sharply. Additionally, falling mortgage rates have incentivized homeowners to refinance their mortgages at a faster pace. Rising delinquencies and faster prepayment speeds have created additional challenges for investors in residential mortgage-backed securities (RMBS).
Rising delinquencies impact non-agency RMBS in a number of ways. Non-agency RMBS do not carry the implicit or explicit government guarantee that agency RMBS have from Fannie Mae, Freddie Mac or Ginnie Mae. In some deals, bonds have been experiencing interest shortfalls as a result of fewer borrowers making their monthly payments. As these shortfalls trickle up the capital structure, bonds further down the structure can get locked from receiving cash flow until the more senior bonds are repaid. Servicers in some deals will advance the missed payments until deemed non-recoverable, at which point the advances will be repaid from future deal cash flow and/or principal loss on the deal.
Deal structures can change as delinquency triggers are hit. In credit risk transfer (CRT), bonds can be locked out of unscheduled and/or scheduled principal. Non-qualified mortgage (NQM) deals with a pro-rata senior structure can trigger a switch to a sequential senior structure. Deals with a shifting interest structure (jumbo prime 2.0, seasoned re-performing and expanded prime) can reroute any unscheduled principal due to the subordinate bonds back to the seniors. Re-performing loan (RPL) deals are already structured sequentially and have no delinquency trigger.
Faster prepayments reduce the return on RMBS in the current environment, as most bonds are trading at a premium to par due to falling interest rates and tighter spreads. The deterioration of collateral in a deal is another risk. Borrowers with better credit and higher mortgage rates have been refinancing at a faster rate, which reduces the overall credit quality in the deal and lowers the net weighted-average coupon available to pay interest on a deal’s bonds. In addition, some of the older vintage jumbo and expanded prime deals are seeing unsupported interest shortfalls on all bonds in the deal — including the senior bonds — as a result of intra-month prepayments and insufficient compensating interest provided from the servicing fee structure.
Key Takeaway
The current environment for investing in non-agency RMBS is challenging. A one-two punch of rising delinquencies and faster prepayment speeds, along with ever-tighter spreads, has valuations looking expensive. Investors in the RMBS sector need to fully understand the changes in cash flow and deal structure and composition that are ongoing during this period of unprecedented economic uncertainty created by the coronavirus pandemic.
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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