In Regan’s view, the often-overlooked residential mortgage-backed securities (“RMBS”) market offers far better risk/reward trade-off than any other sector of the credit market today. RMBS is one of the only asset classes that becomes safer as it approaches maturity because the mortgage instruments naturally amortize over time. As borrowers pay their mortgage every month, the underlying loans backing RMBS de-risk. The cashflows are returned to RMBS investors, allowing them to de-risk their investment. The resulting return of cashflows can continually be redeployed, allowing for superior compounding and income generation. In contrast, other traditional fixed income vehicles such as corporate and municipal debt become riskier as the obligations come due since issuers often have to pay off debt in full at maturity rather than over time.
With an estimated $1.9 trillion in new mortgages originations expected in 2020, the US residential real estate market is one of the largest markets in the world. $10.3 trillion of the existing mortgage market is held in RMBS, second only to the US Treasury market.
Approximately $8.8 trillion of the market is classified as Agency RMBS, and $1.5 trillion as Non-Agency. This primer will serve to lay out the enormous opportunity that exists in the US mortgage market and illustrate how an investor can concurrently add cashflow and reduce duration risk and ultimately add desirable diversification within a broader fixed income allocation.
The first mortgage-backed securitizations were created in the 1980s in the form of CMOs (Collateralized Mortgage Obligations). The underlying pools of loans were government guaranteed mortgages issued by the Government National Mortgage Association (“GNMA” or “Ginnie Mae”). This eventually grew to include agency mortgages guaranteed by the Federal National Mortgage Association (“FNMA” or “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“FHLMC” or “Freddie Mac”). CMOs allowed investors to participate in specific parts of the mortgage life cycle. A dealer would tranche out interest and principal repayment into multiple layers, assigning each layer a specific priority to receive principal distributions. An investor looking for a shorter window to recoup capital, for example a money market fund, could participate in the tranche designed to pay back principal the earliest. Another investor, such as an insurance company with longer dated liabilities, may prefer a longer stream of interest payments before receiving any principal and could purchase a security with a lower priority of principal repayment. This novel concept of creating tranches and allowing investors to pick and choose their preferred cashflow profile paved the way for what would eventually become a multitrillion dollar industry.
Sample Agency CMO Structure
Eventually, private label non-agency mortgages (not guaranteed by a government agency) were being securitized into CMO structures. The creation of CMOs added liquidity to the market and allowed more participants to be involved in the secondary mortgage market, since the documentation required in owning outright pools of mortgages was often onerous and an impediment to investing in such assets. The ability to create CMOs also gave lenders a way to move interest rate and credit risk associated with mortgage assets off their balance sheet. These loans typically have one or more characteristics that do not conform to agency guidelines; therefore, they are not eligible to be sold to the agencies. Typical investors include, but are not limited to, traditional money managers, mutual funds, hedge funds, real estate investment trusts, banks and insurance companies. The structural nuances of RMBS allow investors with varying risk tolerances and return hurdles to participate in different parts of the RMBS capital structure. These investment firms are not in the business of creating mortgages, but through RMBS they can gain access to the massive mortgage market and add effective diversification and risk adjusted returns to their investment portfolios.
The most common deal structure is to create multiple tranches that participate with varying levels of compensation and risk. Every month, as underlying borrowers pay their mortgage, the principal and interest components collected are paid back to bond holders in the form of principal amortization and interest. At issuance the most senior tranche of these structures is often rated Investment Grade by the rating agencies (S&P, Moody’s, Fitch) and is first in line to receive principal cashflows while the most junior tranche is either lower rated or not rated at all and is first in line to receive losses. Senior tranche investors accept lower interest rates in order to receive cashflow priority and earlier return of capital while subordinate notes receive a higher interest rates to compensate for increased credit risk and lower priority of principal repayment. Investors in the senior most bond often include banks, insurance companies and investment grade money managers while the subordinate bond may be of interest to a hedge fund or private equity fund with a higher risk appetite and return hurdles. Below is a sample diagram of how an RMBS deal can look.
In the example above, $100 million of mortgage loans with a net interest rate of 5% are pooled together and funded by $100 million of bond holders comprising three tranches. The AAA rated Senior Bondholders are offered credit protection from the two tranches below them and will not assume even $1 of loss until the $15 million Subordinate Bond and the $35 million Mezzanine Bond are completely written off. In that scenario, 50% of the mortgage loan pool would have become completely worthless due to default, which is far beyond the losses seen even after the great financial crash of 2008. As the mortgage loans return monthly principal and interest, every bondholder receives their scheduled interest payment and every dollar of principal pays the AAA bonds holder first, until their entire $50 million investment it paid back in full. The Mezzanine Bond in next in line to receive principal, while the Subordinate Bond continues to absorb losses and wait for their return of principal, while receiving its hefty 9% interest rate.
RMBS credit risk is confined to a single trust that holds mortgage loans. Unlike corporate and municipal debt, backed by complicated balance sheets and multiple tiers of debt obligations, RMBS collateral trusts are generally first lien and static, with risks spread across many borrowers rather than one.
RMBS offer superior absolute income. Bondholders receive cashflow via interest and principal monthly, allowing investors to de-risk and redeploy returned capital more efficiently.
As an asset class, RMBS has a higher barrier to entry for investors. Today, any investor can access individual equities and corporate bonds on electronic platforms such as Fidelity. RMBS are primarily traded over the counter and require managers to rely on years of deep relationships with primary dealers and brokers in order to access more compelling and less commoditized opportunities.
Due to the complexity of analyzing RMBS, investors are compensated with superior risk adjusted returns relative to other fixed income alternatives.
The Non-Agency mortgage market is comprised of a multitude of loan types, each of which comes with various risks and mitigants. At the loan level, an investor is constantly thinking about many factors, including credit score, loan size, geography, and borrower payment history, among other things. Since RMBS investors can ultimately take a view on both collateral and structure, a focused, bottom up analysis is crucial to understanding where the best risks and rewards lie. Only after a thorough analysis of the underlying loan pool characteristics should an investor decide if they will participate in a deal, what level of tranche risk they are willing to take, and if they are being adequately compensated for that risk. We will discuss at a high level the subsectors that make up most of the currently investable universe.
The legacy Non-Agency market refers to transactions that were completely prior to the 2008 financial crisis. Most of the currently tradeable universe in this sector was created between 2005 and 2007, during the peak of the housing bubble. We typically tier legacy collateral into 3 buckets based on FICO.
FICO credit score greater than 720. These are typically the best rated borrowers with very clean credit histories but they may not qualify as agency-conforming loans due to size or other factors. Banks often make these loans with the intention of holding them on their balance sheet or securitizing them in the future.
FICO credit score greater than subprime (660) but less than prime (720). Typically, Alt-A borrowers may also have less than full documentation on their loans. Less than full documentation can simply mean they don’t receive a W-2 because they are self-employed.
FICO credit score below 660 at the time of loan origination. Subprime borrowers often have less than full documentation on their loans, higher debt-to-income ratios, and less consistent income history.
Credit crisis: as the market grew, demand for RMBS outstripped mortgage supply incentivizing lenders to find sources for new borrowers. Lending standards relaxed and the volume of newly originated subprime mortgages rose to unprecedented levels and much of these subprime mortgages were then structured into RMBS securities. Eventually these large pools of subprime mortgages began to default in large numbers wreaking havoc on the financial system. Many of the RMBS tranches created with these subprime mortgages couldn’t withstand even 5% in defaults without being wiped out so with defaults far exceeding those levels many institutions holding these securities were under significant distress. The weakness in underwriting was not exclusive to just subprime borrowers. As the appetite for more loans to feed the securitization machine grew in general, lending standards were relaxed across all tiers of borrowers leading to the eventual trouble in the housing and securitized markets.
Post-crisis opportunity: with banks no longer able to get significant leverage on these securities, a sizable portion of the buyer base left the secondary RMBS market. Supply of RMBS securities also declined as interest rates dropped to near-zero and consequently the arbitrage required for new structures went away. So in the wake of the crisis there were; 1) large numbers of defaults in the underlying mortgage pools, 2) demand was out of balance as a large portion of the buyer base went away and 3) supply was also out of balance as the new origination of RMBS structures came to a screeching halt. Prices on RMBS fell precipitously setting up one of the most profitable trades of the decade for those still investing in this asset class.
By 2010, much of the ambiguity and unknowns about the mortgage pools underlying the RMBS market had been worked out. Many of the borrowers that would default had already done so and those borrowers that had continued to pay their mortgages through the worst economic downturn since the Great Depression, would continue to pay. Prices on RMBS securities did not, however, recover until many years later. Many large hedge funds and non-bank institutions that allocated significant amounts of capital to RMBS from 2009-2013, were compensated with outsized returns, but by the end of 2013 prices had largely recovered and stabilized. Fast forward to today, the borrowers that remain in these pools are now 13 plus years into their mortgage obligation. Between principal amortization and post crisis home price recovery, the imbedded average equity in these homes exceeds 43% and grows with every monthly payment these borrowers make. As a comparison, the average equity in a home during the peak of the credit crisis was -10% and a new loan at origination is generally at 20%. An investor in senior legacy RMBS today has the benefit of collateral that has many years of payment history, borrowers that have survived the darkest depths of the financial crisis, and a massive surplus of built in equity to protect their downside.
Issuance for Prime 2.0 deals in 2018 and 2019 totaled approximately $18 billion each year, and the market is projecting about $16 billion of new issue in 2020. The new issue private label securitization market went into a long period of hibernation after the financial crisis. It took years for investors to digest the immense dislocation that occurred in legacy Non-Agency and analyze many of the underwriting shortfalls and systemic leverage that caused the sector to implode in the first place. New loans were being originated, however, lenders severely tightened up lending standards for new mortgages which they were to hold on their balance sheets. The requirements for these loans typically fit the underwriting standards required by the agencies, aside from loan size. The main drivers of risk such as debt to income, FICO, employment and asset verification, and proper appraisals were paramount to approving or turning down a new mortgage application.
Aside from better loan underwriting, the structural improvements protecting investors in 2.0 Non-Agency bonds from losses were vastly improved as well. This came in the form of higher subordination for senior noteholders and more stringent deal covenants, among other things. Pre 2008 new issue deals assumed very low potential losses in loan pools during a prolonged housing bubble, thus providing less protection measures for bond holders as investor demand persisted. The market has learned from those mistakes, and senior bond holders of new issue deals are much more insulated from losses in the collateral pool.
In 2010, the government created Ability-to-Repay (“ATR”) standards under the Dodd-Frank Wall Street Reform and Consumer Protection Act. It required mortgage lenders to make good faith determination of a borrower’s ability to meet their mortgage obligations. Subsequently, in 2014, the Consumer Financial Protection Bureau (CFPB) created the concept of Qualified Mortgages (“QM”). QM Loans were meant to protect borrowers from predatory lending behavior and provide legal protection for lenders that complied with the new standards put in place. In order to be considered a QM, the criteria below would have to be met:
After QM standards were put in place, there was still a large subset of borrowers that did not fit onto the QM box, that ultimately fell into the Non-QM category. The borrowers were not necessarily super high risk or a modern-day equivalent to subprime borrowers, they just did not fall into the more stringent QM standards for various reasons. Some Non-QM loan characteristics include:
This gap in the market brought in a host of new private lenders looking to fill the void created by QM standards. The Non-QM product has become an integral part of the mortgage origination market due to the flexibility it provides specific borrowers. The securitizations that have followed have been well received by the investment community as it has gotten more comfortable with the underwriting and structuring standards.
In 2013, Fannie Mae and Freddie Mac began issuing Credit Risk Transfer (“CRT”) deals to the private market. CRT allows investors to access a structured investment in agency conforming mortgages with a higher return than traditional agency CMOs. The loans in the program are underwritten to the usual agency guidelines, but rather than guaranteeing the credit risk in full using taxpayer money (as they would in a traditional Agency CMO), the agency is able to effectively offload part of the risk to private investors by paying them to take on the credit risk. Like other RMBS we have discussed, bonds are created in a senior subordinate structure allowing investors to participate at varying levels of risk. Each CRT transaction corresponds to a pool of roughly 100,000 mortgages. The bond holders receive interest on the bond they participate in commensurate with the level of seniority of their respective tranche. If losses occur in the underlying mortgages, losses in the CRT deal is are allocated to the junior most tranches first, then make their way up the capital structure. Principal repayments are paid top down, benefiting the senior most investors first. In order to continually keep the agencies’ interest aligned with investors, the agencies retain a portion of each tranche they create as well. This is treated as “skin in the game”, giving investors additional comfort in the quality of the loans and CRT structure being presented. Since the inception of the program, the agencies have issued over $2.1 trillion of CRT securities to the marketplace.
The aftermath of the 2008 financial crisis left many lenders with distressed loans on their balance sheets. Even though many loans created before 2008 were subsequently put into an RMBS transaction, lenders were still left holding many loans that were never securitized. As of 2016, the size of the outstanding NPL/RPL loans was a whopping $400 billion held between money center banks, regional banks, GSEs and the US Department of Housing and Urban Development. Due to stringent capital and regulatory restrictions, it was onerous for these entities to continue holding these loans while an optimal resolution for distressed homeowners was reached. To alleviate this, lenders began selling many of these distressed loan portfolios at steep discounts to investors that are less constrained by regulations. Investors can spend more time and resources to work these loans out in a more economical way. The goal for investors is to extract value from the using three main tools:
Liquidation: Sell the property and use sale proceeds to return principal on the purchased loan
Loan Modification: Work with the borrower to get them back on track with favorable rate modifications and loan terms, thus getting the loan to reperform and return cashflow over time.
Loan Sale: Resell some of the portfolio loans into an actively traded secondary market to recoup principal. To the extent any of the loans continue to reperform, the potential sale proceeds increase.
In order to help finance the purchase of these large pools of loans, these loan investors began to issue RMBS backed by the NPL/RPL loans. The simple structure issued one to two senior notes that represented approximately 50% of the transaction. The remaining 50% would be comprised of subordinated bonds that the issuer would retain. To the extent any loans are monetized using one of the three methods described above, investors in the RMBS would receive principal back in the same top down priority characteristic of other types of RMBS. The issue does not receive any principal on their retained junior tranches until the senior holders are made whole. Additionally, if the value of the loans they purchase are deemed lower than they initially purchased them for, the losses are first applied to the junior tranches. Therefore, it is in their continued best interest to successfully figure out how to monetize the loans they securitize in these transactions.
The Single-Family Rental (“SFR”) market was created in 2013 as a way to finance the burgeoning market for detached single-family rental properties. Traditionally, hard asset investors that wanted larger scale exposure to residential rental property cashflows participated by owning multifamily assets (apartment buildings specifically purchased to rent out individual units to tenants) and structured products investors accessed these cashflows via Commercial Mortgage Backed Securities (CMBS). Because of its focus on rental cashflow yields, multifamily has fallen into the camp of commercial rather than residential property for the purposes of loan underwriting and securitization. After 2008, there was a massive glut of homes where homeowners either defaulted on their mortgage or simply walked away. While the economy started recovering, many individuals either did not qualify for a mortgage under more stringent underwriting guidelines or simply could not afford to purchase a home. This brought about an enormous opportunity for institutional investment firms to participate in the purchase of large portfolios of single-family detached homes, something the market had never seen before. Large institutions were able to purchase entire portfolios of homes in cash with very short closing timelines. This added a large amount of much needed liquidity to the housing market at a time when loan origination seized up, consumers were under enormous pressure and massive amounts of vacant inventory were left otherwise sitting on the market. There was a dramatic demand shift to renting single family homes that historically were purchased as primary residences. The SFR market eventually arose as a vehicle to securitize loans that were created to finance these larger scale home purchases.
Investors in SFR RMBS receive interest and principal on their bonds, however one key differentiation to point out is that the monthly cashflows are derived from rental income on income producing real estate and principal proceeds are not paid in full until the borrower refinances or sells an underlying property in the portfolio. Because of this distinct characteristic, SFR is better viewed as a hybrid of residential and commercial investing. This sector differs from other RMBS in how its cashflows are derived, and as mentioned, is better suited to be analyzed from a commercial real estate investment framework that focuses on rental yields, debt service coverage, and vacancy rates. However, we include it in our discussion since the assets underlying the sector are still residential homes that will derive value, liquidity and risks associated with traditional residential housing.
The RMBS market has undergone many significant changes since its birth almost 40 years ago. Through both favorable times and a historic crisis, RMBS has proven to be a resilient asset class. The housing market will always be a staple of the US economy and surviving the 2008 crisis has further strengthened the underlying dynamics of the market. This sector continues to provide some of the best risk-reward potential of all fixed income asset classes. The structure and collateral of RMBS offers all investors a unique opportunity to effectively add diversity and stable income to a broader portfolio of fixed income investments. Regan Capital’s years of experience analyzing and trading the subsectors of the RMBS market enables maximization of risk-adjusted returns in one of fixed incomes most attractive asset classes. Regan Capital’s recognition and in depth understanding of the key investment risks and their impact on each security type makes us well equipped to navigate this $10+ trillion market. We remain constructive on the sector and look forward to partnering with our clients to take advantage of the opportunities ahead as the RMBS market continues to grow, evolve and mature.