The Oakleaf Group recently attended IMN’s 28th Annual ABS East conference. Over 4,000 structured finance professionals gathered in Miami, Florida to gain insights on developments within the securitization industry.
This year’s event included sessions covering various topics, including CLOs, CMBS, ABS, RMBS, and ESG. Key takeaways from Day 1 RMBS panels are as follows:
Home Prices: The Real Estate and Mortgage Market Dynamic session focused on home prices, loan quality, and origination volume. A poll of the audience regarding its expectations for home prices in 2023 indicated that roughly three-quarters of respondents expect prices to drop by 10% or more, although some panelists were less pessimistic. However, distinctions were drawn between the impact of current house price declines on mortgage performance versus those that occurred during the Great Recession.
Unlike the previous crisis, there remains a persistent housing supply shortfall and to date new home construction has not recovered to pre-2008 levels. Also, home price movements are localized due to migratory patterns. For instance, prices and inventories on the West Coast have reacted quickly to rising mortgage rates by softening prices and increasing supply, while other areas like Miami continue to see elevated prices and limited inventory due to ongoing migration to Florida. Another distinction between the current situation and the previous crisis is the exposure of home price tiers to vulnerabilities. In today’s market higher priced homes are experiencing greater softening in comparison to lower priced homes, whereas during the 2008 crisis, lower priced homes experienced the steepest declines.
Underwriting Quality: Underwriting quality and low loan-to-value ratios (LTVs) for recent originations are sound and will serve as key mitigants to default and losses during a housing and economic slowdown. However, a sizeable portion of originations are loans made to ITIN borrowers (Individual Taxpayer Identification Number assigned to resident aliens and non-US residents), investor loans underwritten to a debt service coverage ratio (DSCR), and asset-based lending (i.e., asset depletion loans). Risks associated with these loan programs feature the lack of performance data during a downturn and little transparency and heterogeneity in underwriting programs. DSCR loans also face the risk of tenants’ inability to meet rent and deal cash flows . Offsetting these risks are the relatively low LTVs and equity cushion that provide protections against default and loss risk.
Prepayments: Prepayment speeds have dropped from their peak speeds of 40-50% and are likely to drop to 6%. Borrowers are both locked-out and locked-in. Prospective buyers are now facing a 55% higher mortgage payment and buying power is down 35% which will hamper new home purchases, historically accounting for most prepayments. Locked-in borrowers have ~3% rates and are unlikely or unable to trade-up or cash out refinance. These borrowers will look to second liens for financing to the extent home prices support the additional debt.
Credit Risk Transfer: CRT issuance is expected to decline in 2023 due to lower origination and refinance volume. Affordability products (HomeReady and Home Possible) programs are likely to grow and become a larger portion of volume as Fannie Mae and Freddie Mac focus their attention on expanding access to credit and increasing affordability. The expectation is that they will loosen current restrictions. Credit fundamentals are still strong; however, modification losses are starting to be factored into pricing due to higher rates and more room for rate cut modifications if economic conditions deteriorate and delinquencies increase.
Nonagency RMBS: Volume is down substantially, especially in prime jumbo, as the bank portfolio bid is strong. Non-Qualified mortgage (NQM) volumes are down year over year by 30% and flat from last quarter. Spreads continue to exhibit volatility, which are making issuance conditions challenging. Given that adjustable-rate mortgages (ARMs) are not a large part of the market, payment shock risk will not cause a sharp rise in delinquencies; however, RMBS with heavy concentrations may be at risk. Offsetting the payment shock risk is the Ability to Repay Rule’s underwriting requirement to the fully indexed principal and interest payment. However, with the 400bp increase in rates, more ARM originations, 10-year interest-only loans and 40-year loan term loans are likely to grow. Non-bank originators’ financial health depends on whether they have a deep-pocketed parent or have mortgage servicing rights (MSRs) to sell to raise capital. However, more complex mortgage products are serviced by companies without capital or owned by financially sound parents. Call optionality is a concern with lower prepays, especially if higher delinquencies/modifications occur. Most sponsors own the residuals and are at risk of cash flow stoppages if performance deteriorates and these holders own the call rights.
Environmental, Social and Governance: ESG measures are an increasing focus of investors and issuers alike and is firmly here to stay. However, for ESG to gain more traction in U.S. structured finance, regulation and consistency in measures is needed. A common language to define ESG is needed, but balance in regulation is key. Excessive restrictions will not work. Striking a balance between loosely-written regulations, which could result in “greenwashing” (a tactic that promotes an ESG program but products have no substantial ESG features), and those that are too rigid and stifle innovation and issuance require dialogue and a harmonization of issues from regulators, communities, issuers, and other stakeholders.
A program such as loans made by Community Development Financial Institutions (CDFIs) would satisfy the social component, but it is a nascent product and warehouse financing is currently insufficient for this market to grow meaningfully. Solar panel ABS is another example of an ESG-specific program and has been positively received by the market but needs more commoditization for the market to grow.
The mortgage and housing markets are facing headwinds in 2023 but sound underwriting and credit quality will offset performance deterioration should economic conditions weaken. ESG continues to be a focus as the market works towards greater transparency and developing common measures.
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