The post-crisis RMBS market ended 2016 looking like a model child in the credit markets, driving down delinquency rates on multifamily and commercial mortgages to levels well below 5% among the five major investor groups.
Historically low interest rates have played a key role in that development, first by giving banks incentive, through low-yielding deposits, to keep mortgage loans on their balance sheets instead of securitizing them. Only loans that met qualified residential mortgage requirements were securitized, which gave RMBS portfolios a head start with healthy pools of loans. For borrowers who qualified for mortgages under tighter underwriting requirements, the low rates have made mortgage financing more affordable, so they kept up with their payments. Prepayment levels were also higher.
Three investor groups saw decreases in delinquencies in the loans on their balance sheets from Q3 2016.
- Banks and thrifts: 90-day-plus delinquency rates were 0.59%; down 0.03 percentage points from Q3 2016
- Life companies: 60-day-plus delinquency rates were 0.04%; a 0.04 percentage point drop
- Fannie Mae: 60-day-plus delinquency rates were 0.05%; down from 0.02 percentage points from Q3 2016
Two investor groups saw increases:
- Freddie Mac: 60-day-plus delinquency rates were 0.03%, an increase of 0.02% from Q3 2016
- CMBS: 30-day-plus delinquency rates were 4.53%, an increase of 0.30 percentage points from Q3 2016
Other asset classes, such as credit cards, have done well, too. In its Q4 analysis of credit card ABS performance, Fitch Rating found that charge-off rates had fallen to 2.51%. But that still doesn’t beat the mortgage market.
Times are about to change, however, after the Federal Open Markets Committee decided to raise the target federal funds rate to within a range of .75% to 1%, and indicated that it would continue to increase rates over the next couple of years. As the credit markets operate in an environment of increasing borrowing costs for the next couple of years, how will the mortgage finance market adapt?
“We could expect that some of those deposits could leave the banking system,” said Mike Fratantoni, chief economist of the Mortgage Bankers Association. “They could go to other instruments that have higher yields.”
As short-term rates increase, you could see the amount of private label securitization go up a fair amount, Fratantoni said, especially if most mortgage loans on bank balance sheets meet the qualified residential mortgage standards for exemption from the risk-retention rules.
Even so, the market cannot expect to see an astounding increase in securitization of mortgage loans, especially from banks. The institutions have issued a very little private-label RMBS deals over the last couple of years. In 2016 QRM RMBS deals accounted for about $10 billion out of an almost $2 trillion total asset-backed securitization market, Fratantoni said. This year issuance is expected to pick up, and could reach $20 billion. That amount would be a mere echo of the expected $1.6 trillion total ABS market.
Increases in interest rates create more coupons on loans – extra cash. Issuers will have more options before them when weighing which approach makes the most sense for managing the loans on their balance sheets. If the RMBS market did drastically increase its issuance from 2016, the move could be memorable – as long as dealmakers also remember to install a few safety guardrails. It would most likely begin with the issuers.
To the extent that some issuers were expecting interest rates to remain flatter for a longer period, they might change their expectations to reflect the fact that prepayments will likely decrease, said Jack Kahan, a managing director for residential RMBS at Kroll Bond Rating Agency.
Depending on the product type, lower prepayment rates could lead to delinquencies and defaults – but not by large margins, initially, Kahan said. Should that happen, then the RMBS market could see minor or moderate increases in subordination. delinquencies.
Should subordination levels increase, then inquisitive investors will become a first line of defense in restraining the enthusiasm of eager dealmakers. Even with additional tranching, the structures of future deals would need to be clear to investors who are trying to price bonds. That might seem obvious now, but think about the Pandora’s Box of troubles that creative deal structures unlocked during the last financial crisis. Also, remember that the new presidential administration is taking a closer look at the regulatory environment, with a scalpel in hand.
The state of the RMBS market looks very different from the days when demand for the bonds ultimately drove half of all mortgage originations. Nowadays deals are less complex. Underwriting standards are tighter and borrowers are more cautious. It is tempting to attribute the markets’ relative smooth sailing lately to the idea that lenders and borrowers simply know better this time around. Astute observers of market behavior, however, know that it is all too easy for institutions and consumers to lose their way and run aground. If higher rates translate to higher-yielding bonds, then the market will have to fall back on firmer mechanisms to keep its enthusiasm in check as it seeks to maximize profits from the current changes.
“Market conditions and credit standards tend to be cyclical, and the market has swung from being loose to tight,” Kahan said. “What you don’t want to have happen is these two things swing back in the same direction at the same time.”