By Brendan Teeley, Senior Vice President, Whole Loan Sales & Trading
Prior to COVID-19, unemployment was at a 50-year low and inflation was also below the Fed’s target of 2.0%. A significant portion of the U.S. economy closed and remains closed due to COVID-19. Real GDP growth fell during the second quarter by a nearly unprecedented 31.4%, numbers that we have not seen since the Great Depression. This directly impacted mortgage performance in ways that we could have never imagined. In March, the Mortgage Credit Availability Index contracted by an average of 16.1% across all mortgage classes – reflecting increased risk aversion within the mortgage industry. The shutdown of industry, manufacturing, and retail, with no end in sight, created a great deal of uncertainty which caused capital markets to freeze up. This caused the government to step up and inject liquidity into the economy via the CARES Act. Current mortgage deferral rates are continuing to improve, down to 5.4% in total, or 2.7 million mortgages, except for very specific geographies where the shutdowns are more pervasive.
COVID-19 deferrals and the restriction on delivering loans that were not contractually current caused a temporary bottleneck in production for many originators. Fortunately, the GSEs moved quickly to resolve the issue by restoring liquidity during this challenging time. The ability of workers to work remotely provided opportunities and increased demand in secondary housing markets. This also fueled the moving economy, home sales, and of course, mortgage demand.
The disruption in March caused many originators to either shutdown operations, face margin calls, or markdown their books in an adverse fashion. The lack of non-QM capital markets has contributed to the lowest levels of credit availability since 2015. This is largely attributed to the higher funding costs, increased defaults, and the likelihood of continued forbearance.
Non-QM 2.0 issuance has begun to ramp up production slowly, like in 2014 when the product was primarily originated by depositories and sold to insurance companies and pension funds. The majority of current non-QM production is much higher quality: 24-month bank statements, higher minimum FICOs, and lower maximum LTVs.
Delinquency rates on 12-month bank statement (BS) loans spiked to much higher levels than delinquency rates on 24-month BS loans earlier this year, in part because the CARES Act helped employees much more than the self-employed, which are overrepresented in the 12-month BS programs. In fact, research from the Becker Friedman Institute at the University of Chicago found that between April and July 2020, 76% of workers eligible for regular Unemployment Compensation were eligible for benefits that exceeded lost wages.
We expect that loan officers will continue to focus on higher balance and high credit quality Agency loans and FHA/VA streamlined refinances over the near term. This is because, in light of the loan officer compensation rules promulgated as part of Dodd-Frank, MLOs cannot be compensated at a higher rate for the more difficult loan programs. However, as the population of these easier-to-originate loans get refinanced, loan officers will turn their attention back to non-QM originations to maintain volume.
Non-QM loan performance is driven by many of the same factors that drive Jumbo, Agency, and FHA/VA performance. For example, DTI, FICO, LTV, and SATO are big drivers of credit performance. Similarly, age, balance, refinance incentive, and burnout are important drivers of prepayments. However, MIAC’s research has found that originator and servicer play a much more important role in non-QM credit performance than in Jumbo and Agency. Also, our research has found that non-QM prepayments have very different aging profiles than those found in other sectors. This is because a significant segment of the non-QM market is effectively bridge loans. Once the Agency Bankruptcy or Foreclosure seasoning requirements are met, non-QM borrowers will refinance out of their non-QM loan into an Agency loan on much more favorable terms. This is particularly important for conforming balance non-QM, which form the bulk of the sector. MIACs has developed specialized non-QM collateral models, deployed in our Vision platform, to capture this sector-specific performance.
Scratch and Dent (SD)
The Scratch and Dent market for Agency kickouts loans has been robust in 2020, driven largely by the tremendous volume of new originations. With pressure to close loans on time, the challenge of on-site appraisals, and the disruption caused by the shift to remote work amongst mortgage originators, the defect rate has increased. The large volume of purchase transactions, which tend to have higher DTIs and higher LTVs, can lead to greater performance, appraisal, and income defects. Fortunately for sellers, SD demand is robust, and pricing is as strong as it has ever been. This pricing, combined with very low interest rates which limit the availability to cure the defect, has created a situation where the best execution is often a loan sale.
GNMA Early Buyouts (EBOs)
GNMA EBOs have become one of the most desirable alternative asset classes, as many of the large funds who had been buyers of non-QM are now exploring other asset classes to deploy capital. The risk/yield relationship is very attractive to this buyer base. Despite several very large sales this year, it has been difficult to satisfy the market. We have seen that the complexity of these transactions and disposition has been underestimated by some accounts as they wade into the universe of government regulations. The competition for these loans has driven prices to levels we have not seen since a very brief period in late 2018 when a potential HUD auction was circulating.
EBO pricing has largely been dependent upon the size of the offering, with the larger deals (e.g., >50 million), receiving markedly better bids, centering around par. The volume of this trade has started to contract recently, largely due to COVID-19 relaxing and greater certainty regarding borrowers’ futures. MIAC is active in the EBO space and currently provides monthly valuations of nearly 20 billion GNMA across a range of clients.
Non-Performing Loans (NPLs)
Pricing has improved to levels not seen in recent years, largely driven by demand, lack of deals, and more capital chasing these yields in whole loans. With the contraction in the non-QM market, many funds were left with capital to deploy, and NPLs provide an attractive risk-adjusted yield. As originators have had record years, there has been less bandwidth to do anything other than originate. These gains in new origination this year are a great tool to offset any losses that may be realized in a non-accrual sale.
There are numerous sources of uncertainty impacting the volume and pricing of NPLs. First, policy risk exists in terms of the size, timing, and terms of additional Federal stimulus legislation which will impact the ability of borrowers to make timely payments. Importantly, new legislation could easily advantage wage earners over self-employed borrowers, which would further bifurcate the credit performance we witnessed earlier this year. The second source of policy risk is foreclosure and eviction moratoria which can be enacted and extended at the federal, state, municipal, and program levels. For example, all properties secured by VA-guaranteed loans are subject to a foreclosure and eviction moratorium through February 2021, which was originally set to expire in December 2020. Third, a new administration with an emboldened CFPB could easily impose additional servicer mandates that raise costs and extend timelines. The pace of economic recovery will also impact the population of borrowers who can re-instate or otherwise cure, and the level of rates will impact the availability of payment-reducing modifications.
Looking ahead to 2021 and beyond, there is likely to be a flood of NPL loans into the marketplace. Combined with additional supply in the non-QM market, we expect that gains in NPL pricing experienced in 2020 will abate or even reverse. And faced with the extended time frames and expensive servicing obligations, a sale is often a more compelling option, especially if in-house default servicing capacity does not exist.
Any serious analysis of NPL valuation and risk needs to accurately forecast the frequency and timing of borrower reinstatement, liquidation timelines, and loss severity given default. MIAC’s CORE™ Residential Model Suite provides a comprehensive and consistent framework that accommodates each of these features, as we have discussed in recent CORE webinars. As highlighted in these presentations, the above model components are fully and consistently integrated. As an example of this integration, any increase in liquidation timelines (e.g., due to a foreclosure moratorium) will automatically increase loss severities due to increased tax and maintenance expenses. For more details regarding our framework for Liquidation Timelines, see our November 2019 issue of MIAC’s Research Insights Series.
Outlook for 2021
The impact of COVID-19, from a macro perspective, as it affects both employment and the economy, but also the mandated forbearances in the mortgage space, will continue through mid-2021 at a minimum. The political climate will likely lead to additional availability of mortgage forbearance programs, at least through Q1 and likely Q2.
Once forbearances run out, there is a limit to what servicers and taxing authorities can afford to float, some percentage of these loans will ultimately default. Will the overhang of deferred balances impact the mobility of borrowers who may need to move to find new employment? This is just one question that will need to be addressed.
On a macro level, there are simply some borrowers who will have challenges in resuming payments, perhaps their employer was a victim of COVID-19, or other factors affect their ability to pay. These loans will likely convert to non-accruals and continue down a path to REO. This will create a burden on mortgage insurance companies and GNMA that will ultimately trickle up into the broader mortgage financing market, impacting all borrowers to some degree.
The bright spot in the mortgage market is that there is sufficient capital waiting to be deployed at the right time. That may come when forbearances end, when there is clarity in the economy, or when the judicial risk in certain states is better understood. The largest challenge in this economy is simply uncertainty. If a vaccine eases this, or if additional taxpayer bailout monies are made available, liquidity can only improve.
MIAC Perspectives: 2020 Market Retrospective
Brendan Teeley, Senior Vice President, Whole Loan Sales & Trading