By Nicholas Dorn, SVP, Whole Loan Sales, Trading
The overarching themes in the whole loan market are much higher rates, wider spreads, inflation, stagnating or declining home prices, and declines in existing home sales. We provide an overview and analysis of these data in the Market Overview article in this issue of MIAC Perspectives.
Scratch and Dent (S&D)
The Scratch and Dent market has continued to be an important tool for non-bank originators and others in the space with limited balance sheet capacity. Originators can eliminate both credit and interest rate risk by selling loans that would otherwise adversely affect their warehouse lines or balance sheets. In an environment with heightened rate volatility and uncertainty regarding the magnitude of prepayment extension risk for deep out of the money (OTM) loans, hedging rate exposure has become increasingly challenging for many market participants.
Due to the unprecedented rate sell-off, a significant fraction of Agency and investor kickouts have note rates well below current market rates. This is due to the timing lag between origination and the time at which the S&D loans are ready for sale, which is often 6 to 12 months. This rate sell-off has effectively eliminated the refinance strategy for many S&D investors, resulting in pricing that needs to account for below market contract rates. It is common to see bids in the low 70s for 3% coupon loans, which reflects the market’s expectation of a strong lock-in effect on turnover prepayments. Often performing S&D assets will price below non-performing assets with similar characteristics. Originators are now deciding whether to keep these loans in hopes of future price improvements, or to unload them and move forward without being burdened by negative carry assets on their balance sheets.
MIAC’s Whole Loan Trading Desk is active in the Scratch and Dent space, usually executing at least one deal a week. Our seller clients can free up and redeploy capital and improve the overall credit profile of their remaining balance sheet. In addition, they avoid both the operational headaches of trying to cure the assets internally, as well as the difficulty in hedging the significant rate exposure.
The typical transaction averages $1-5M UPB, depending on the size of the originator and their aggregator relationship(s). As an important value-add, MIAC understands and classifies the defect or reason the loans are not deliverable and matches these loans to buyers who have the most favorable outlook on that type of defect. We work to minimize any friction in a sale, and by understanding the economics of each buyer, enable sellers to optimize their execution.
Non-Performing/Re-Performing (NPL / RPL)
Non-Performing Loans (NPLs) have benefitted from the nationwide increase in HPA over the last few years. This has many NPL pools going to market with significant equity when property value is compared to total debt, which includes delinquent interest, recoverable advances, and deferred balances.
These low mark-to-market LTVs (LTV-MTM) increase the likelihood of a full payoff and decrease the probability of a liquidation event. In addition, should a liquidation occur, it is (1) much more likely to be a short sale or foreclosure alternative, and (2) have a low loss severity. For more details regarding the impact of LTV-MTM on prepays, liquidations, liquidation timelines and loss severities, see our CORE™ Webinar and related publications.
The recent low unemployment rate and strong economic growth has led to a declining supply of NPLs. It can take years in some states to foreclose on a borrower and many judicial states (such as NY and NJ) afford borrowers opportunities to extend the process well beyond the agency published timelines. For more details regarding liquidation timelines, how they are handled by our Core Models, and their impact on MSRs and Whole Loans, please access our previous Perspectives issue, ‘A Closer Look at Liquidation Timelines in MIAC’s CORE™ Models’.
We do not expect to see a great influx of NPLs coming to the secondary market in the near term. In the intermediate to longer term, a significant drop in home prices or an increase in unemployment could create some meaningful supply. This past June, FNMA released the results of a May auction of NPLs with $477.2M UPB, which executed above the cover bid of 97.9%. The pools had a combined LTV of approximately 55%. In addition to whole loan brokerage, MIAC also delivers independent valuations for performing, reperforming and non-performing loans. We have provided these services to a diverse set of global financial institutions since our founding more than 30 year ago.
Re-performing Loans (RPLs) are a by-product of curing NPLs with or without an intervening modification. Pricing for seasoned RPLs with 24 months of clean repayment history is similar to that of performing whole loans with comparable levels of significant equity. This pricing is consistent with our Core models. In particular, re-performing loans with a long payment history have credit behavior that is very similar to always current loans. As the mark-to-market LTV increases, holding UPB fixed, prices drop more rapidly for RPLs than for performing loans. In other words, the LTV-MTM effect is more pronounced in RPLs than in always current loans. This LTV-MTM effect in market pricing is fully consistent with the implications of our Core Suite of Credit, Prepayment, and Loss models.
In the RPL market, as the LTV increases above 70%, the additional balances will have a diminishing value (approaching 0% for each additional $1 of UPB above the property’s market value). A recent FNMA RPL pool announced in June 2022 with a 51% LTV traded to a 5.75-6.25 yield, according to our analysis.
Non-QM / Fix-and-Flip (Bridge) Loans
Many Non-QM lenders have tightened their buying or exited the business altogether leaving a void for flow buyers of this paper. For example, FGMC declared bankruptcy and Sprout Mortgage closed their doors in June 2022. Rate increases have made trading seasoned paper more challenging as buyers require a discount to bring yields in line with current production, and sellers are unwilling or unable to recognize the loss.
If the Fed can effectively reduce inflation while avoiding a major recession, holders of this paper will be happy they held on. Otherwise, the slightly discounted prices currently offered for these products will not attract buyers. For now, the focus has turned to flow arrangements as an acceptable middle ground, where originators can find par plus pricing and buyers can take advantage of the higher current yields coming onto their balance sheets.
Short Term Bridge (aka Fix-and-Flip or Residential Transition) loans began as a niche private lending product with small lenders. However, this asset class has grown in recent years; up to $10B is expected to be originated in 2022. These loans are interest only, carry prepayment protection, and range in term from 12 to 36 months. Note rates are now in the 10-15% range. Many Bridge loans are structured with funding for repairs. Exit strategies usually include rehab and sell or refinance/rental after a credit repair or other curable event.
The origination market has grown organically, from family offices to regional mortgage originators, and now to larger originators/securitizers such as Angel Oak and Kiavi (formerly known as LendingHome). Many sellers of Fix and Flip loans attempt to retain servicing to keep their revolving relationships and pass through an 8%+ yield to their investors.
MIAC works with originators in numerous geographies to identify opportunities for both buyers and sellers. Bulk sales volume has dwindled with the rate sell-off. Flow opportunities have become the more likely win/win scenario for originators who are reluctant to sell at even a moderate discount and sellers looking to pull through at current yields. On the buy-side, there has been a great deal of capital shift toward this space in the search for yield.
MIAC Perspectives: Whole Loan Market Update – Q3 2022
Nicholas Dorn, SVP, Whole Loan Sales, Trading