By Brendan Teeley, Senior Vice President, Whole Loan Sales & Trading
GNMA Early Buyouts (EBOs)
EBO pricing is at record highs as APM 20-07 increases the burden on servicers and owners to re-pool their delinquent GNMA loans. The requirement of 6-month consecutive payments means that borrower must be current for effectively 7 consecutive months prior to re-pooling. For additional details, see the “Update on RG Pooling Mechanics” elsewhere in this issue. This re-performance requirement creates both performance (i.e., some assets will not re-perform) and rate risk (i.e., those assets which do re-perform will have significant duration). This duration risk is exacerbated by the fact that re-performing loans have slower voluntary prepays than clean current loans. Left unhedged, a rate rise could reduce or even eliminate much of the potential profit. This reality has compelled many owners to sell into record-high pricing, in many cases recouping all expenses. The owner has then laid off nearly all risks, including compliance, litigation, foreclosure, interest rate, performance, HUD Score Card, and perhaps, most importantly, headline risk.
The three most recent large transactions have been bought by large funds in pursuit of attractive risk-adjusted yields. Pricing has consistently centered around par of Total Balance, subject to loan-level detail. Pricing has been strong enough to justify a true sale as opposed to the popular financing opportunities that have been a common strategy in recent years. These financing structures have carried both interest rate and performance risk and the opportunity to avoid these significant potential downside exposures has been compelling.
Scratch and Dent (S&D)
The Scratch and Dent market continues to push through to higher prices and lower yields for buyers as capital sources shift toward the space. The biggest problem in the space is a lack of product availability, both in deal size, but also in total volume. There is plenty of capital available, and sellers with sizable deals ($5mm+) are receiving better pricing.
We do expect that increasing mortgage rates have reduced the opportunity of using a refinance to cure defects. This will ultimately lead to more selling rather than curing, a similar cycle that we have seen in recent years. When rates increase, the benefit to borrower hurdle becomes a more costly one that often points towards a sale as a preferred resolution. COVID deferrals have certainly added a layer of complexity to these transactions as well. Also, record production generally results in higher defect rates, due to over-stretched staff as well as time limits in purchase transactions. However, the elevated gain-on-sale margins experienced by originators in recent quarters allow for more than a complete offset of the price discounts reflected in scratch and dent activity.
Fix and Flip
The Fix and Flip market has grown considerably with the introduction of two very large sources of capital this year. These non-owner-occupied (i.e., NOO) loans have 1–3-year terms, carry note rates in the 6-9% range and are primarily made to professional investors. Despite the soaring home prices, there is still money to be made in the renovation space and the originators in that space are reporting large increases in production as well as the opportunity to charge higher interest rates and capital trails demand. All rate and term refinance markets inevitably run their course – either through a rate backup or a re-setting of the outstanding mortgage universe. The Fix and Flip market provides originators with an opportunity to maintain volume in a flat or rising rate environment. In addition, originators can grow their client base and have the opportunity for multiple transactions per client.
Non-Performing loans have benefitted from the nationwide increase in HPA over the last few years. For example, according to the FHFA, nationwide home prices rose 15.7% between April 2020 and April 2021. Other indices exhibit similar or larger gains. Higher home prices benefit the NPL market by increasing self-cures, increasing the probability of a foreclosure alternative (such as short sales), and lowering loss severities upon liquidation.
However, the confounding fact is that COVID (and the resulting servicer guidelines and foreclosure and eviction moratoria) has made forecasting liquidation timelines highly problematic. As discussed in the Liquidation Timelines piece in this issue of MIAC Perspectives, the transition of loans from Seriously Delinquent to either Liquidation (i.e., via short sale) or to REO loans has completely stopped.
This backlog of foreclosure cases will likely lead to greater strategic defaults and prolonged judicial proceedings. It may well be the case that borrowers will be able to stay in homes without making any payments for even longer than we saw during the GFC in 2008-10. An activist CFPB will further burden servicers.
An unintended consequence of COVID deferrals – equity stripping by accumulated deferred payments – will show up in reduced borrower mobility in the coming years. A high-LTV borrower, such as an FHA purchase borrower that rolled in their closing costs and perhaps even the down payment, is especially vulnerable to this reality. Despite the rapid increase in home values, the accruing interest and escrow advances may outpace home price appreciation. We have seen in the last downturn how a borrower with limited equity, the opportunity to occupy the property for a lengthy period before losing title and occupancy, and protection from deficiency judgments may have little motivation to resume or continue making mortgage payments.
Whole Loans: Mid-Year Market Update
Brendan Teeley, Senior Vice President, Whole Loan Sales & Trading