Subprime mortgages (that is, loans made to subprime borrowers) are like the dinosaur — extinct. But as Ian Malcolm said in the movie Jurassic Park … life finds a way. They simply morphed into a less-threatening sounding product: the non-qualified mortgage (NQF).
(Bloomberg) The subprime mortgage-backed bond may be dead in America a decade after it helped trigger the global financial crisis, but a security with some of the same high-risk characteristics is starting to take off.
It’s called the non-qualified mortgage — basically a loan granted to borrowers whose checkered financial record made them ineligible for conventional mortgages.Lenders have bundled more than $18 billion worth of these loans into bonds this year that they then sold to investors, a 44% increase from 2018 and the most for any year since the securities became common post-crisis.
This surge in issuance of non-QM bonds, as they’re called, comes just as some initial indications of delinquency rates on the loans are starting to emerge. The short answer: They’re high. About 3% to 5% in some bonds, according to Barclays Plc. That’s multiples of the current 0.7% delinquency rate on Fannie Mae loans.
And while no one is saying these bonds are in danger of defaulting any time soon, their newfound popularity does reflect the growing risk that yield-starved investors are taking to boost returns at a time when the U.S. economy is slowing. It’s similar to the way demand for junk bonds and securities backed by fast-food franchises and private credit have all surged this year. In the case of non-QM bonds, coupons on the debt can be north of 5%. A typical Fannie Mae mortgage bond sold nowadays has a coupon closer to 3.5%.
“It’s obviously disturbing this late in the cycle to see originations for these loans at the kind of level they’ve kicked up to,” said Daniel Alpert, managing partner at Westwood Capital. “The housing market is not quite ready for a big infusion of this product.
The non-QM bond market is for now, at least, way too small to cause the kind of broader disruptions that subprime bonds did when they soured en masse a decade ago. (That’s what she said!) Moreover, the bonds are built to withstand tougher housing downturns than they used to be, and the borrowers aren’t as risky. The securities may face some sort of hit if the housing market weakens, but it won’t be severe, Alpert said.
“It’s not the subprime we remember from 2006 to 2007,” said Mario Rivera, managing director of the Fortress Credit Funds business, which has bought non-QM bonds. “It’s more of a second or third inning of non-QM. We’re getting the best collateral before the more aggressive lending comes in.”
But fund managers’ willingness to plow money into these securities shows how the intense suspicion that met mortgage bonds after the housing bubble burst last decade is starting to slowly fade. The subprime mortgage crisis triggered hundreds of billions of dollars of losses for investors.
There are more than $27 billion of outstanding bonds backed by non-qualified mortgages now, a small fraction of the approximately $10 trillion mortgage-bond market. In 2007, there were around $1.8 trillion of bonds backed by loans to non-prime borrowers.
The “non-qualified” moniker refers to any mortgages that don’t meet rules from the Consumer Financial Protection Bureau that went into effect in 2014. Many investors and issuers expect the market for non-QM bonds to grow. A temporary rule that lets Fannie Mae and Freddie Mac buy some home loans that don’t meet all the qualified-mortgage rules is set to expire in 2021. That will result in more debt being available to be bundled into non-QM bonds. Redwood Trust Inc., which issues mortgage securities, estimated in May that some $185 billion of home loans bought by the government-backed agencies annually would be considered non-QM.
JPMorgan, Angel Oak
A handful of lenders, including JPMorgan Chase & Co., Angel Oak Capital Advisors and Caliber Home Loans have been making the non-qualified mortgages and bundling them into bonds.
Borrowers’ scores in non-QM bonds are typically lower than what’s seen in other mortgage securities without government backing, like credit-risk transfer securities. But the consumers typically have relatively small debt loads compared with their incomes and the value of their homes. In many recent deals, non-QM borrowers have average credit scores in the low to mid 700s, a level credit reporting groups generally deem “good” to “very good.” Subprime borrowers typically have scores of 660 or less.
The bonds themselves also have more safeguards for investors than they used to. According to a Fitch Ratings analysis, an average of 36% of principal would have to be lost before the top-rated slice took a hit. The cushion in crisis-era “alt-A” bonds with the same rating was just 6%.
“There’s a lot more cushion, as there should be,” said John Kerschner, head of U.S. securitized products at Janus Henderson Group Plc, which manages $360 billion. “You can get some comfort that even if defaults inch up, the losses from those defaults aren’t going to be egregious.”
But even if non-QM bonds aren’t toxic, they have real risks. Many borrowers with non-qualified mortgages offer lenders bank statements to verify income instead of more stringent tax returns. Fitch says such documentation may offer only partial verification, and these borrowers could have unstable income because, for example, they own small businesses.
Making non-qualified mortgages can be legally riskier for lenders. If a borrower misses payments, and it turns out they shouldn’t have received the loan in the first place, they can sue the lender or even the securitization trust that owns the loan. Qualified mortgages have more legal protections for lenders and bondholders.
The strength of the housing market has helped support the bonds for now. Home-price appreciation has slowed over the past year, but the average U.S. house value still rose more than 2% in August from a year earlier, according to S&P CoreLogic Case-Shiller data. In a downturn similar to the financial crisis, when home prices contracted around 34% between 2006 and 2012, Barclays expects only the riskiest, lowest-rated portions of most non-QM bonds to lose money.
That’s partly why Barclays says the top-rated portions of non-QM bonds are a good buy at current prices. (Famous last words!) The notes tend to pay down quickly, because borrowers refinance into more conventional mortgages when they can. And the securities offer higher yield relative to alternatives like credit-risk transfer bonds.
“At least for now, credit concerns for most non-QM deals should be modest for investors who purchase the investment grade-rated classes,” Barclays strategist Dennis Lee wrote in a note in September.
That is, as long as there isn’t a home price bubble that bursts like in 2008. Like the stock market could.
The S&P 500 Index’s second fresh high this week saw the equity benchmark close just shy of 3,047 on Wednesday and continue its upward trajectory toward an overbought level.
Its GTI Global Strength Indicator — a smoothing oscillator showing the strength of a price — reached 66.5 intraday, the highest since mid-July. Earnings and Friday’s U.S. payrolls report may help to determine whether the technical gauge triggers its first sell signal since that month or remains in a neutral zone between 30 and 70.
Technical indicators are adored by many (just not academics). BUT if you believe in Bollinger Bands … the S&P 500 index (white line) is near the upper limit of its upper band (pink).
Do you believe in the Ichimoki Cloud? Currently, the NYA (New York Stock Exchange) is trading ABOVE the cloud.
How about the Hindenburg Omen? It was correct in signaling a market downturn way back in 2007, but has not really been a good forecast of market corrections since 2007.
“The financial stability environment remains challenging, as the global economic outlook has deteriorated,” Draghi told fellow policymakers on the International Monetary and Financial Committee in Washington.
“There are mild signs of overstretched valuations in the euro area in some riskier segments of the financial markets, as well as in real estate markets, with marked differences across regions.”
The ECB has acted unnaturally since the financial crisis of 2007-2009 by dropping their main refinancing rate to 0% and rapidly expanding their balance sheet.
In addition, the ECB’s M3 money growth continues to grow.
And 17 European nations now have negative 2-year sovereign yields.
The heartland of Euro (meaning Germany, France and Austria) oppose more QE (asset purchases by the ECB) while peripheral counties (Spain, Italy and Greece) want to keep on expanding the ECB’s balance sheet.
Of course, none of this Central Bank interference is natural and sets the stage for a bubble burst.
Unlike the housing bubble and “The Big Short” years of 2005-2007, when home price growth was greater than average hourly earnings growth, we are now in the opposite situation: slowing 2% YoY home price growth and the highest average hourly earnings growth rate since 2008 and President George W. Bush.
Home price growth is slowing …
As average hourly earnings growth rises to its highest level since 2008 and George “Dubya” Bush.
Using a different home price growth index (FHFA Purchase Only) and an average hourly earnings for the majority of Americans, you can see where home price growth exceeds average hourly earnings growth starting in 1998 and ending in 2006 (the “Big Short” bubble) and the QE3-induced home price bubble starting in 2012 to today.
The decline in national home price growth coincides with The Fed’s decision to let its balance sheet self-unwind.
Phoenix, my former residence, is now the fastest growing metropolitan area in the US, even faster than Las Vegas. Seattle is now the slowest growing metro area in terms of home prices and is actually declining. San Francisco is barely above 0% at 0.7% YoY.
The FHFA purchase-only home price index YoY has fallen to 1.0.