Mortgage Lending and RMBS: Market Momentum Heading into 2020

With political turmoil, mixed economic signals and some industry-wide changes afoot, unpredictability seems to be the hallmark of the RMBS market. Since unpredictability can make people more dependent on predictions and past experience, we’ve identified some of the key events of 2019 and where they might lead in 2020.

Mortgage Lending and Securitization

In 2019 we reported on mortgage loan and RMBS performance numbers and noted how much non-qualified mortgages are driving business. While some say non-QM mortgages raise subprime issues from the past, they don’t seem to be a subprime disaster in disguise, as many are being taken out by prime borrowers with higher FICO scores. There is certainly still risk, but it’s not necessarily déjà vu all over again.

Echoes of subprime’s past are more easily identified in other market dynamics. For example, cash-out refinances (refis), which surged in the years leading up to the housing crisis, appear to be making a comeback. In Q3 2019, 52% of refis were of the cash-out kind – up 24% since Q4 2018. We have also seen an increasing number of re-defaults from previously modified loans. In Q1 2019, that number was 21%. In the most recent OCC report from September, such recidivism stood at 19%.

Pessimism related to home purchases has been a concern. The Fannie Mae Home Purchase Sentiment Index has fallen 2.7 points to 88.8, which Fannie Mae still views as a “robust” purchase sentiment. But even with interest rate drops, 21% of a net share of Americans still don’t think now is a “good time to buy.” Wage stagnation and persistent high student loan debt, combined with higher housing prices and less housing stock, is reducing housing affordability, and as one commentator notes, this all paints a bleak picture for the housing market in contrast to Fannie Mae’s “robust” optimism.

Yet the numbers do have a ring of positivity. The NY Fed reported that third quarter mortgage originations (including refinances) were $528 billion, which is up year-over-year. The NY Fed also noted that the third quarter flow of delinquencies into 90+ days was “mostly unchanged from last quarter” at 1% and “[t]his is the lowest level observed in the data history.” SIFMA reported that overall mortgage-related securities issuances are up 3% comparing year-to-date numbers between 2018 and 2019, with an increase in agency securities (13.7%) and a decrease in non-agency (down 59.4%).

Government Reform

We noted this year that government reform is in the air for the GSEs – Fannie Mae and Freddie Mac, which now hold more housing debt than ever before. The U.S. Department of the Treasury Housing Reform Plan is out now and the main thrust is that “serious reform” is needed. In their report, the Department of the Treasury raised preconditions that needed to be met before the GSEs are released from conservatorship, including making sure an “appropriate provision has been made to ensure there is no disruption to the market for the GSE’s MBS, including its previously issued MBS.”

In a committee hearing in October, the FHFA Director Mark Calabria said that he would be willing to wipe out the GSE’s shareholders as part of the reforms, and mentioned plans for a rule to cut back on what he viewed as “charter creep.” There have also been reports of private banks hoping to win that business should the GSEs become private entities, which would be a coveted prize for any of the banks looking to gain this market share. For now, much of this is speculation, and while the landscape for what these GSEs might look like in the future is unknown, it does seem that a number of drastic approaches are being considered.

Meanwhile, although the qualified mortgage patch that temporarily provided for an exemption for Fannie and Freddie loans from qualified mortgage standards brought liquidity after the market crash, it has led some critics to complain of a market imbalance. There has been more of a push to eliminate the patch once its temporary timeline expires in January 2021 so that private-label MBS issuers could gain more market share.

Climate Concerns

We have been on the ESG (environmental, social, and governance) investing beat for a while, looking at PACE liens and how environmental concerns are impacting housing trends. But we’re now starting to see climate change impact housing finance behavior.

A study of mortgage lenders in hurricane hit areas has shown lenders increasing the percent of mortgages offloaded to GSEs in those areas. Since the GSEs do not take natural disaster risk into their pricing, the GSEs take on this greater risk, which is, in turn, passed on to taxpayers. The banks can get this higher risk off their books without any additional cost. Although large lenders questioned about this report have denied engaging in this kind of practice, it is an issue we expect to hear more about, as there may be similar patterns in other areas – perhaps California due to wildfire risk.

DeltraTerra Capital, an RMBS investment firm, is considering climate risk as part of their investment strategy for areas where weather risk is a concern. They have taken the position that mortgage investments are not priced correctly to take into account climate change, rather pointing to outdated flood maps from the government and serious gaps in flood coverage that follows from that. We expect to see more discussion of climate change in this area going forward.

Looking Ahead

While the Libor switchover is coming (it phases out by the end of 2021), it appears that many ABS issuers and banks are not quite prepared when it comes to choosing a replacement benchmark rate. The industry advisory committee has recommended Secured Overnight Financing Rate (SOFR) as the new rate. Although it has been adopted for many transactions ($1 trillion according to this article), there is still uncertainty for much of the industry.

All of these issues – the rise in non-QM mortgages, higher levels of recidivism from greater cash-out refi activity, combined with housing finance reform and climate concerns – lead us to predict more unpredictability in 2020. Unpredictability is not inconsistent with stability so long as the uncertainty is expected. It would take a market downturn to tip the balance dramatically.

Nicole Serratore, an Attorney in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post and Emily Hatchett, a paralegal in the Insolvency, Creditor’s Rights and Financial Products Group, assisted with this post.

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