by Keith Jurow, Capital Preservation Real Estate Report
Real estate investment euphoria is widespread. An asset class for which Wall Street has provided little useful information – residential mortgage-backed securities (RMBS) – is especially vulnerable if this euphoria is misplaced.
Let’s look at the history of the RMBS market and the fundamentals behind these securities today.
The desperate search for yield
As I have discussed in numerous articles (see here, for example), high-net-worth investors as well as institutions have been in a desperate search for yield. The Federal Reserve has driven down interest rates to levels that have made it impossible to obtain acceptable rates of return for traditional fixed income investments.
Because of the Fed’s QE policy, investors are compelled to purchase riskier investments hoping that they will provide higher rates of return. Many have plunged into RMBS.
Non-agency mortgage-backed securities
Non-agency RMBS are securitized mortgages that are not guaranteed by Fannie Mae or Freddie Mac or insured by the FHA. By early 2004, the outstanding amount of non-guaranteed RMBS had more than doubled over the previous four years to $644 billion. Then the speculative mania moved into high gear. Subprime lenders were fed increasingly riskier loan applications by 50,000 mortgage brokers who recruited nearly any borrower who could sign his/her name.
With Wall Street frantically securitizing these loans and the three large rating agencies (Moody’s, S&P and Fitch) giving what later turned out to be highly questionable AAA ratings, underwriting standards deteriorated rapidly by mid-2006.
By the end of 2006, speculation reached incredible proportions and underwriting standards had completely collapsed. Half-million dollar mortgages with no down payment were commonplace. Most borrowers could get loans even when their total debt-to-income (DTI) ratio exceeded 50% as long as they had not defaulted in the previous two years.
From coast to coast, speculation had become the order of the day. Yet few analysts even hinted that this was certain to end in disaster.
As the housing insanity headed straight over a cliff, the total amount of outstanding subprime and other unconventional mortgages soared. When mortgage lending finally peaked in July 2007, an incredible $2.31 trillion of non-guaranteed RMBS were outstanding.
No one really knew the extent of the mess that was created.
Mortgage modifications designed to stop the bleeding
Before Lehman Brothers went bankrupt, a growing number of homeowners with non-guaranteed mortgages had already started defaulting. As 2008 unfolded, mortgage servicers were compelled to modify large numbers of mortgages to slow down this avalanche of defaults.
Hopes ran high that these modifications might slow the bleeding. Unfortunately, these hopes were dashed. Borrowers began defaulting on their modified mortgages in huge numbers. Amherst Securities Group (ASG) was the leading firm supplying comprehensive data on the mortgage market. They reported that by the end of 2009, 61% of borrowers with modified mortgages had re-defaulted within 12 months of receiving their modification.
A January 16 email report issued by the highly respected Inside Mortgage Finance stated that sub-prime loan modifications now totaled 62% of the loan balance of all outstanding sub-prime loans and a whopping 19% of all prime loans.
Millions of modifications have done little more than defer an inevitable calamity. The graph below showing the high rate of re-defaults makes this clear. The x-axis displays the number of months since the modification occurred.
The re-default rate for the earliest (2007-2008) modifications was extremely high because they were shoveled out to nearly every delinquent borrower. When mortgage servicers became more selective, default rates for later modifications dropped substantially. Yet even the most recent modifications of 2012 and 2013 show re-default rates of 30% or more and have been clearly climbing. Delinquency rates would have been considerably higher over the past several years had these modifications not occurred.
Mortgage servicers and the advancement of principal and interest
There is one more important factor that investors and their advisors need to consider carefully.
Mortgage servicing companies have what are called pooling and servicing agreements (PSAs) in place requiring them to advance both the principal and interest due to the RMBS trustee from delinquent borrowers. Under the PSA, the servicer is entitled to be reimbursed for these up-front out-of-pocket expenses when the property is eventually foreclosed.
Advancing these payments is a major expense for the servicer. It is also very risky because there is no guarantee that the proceeds of the foreclosure sale will be sufficient to reimburse them for all the funds spent. So the PSAs have a very important escape provision. It enables the servicer to avoid advancing these payments if it determines that it is unlikely it will be fully reimbursed at the time of foreclosure. The servicer has ample discretion to make that determination.
To what extent have servicers been using this escape clause to avoid making the principal and interest advances? Take a look at this graph from TCW.
This graph is shocking. More than 41% of all seriously delinquent sub-prime mortgages did not have the principal and interest advanced by servicers in December 2014. Although the rate is much lower for prime mortgages, that percentage has been increasing steadily for the last four years, and the rate of increase has climbed sharply over the past year.
Wall Street analysts hardly ever mention this growing problem when discussing the risks or benefits of investing in the RMBS space. But it is a crucial consideration for investment advisors and their clients.
Downgrades of non-agency RMBS by Standard & Poor’s
It is fairly well known that after the sub-prime collapse began in 2007, most sub-prime RMBS tranches rated by S&P were either seriously downgraded from AAA rating or had their rating withdrawn.
What most investment advisors do not know is that S&P has continued to underestimate the expected default rates on sub-prime RMBS. In August 2012, S&P reported why it was revising its default projections for mortgages collateralizing non-agency RMBS. This is how they explained the change.
“We have increased our roll rate assumptions for loans that are currently delinquent (meaning we expect more of these loans to ultimately default). We are also raising default rate estimates for ‘reperforming loans’ vis à vis current loans.”
S&P was forced to admit that its previous assumptions on default rates for non-agency RMBS tranches were much too optimistic. This applied to both delinquent loans and modified loans that had become current.
S&P explained that its new default estimates applied to roughly 80% of all the outstanding RMBS that they rate. This included subprime, alt-A, negative amortization and prime mortgages originated before 2009.
How did it reach these revised estimates? S&P had performed an “impact study” covering about 10% of all the tranches to which its new estimates would apply. The results of this study indicated that for the sampled tranches, “approximately 30% of ratings will be lowered by four or more notches.”
Toward the end of its explanation, S&P gave specific percentages for what it called the “base case default frequency assumptions.” It stated unequivocally that for any mortgages in non-agency tranches that were 90 or more days delinquent, it expected that 100% of them would end up in default. Not some of them; all of them.
Although S&P was clearly warning investors that thousands of downgrades were expected, Wall Street and the media gave the August 2012 announcement little attention at all. I found it by accident while doing research on non-agency RMBS. I have still not uncovered a single article or report covering it.
A month after this dire warning, S&P lowered the ratings of dozens of sub-prime RMBS that had been issued between 2005 and 2007. No one seemed to care.
Downgrades of RMBS continue without letup
Although downgrades of sub-prime tranches have been massive since the collapse, it would be wrong to think that these downgrades are winding down.
In April 2013, S&P published a new “US RMBS Recovery Analytics” report. Applying its new rating criteria from the previous year, the report revealed that of the 7,111 pre-2009 tranches still rated AAA in 2012, a mere 1,119 remained at this level. Here is a table from that report.
Nearly 85% of the tranches still rated AAA in 2012 had been downgraded by 2013. One out of five was downgraded to BBB or lower. Incredibly, more than 10% of them were such junk that they lost their credit rating completely.
Downgrades by rating agencies resumed in 2014. Last May, Moody’s reported that it had downgraded $216 million of RMBS tranches holding sub-prime mortgages originated in 2003. All eleven tranches had previously been downgraded either in 2011 or 2012.
A Moody’s press release described the reason for the new downgrade as “a result of deteriorating performance and/or structural features resulting in higher expected losses for the bonds than previously anticipated.” That sounds very similar to S&P’s warning from August 2012.
This downgrade of sub-prime tranches is a warning to RMBS investors. Loans issued in 2003 – even subprime mortgages – had much higher underwriting standards than those originated in 2005 and 2006. If performance of 2003 loans is “deteriorating” as Moody’s puts it, what does that indicate about the worst mortgages originated in 2006 and early 2007?
Putting S & P rating downgrades in perspective
Since the vast majority of formerly top-rated RMBS tranches have either been seriously downgraded or have lost their credit rating entirely, how much credibility should be given to their current credit rating? As I see it, not much at all. The fact that so many have continued to be downgraded well after the credit crisis allegedly ended supports my skepticism. The soundness of current credit ratings should not be trusted.
How does all this impact a non-agency RMBS investor? If you are the investment advisor for a client who owns these tranches either through shares of a total-return bond fund, a mortgage REIT or a hedge fund, what prudent advice should you give about the risks they pose to return of capital?
The coming mortgage delinquency fiasco
Much nonsense has been written about the so-called housing recovery. For several years, I have provided in-depth compelling evidence that this recovery is nothing more than an illusion.
On January 26, the Washington Post published a lengthy article depicting the plight of an underwater homeowner couple in Prince George’s County, a suburb of Washington, D.C.
The couple began their journey by purchasing a three-bedroom townhouse in 2000 for $128,000. Because their property had nearly tripled in value in the red-hot D.C. suburbs market, they decided to build a larger home for their growing family in 2005 for $600,000. To pay for the house, they took out a $493,000 interest-only first mortgage and used a cash-out refinancing on their townhouse for the down payment. Monthly payments on the two mortgages amounted to $5,500.
A year later, the couple decided to refinance the mortgage on their new home and consolidate other personal debt. They took out a $620,000 first mortgage from the infamous sub-prime lender Countrywide Home Loans. It was also an interest-only mortgage whose rate would rise in two years.
Unfortunately, this was the peak of the housing bubble and prices began to crumble. They tried to hang on as long as possible. However, they realized that they could not cover the higher mortgage payment when it reset to a higher rate. Because the property was underwater, they also could not refinance. So they stopped making their mortgage payments in the fall of 2008.
In mid-2010, the couple received a first notification that their mortgage servicer intended to foreclose on their home. They had not made a payment for 20 months. They applied several times for a modification of their mortgage but were turned down. In the spring of 2011, they were rejected for a modification under HUD’s HAMP program.
In the summer of 2011, the couple was sent an unsolicited short sale agreement by their mortgage servicer explaining the terms of a short sale that would require them to sell the home at a substantial loss.
Fast forward to 2014. Bank of America sold the mortgage servicing rights to Nationstar. The new servicer informed the couple that their delinquent payments totaling $318,000 were now due.
A spokesman for Nationstar informed the author of the Washington Post article that a foreclosure had not been scheduled. Nationstar called the couple in January of this year to “find ways to work things out.”
Work things out? What insanity! If you add the couple’s personal debts to the mortgage debt on their two properties, the total is $1.3 million. Their house had a market value that was little more than one-third the outstanding mortgage debt on it. Despite the fact that this couple had not made a mortgage payment in more than six years, the servicer was not ready to foreclose on their home.
Throughout the country, there are millionsof homeowners who are now in similar situations. Servicing banks are not putting the vast majority of them into foreclosure. Most remain in their house without making mortgage payments. Many others have either abandoned the property or moved out and rented it.
Let’s not forget the massive numbers of homeowners who have received a mortgage modification and re-defaulted. That number increases every day.
If your client owns a piece of a non-agency RMBS tranche not guaranteed by the GSEs, there are substantial numbers of these delinquent and underwater mortgages which are the collateral behind their bond. They need to understand that sooner or later, these loans will be liquidated.
For several years now, far too much attention has been placed on interest-rate risk and too little on credit risk. It is incumbent upon advisors to review whether the default and non-payment assumptions which they use to determine the appropriate price for non-agency RMBS bonds are sufficiently realistic to withstand the turmoil that awaits the mortgage and housing markets.
If not, clients who own non-agency RMBS bonds should sell them before the housing market worsens. If your client is considering buying one of these RMBS bonds, apprise them of the serious risks before they step over the cliff.
This article also appeared at Advisor Perspectives.
Keith Jurow is a real estate analyst and former author of Minyanville’s Housing Market Report. His new report – Capital Preservation Real Estate Report – launched a little more than a year ago.