Massive mortgage market transformation: The return of subprime?
Last week was a sleeper in the bond market
The MBA Mortgage Application Index was basically flat, closing out the week at 445—slightly higher than the recent low it posted a week before. The ten-year bond yield fell slightly to go out at 2.78%. The only real excitement economically was the durable goods report, which came in disappointing and drove rates lower. The second quarter GDP report came in better than expected, which pushed rates a bit higher. So far, we’re not seeing any sort of flight to quality trade based on the Syrian situation. Overall, it was a quiet market, as it usually is late in August ahead of the three-day weekend.
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Big transformation happening in the mortgage market
The mortgage market is undergoing a massive transformation as the private label mortgage market returns. Bob Corker (R-TN) and Mark Warner (D-VA) recently introduced a bill to end GSEs (government-sponsored enterprises) and put the government in a re-insurance role. All the securitization that was done by Fannie Mae and Freddie Mac will now be done by private entities, some of whom could be mortgage REITs.
Since the bubble burst, mortgage origination has been almost exclusively government-driven. The big buyers of new origination have been the agency REITs like Annaly (NLY) and American Capital (AGNC). The U.S. government bears 50% of the credit risk of the entire U.S. mortgage market. Originators typically don’t hold their mortgages: they either sell them to the big banks or securitize them. Since the securitization market has been dead, originators have no outlet for non-agency mortgages. Redwood Trust (RWT) has been the only issuer of private-label mortgage-backed securities (securities backed by mortgages that aren’t government-guaranteed), and it has focused exclusively on high-quality jumbo loans. Pennymac (PMT) noted on its call that origination increased nicely in the second quarter.
Finally, some lenders are moving out on the risk curve
We’re beginning to see the return of lenders (primarily hedge fund lenders) who are willing to brave the non-QM world and offer subprime loans. These are not yet securitizable, which means most lenders won’t touch them, but the sense is that as the economy improves, more investors are starting to crave yield. The non-QM world is interesting in that there are many loans that are probably great, but they fail the debt-to-income limit of 43%, so many lenders won’t touch them. (What about a borrower who has a debt-to-income ratio of 50%, but also has 50% equity in the home?) That loan should have a very low default risk.
This will prove to be an interesting space. There are many borrowers who are shut out of the mortgage market but shouldn’t be. As the low-hanging fruit of serial refinancers goes by the wayside, originators are going to have to become more competitive. We’re seeing origination spreads begin to tighten as business becomes more competitive. It was only a matter of time before originators started taking more credit risk. So far, we haven’t seen any REITs participating, but the non-agency REITs like Walter (WAC) may become interested in subprime mortgage-backed securities if the yields are there.