Southeastern Evaluation Blog

Subprime Mortgage Bonds Are Back in Fashion
Southeastern Evaluation Team

Many in our industry still remember the subprime mortgage crisis and the role mortgage backed securities (MBSs) played in the crisis. In fact, the environment in which we now operate is a direct result of the crisis. It now seems that subprime mortgage bonds are back in fashion. To recap:

Subprime mortgages are a type of mortgage that is normally issues to borrowers with low credit ratings. A subprime mortgage bond is a bond secured by a mortgage or pool of mortgages and can pay interest in either monthly, quarterly, or semiannual periods.

These bonds are typically backed by real estate holdings. In a default situation, mortgage bondholders have a claim to the property and can sell if off to compensate for the default.

According to the Financial Times, “issuance of securities backed by riskier US mortgages roughly doubled in the first quarter of this year from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago.”

Home loans to people with “scratches and dents” in their credit histories dwindled to almost nothing in the aftermath of the crisis, as litigation-weary lenders retreated to “patch up” their balance sheets. But, over the past couple of years a group of “specialist firms” has begun to bring the loans back, navigating a dense web of “new rules drawn up to protect borrowers and investors” in the $9.3tn U.S. home-loan market.

According to Inside Mortgage Finance, 2017 saw the issuance of more than $4bn of securities backed by loans that would have been called “subprime” before the financial crisis with the pace picking up in the latter half of the year.

The momentum continued well into 2018 with $1.3bn in the first quarter—twice the $666m issued in the same period a year earlier.

“The market is … starting from such a small base that it has a lot of room to grow,” said Jamshed Engineer, a partner at Axonic Capital, a New York hedge fund with more than $2bn in assets under management. “[Investors] are definitely chasing yields. Whenever these deals come out, for the most part, they are oversubscribed.”

The loans in these deals go under a variety of names and range all over the country. But, what they have in common is that they are not eligible to be bought by Fannie Mae or Freddie Mac, or to be insured by the Federal Housing Administration (FHA), which supports first-time buyers. As such, they’re often identified as “Non-QM” loans, or non-qualified mortgages.

Analysts suggest that even more lenders may be temped into the non-QM market as they grow more comfortable with the regulatory environment and as they look to “offset business lost from mortgage refinancing” which tends to fade while interest rates rise. The rating agency Kroll expects issuance this year of about $6bn to $7bn of bonds backed by riskier mortgages.

Are we headed for trouble again? Many analysts suggest no. They say that the deals are safer than the ones that tested the financial system last decade. For one, under Dodd-Frank reforms that took effect in 2015, sponsors of riskier mortgage-backed securities deals have to retain a 5 percent interest in the pools of loans they offer. Since 2014, every mortgage lender also has had to take account of a borrower’s ability to repay the loan.

According to Sujoy Saha, analyst at Standard & Poor’s, “These loans have gone through due diligence and [credit scores] are much higher, and loan-to-value rations lower, than what we’ve seen in the past. The risk is contained, in our view.”

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