Scott Rundell, Chief Investment Officer | August 2023
Introduction
Mortgage arrears have been attracting a fair amount of press lately given the aggressive rise in interest rates and some early signs of ‘mortgage stress’. We believe most of the commentary fails to provide insights on where the risks are, how to avoid them, or what the opportunities might be.
While Residential Mortgage Back Securities (RMBS) arrears have risen, we consider this is entirely normal and nothing to be alarmed about vis a vis RMBS investments. Arrears do not equal losses.
Two questions. First, is RMBS arrears a good indicator of mortgage stress, and second, what does increasing arrears mean for RMBS performance?
Arrears here and now
To ensure full transparency, we’ll stick to public data, specifically Standard and Poor’s (S&P) SPIN data. We have also corroborated this with our own data. SPIN data details the proportion of mortgages held within RMBS structures that are behind on their scheduled mortgage payments for 30 days or more. We’ll focus on ‘non-conforming’ mortgages here, mortgages typically written by non-bank originators, such as RedZed, Peppers, Liberty and Resimac. Non-conforming mortgages are to borrowers who do not satisfy the standard lending criteria of mainstream lenders, including banks, for example self-employed borrowers.
Non-conforming mortgage arrears are sitting at 3.47% as at the end of June, up from 2.18% a year ago. While arrears have risen vs this time last year, the recent trend has been lower, falling -0.52% in recent months as borrowers adjust to the higher interest rate environment. For some historical context, the long-run average SPIN rate is 8.28% (2000 - now), while the post GFC average is 5.66%. The worst SPIN rate on record was 23.25% in July 2000, while the peak through the ‘GFC’ was 17.09% in January 2009. Even though arrears reached such extreme levels, no rated RMBS tranche incurred an uncured capital charge off.
Is arrears data a good measure of mortgage stress?
There are no doubt households struggling with their mortgage payments given higher interest rates rising cost of living pressures. But, from the perspective of investing in RMBS, arrears measures are a poor measure of mortgage stress? SPIN only looks at delinquencies within the RMBS universe, which is a small sub-set of the broader mortgage market. In total there are roughly $2.3 trillion of mortgages outstanding nationally – predominantly written by banks. RMBS outstanding on the other hand is down around $90 billion, or less than 5% of total mortgages.
Although RMBS is not the worst sample size it is however an incredibly biased and inconsistent one. Loans within an RMBS pool experience a high degree of churn as loans are prepaid at rates of 20% - 30% per annum, moving them out of the RMBS universe and into other funding vehicles, often refinanced by banks.
To further complicate matters, outstanding RMBS loans are heavily skewed toward new loans, which are in their early stages (lightly seasoned). This means new RMBS issuances disproportionately influence SPIN, leading to downward pressure on SPIN during periods of high RMBS issuance. Naturally, new loans are less likely to fall behind on payments, with some pools having a weighted-average seasoning as short as six months.
Another consideration is the nature of RMBS structures with call factors on RMBS trusts at around 10% - 25% of the original pool balance. In laymen’s terms, each RMBS trust will be brought back by the issuer at some stage, repurchasing the loans and taking them out of the RMBS universe. The call date is set at a certain date generally within 3 - 5 years of issuance, with an additional call-option if the original pool balance reaches 10% - 25% of its original amount. This means as RMBS loan pools season over a 3–5-year period, most loans are refinanced or paid-off prematurely and the remaining loans are subsequently called back by the issuer and vanish from the RMBS universe. Again, another reason why RMBS and SPIN are poor proxies for mortgage stress.
Does arrears impact RMBS performance?
SPIN is not only a poor proxy of mortgage stress but also a poor measure of RMBS fundamental performance. During the ‘Global Financial Crisis’ or ‘GFC’ (2007 – 2009), RMBS SPIN for non-conforming loans more than tripled, yet no uncured charge-backs were recorded on any rated tranche or note. There was a marked to market impact, given heavy selling on US contagion fears, but actual charge-backs or losses at the time, on rated tranches was zero.
Mortgage defaults are relatively uncommon within RMBS pools since they represent unfavorable outcomes for all parties involved, yet they do obviously occur. Lenders are typically cautious about repossessing properties and handle each delinquent loan individually, utilising various measures to rectify the situation. Furthermore, when a loan does default, it is unlikely to result in a loss because the majority of loans in the RMBS universe have loan-to-value ratios (‘LTV’) below 80%.
Typically, the weighted-average LTV within an RMBS pool is around ~67% or even lower. In simple terms, this means that if the collateral property is sold, the proceeds from the sale exceed the loan amount, ensuring that the lender is repaid in full. This is the principal advantage of securitised lending.
However, even if the collateral does not fully cover the loan, there are additional measures in place to protect RMBS investors from losses. The most significant among these is the presence of ‘excess spread’ within RMBS vehicles. Each month, the RMBS pool collects principal and interest on its loan portfolio, which usually surpasses the principal and interest owed to RMBS note holders. The surplus amount is captured in the structure and can be used to offset any losses incurred by the pool. RMBS trusts often incorporate provisions for accumulating this excess spread in a designated account to prepare for any future losses should they occur. These lock ups / balances can average somewhere between 0.5% and 1.0% of the original pool value.
Lastly, RMBS trusts are structured with different tranches, which constitutes senior and mezzanine financing. If losses occur, the charge-back is assigned to the lowest-ranking tranche, typically the unrated note – usually equity, which holds the lowest rank in the waterfall. Tranches can range from AAA rated (the ‘A’ tranche) down to unrated (the ‘G’ tranche). The excess spread from each period can be utilised to address these charge-backs during any subsequent payment month. It is worth noting again that no rated Australian RMBS note has ever experienced an uncured charge-back.
There is long run historical data to support the strength of RMBS, or more specifically the economics of mortgage underwriting. Within the banking system, the long run average loss rate on mortgages has averaged 0.02%, since at least 1990. Banks tend to lend to prime borrowers only. Within the non-bank originator space, who cater to the non-conforming borrows, the long run average loss rate is less than 0.10% (originators with 20+ years track record). Now, within your standard RMBS structure, credit enhancements protecting the lowest rated tranche – the ‘F’ note, typically rated single B – total 1.00% - 2.00% on average, sometimes more. Again, no rated note has ever incurred an uncured capital charge back.
Why RMBS and Why Now?
While the interest rate cycle is likely maturing, there remains a fair degree of uncertainty around where interest rates will go from here. They may linger around prevailing levels (base case) or they could move higher of inflation lingers. This uncertainty underpins fragility in equity market valuations, which despite earnings headwinds remain within throwing distance of their all-time highs. Accordingly, for the more prudent investor, seeking income stability rather than risking capital loss, RMBS funds represent a worthwhile consideration.
RMBS structures use floating-rate notes to fund mortgages, meaning they offer a coupon determined as a fixed spread or margin determined at issuance over the one-month bank bill swap rate (1MBBSW). Such structures shield investors from interest duration risk and allows them to benefit from a rising interest rate environment, or a steady income stream during periods of interest rate stability.
In the past six months, the credit spread (over the BBSW 1M rate) on RMBS has significantly widened, with notes rated single B, or the ‘F’ tranche, pricing as high as +850 bps. This implies am initial coupon of c.12.5% for note holders. For more risk averse investors, the BBB rated notes, or the D tranches, the spread available is around +450 bps, which provides a coupon of c.8.50%.
Mutual Limited is an active investor in the space, with the investment team having over 30 years-experience doing so. Our Mutual High Yield Fund (‘MHYF’) invests down to the B and BB rated tranches generally, with the fund delivering a current gross running yield of over 9.8%, or yield to maturity if 10.2%. Recent cash inflows to the fund have temporarily diluted the running yield. The fund targets a net return over the bank bill index of +4.5%. For 12-month period ending July 31st the fund returned +9.0% vs +3.2% the bank bill index, exceeding its target by +5.9%.
Further up the capital stack, we have the Mutual Credit Fund (‘MCF’), which has up to 30% of assets under management in RMBS and ABS. This fund typically targets BBB and BB rated tranches in the RMBS / ABS space and currently is providing a running yield of 7.5%. The fund targets a net return over the bank bill index of 2.2%.
Before any RMBS is added to these two funds, and our private mandated clients who appreciate this space, all deals undergo rigorous structural and cash flow stress testing. With regard to the latter, each deal is subject to a doomsday scenario whereby house prices are assumed to fall over 40% in the coming three years, unemployment doubles, the economy contracts by -4.0%, and all defaulting mortgages experience an immediate 15% valuation haircut…among other things. Typically, such an extreme-results in the equity tranche being wiped out, but not the rated tranches, although in some instances there is some very minor charge backs. This is because RMBS pools are structured in such a way to ensure they can survive such extreme downside scenarios. As a sign of Mutual’s analytical rigor, the firm invests in just 17% of the RMBS deals it is presented with.
This note is for information purposes only, it does not constitute investment advice. Readers should consider their own personal circumstances before making any investment decisions.
Disclosure
This information has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347).This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.