Residential Magazine

These Mortgage Trends Are Becoming Clear

Non-QM and adjustable-rate loans are likely to comprise a larger share of securitizations

By Roelof Slump

It’s shaping up to be a busy year for the issuance of residential mortgage-backed securities (RMBS). Last year also was active, but the market for these securities experienced disruptions at the start of 2022 due to rising interest rates and widening spreads. How the rest of this year fares remains to be seen.

Credit-rating agencies perform a vital function by reviewing and assessing the banks, nonbanks and government-sponsored enterprises (GSEs) that package loans to be sold as securities. This includes the companies that originate loans as well as aggregators — such as the GSEs, large banks and nonbanks — that purchase loans from other financial institutions to create these securities.
As such, credit-rating agencies have unique insight into the mortgage market and are able to see emerging trends. From this perspective, credit-rating agencies can see the types of loans demanded by consumers. One thing is clear today: New loan types are in demand as easy-to-originate GSE refinance opportunities are drying up.

Shifting market

Mortgage originators have shown active and growing interest in nonqualified mortgage (non-QM) products — mainly bank-statement and debt-service-coverage ratio loans, the latter of which are used by real estate investors. This is occurring because fewer loans that are easy to underwrite are available today. Non-QM loans don’t meet the strict standards to be purchased by the GSEs and are generally broader in credit than typical nonagency prime loans.
There also is a strong perceived need from borrowers — including the self-employed — for expanded underwriting criteria found in non-QM programs. Although most activity in this sector has come from specialized nonbank originators, some banks and nonbanks that have typically focused on prime loan production are now introducing non-QM loans that offer more flexibility.
Another key shift that is likely to be more meaningful to prime activity is the introduction of higher loan-level pricing adjustments that went into effect for certain GSE-eligible loans in April 2022. These adjustments — which are specific to second homes and high-balance loans of conforming loan size — may be significant enough to cause them to be delivered to aggregators of private-label securities as opposed to the GSEs.
Although it’s still too early to see the full effect of the changes, the impact to RMBS could be substantial given its relatively smaller size compared to the overall GSE business. Several of the larger aggregators of prime products have indicated that more substantial inclusion of these loans in private-label securities are starting to occur this summer.
Certainly, originators are largely focused this year on the rise in benchmark and mortgage rates. Although nearly all prime securities (and a substantial share of non-QM securities) have been backed by fixed-rate loans in recent years, it’s likely that the industry will soon begin to see more adjustable-rate mortgages (ARMs) in residential mortgage-backed securities — especially loans with five-, seven- and 10-year initial fixed-rate periods. These ARMs can provide lower starting rates compared to traditional fixed-rate loans, but some additional default risk can be encountered depending on benchmark rates during the floating-rate period.
It’s anticipated that many of these ARMs will use the Secured Overnight Financing Rate (SOFR) as the benchmark interest rate, but it’s possible that other indexes may appear. It’s not expected that the London Interbank Offered Rate, or LIBOR, will be used as the benchmark on newly originated ARMs.

Operational assessments

The mortgage market discussion around the transition toward fixed-period ARMs further highlights the home-price affordability issue that has continued even as market rates have moved higher. Credit-rating agencies actively monitor home-price sustainability, an important factor in RMBS modeling across geographies.
From an operational-risk standpoint, the processes and controls used by the originating or aggregating company to obtain accurate and complete valuations strongly influence the credit quality of their production. This can be especially important in an RMBS issuance market where rate-and-term refinances become less common. For example, nonstandard or incomplete approaches to property valuation by the originating or aggregating company can lead to property value haircuts in loan-loss modeling.
Strong banks and nonbanks are expected to have experienced underwriting staff; well-documented underwriting guidelines and exception policies; centralized underwriting processes with clear levels of delegated authority; and proper controls and oversight of automated underwriting systems. Results of securitization due diligence also can factor into the opinion of the aggregator, as is the ability to enforce representations and warranties of sellers and their financial position.
Credit-rating agencies look at a company’s management experience; risk management and quality control; sourcing and acquisition of assets; underwriting and credit evaluation; financial condition; technology; and property valuation. For entities that have a less significant impact on the performance of RMBS transactions, credit-rating agencies may choose to conduct an abbreviated or targeted review in which entities may be designated as “acceptable” participants in RMBS transactions. Ultimately, these comprehensive assessments are incorporated as drivers in loan-loss models and are disclosed in presale transaction reports.
Originating and aggregating companies that display the following traits are more likely to receive a higher qualitative assessment. These include an established operating history; a well-defined origination or aggregation strategy; clear product guidelines or guideline overlays; the ability to originate or acquire high-quality products through evolving production environments; an experienced senior management team; and appropriate staffing levels and training programs.
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The operational review of these companies is especially important in this active and complex market where participants are expecting continued levels of elevated RMBS issuance. Certainly, many of the trends are clear — more non-QM products, more ARMs and continued home-price affordability challenges.
It remains important in this environment to observe how the companies that create these securities handle the risks and opportunities with which they are faced. All parties need to adequately address elevated credit risks as they arise. ●

Author

  • Roelof Slump

    Roelof Slump is a managing director and structured-finance head of operational risk for Fitch Ratings in the U.S. and Canada. His operational-risk responsibility for structured finance includes residential mortgage-backed securities (RMBS), originator/aggregator assessments, commercial and residential mortgage-backed securities servicer ratings, and collateralized loan obligation asset-manager assessments. Previously, he managed the assignment of RMBS bond ratings for Fitch. Slump has been engaged in securitization and whole loan activities since 1991. Reach him at (212) 908-0705 or roelof.slump@fitchratings.com.

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