Once a big portion of global structured finance, non-agency RMBS has been a small part of the MBS market since 2008, in spite of a housing recovery in the US. Alexander Saeedy examines the outlook for a comeback of private label bonds in 2019.
Given its legacy as one of the primary culprits of the financial crisis, and a large pullback from mortgage finance by the bank community in the last decade, non-agency securitization issuance is unlikely to rebound to its 2007 peak, when it totaled more than $1tr.
However, the market in 2019 is looking up, according to the dedicated investors and asset managers who have stuck around to trade on what they see as one of the best, most robust underlying assets in the world: the US mortgage.
While total annual non-agency issuance rose slightly in 2018 from $64bn in 2017 to roughly $75bn, that figure is more reflective of a decline in re-performing and non-performing loans, which slipped from $26bn in issuance to $14bn. Rising rates are seen as the main cause of the drop, increasing the duration of these non-conventional mortgage bonds as the refinancing window closes.
“This market has hit some headwinds as of this year,” says Neil Aggarwal, head of trading at Semper Capital Management. “The NPL trade is largely over, as supply dissipates and is now dominated by re-performing borrowers. Further, it is within the RPL mortgage trade that duration very much matters, and six to eight year bonds are soon becoming 10 plus year bonds as mortgage rates continue to rise.”
Issuance in other classes has picked up, however, as the non-agency market diversifies and takes on new complexity.
Perhaps the most obvious trailblazer for non-agency credit is the credit risk transfer (CRT). Derivatives based off the performance of underlying collateral, the deals have helped both Fannie Mae and Freddie Mac to transfer the risk from their mortgage portfolios while creating a further secondary market based on US residential mortgage credit.
A tweak to the legal structure of Fannie Mae’s CRT, which saw the agency issue debt through a real estate mortgage investment conduit (REMIC), was a big step forward in bringing more investors — most notably, Reit and international investors — into the asset class.
Laurel Davis, vice president of CRT at Fannie Mae, says Reit participation in the bottom tranches of the deals jumped from roughly 7% to 22% with the new legal structure. The agency now intends to issue all its CRT deals via the REMIC structure.
Private label progress
While the US agencies dominate CRT issuance, some private label issuers are making inroads. Sponsors including Radian, Arch Capital Group and Essent Guaranty all tapped securitization markets in 2018 to transfer portions of the risk contained in their mortgage insurance portfolios. Their comparable bonds trade at sharply different spreads, however, with bonds rated BBB- priced at 100bp wider in several 2018 deals.
Most CRT deals allow investors to take exposure to different parts of agency RMBS deals, although the first loss bonds are retained by the GSEs.
Investors have taken to the product, as shown by tightening spreads since the programme began in 2013. There is also more movement from the non-qualified mortgage sector, where private label issuers have bundled together high quality loans that do not meet GSE purchasing standards into securitizations. Non-qualified mortgage origination volume in 2018 was close to $9bn, spurred by new entrants — more than double that of 2017’s $4bn across six issuers.
“We’re seeing a more programmatic kind of issuance, which is a net positive as there’s more supply and a better understanding in the market,” says Lauren Hedvat, managing director of capital markets at Angel Oak.
However, investors have been critical of how non-qualified mortgage deals are idiosyncratic and potentially expose them to different risks, deal to deal. “This sector is very intriguing, but it’s not standardised,” says Tracy Chen of Brandywine Global in Philadelphia. “You have to look into each issuers’ underwriting. The collateral is a little worse than prime jumbo.”
But, even as non-agency seems poised for a rebound, rising rates and market volatility buffeting fixed income also means that pricing questions could weigh on demand and supply.
There is some solace in the arrival of a new FHFA director, who is expected to encourage further private capital into non-agency RMBS through setting higher agency guarantee fees and potentially modifying loan limits.
But that is still only likely to cause an incremental change, as market forces potentially weigh on issuance and each individual sector within the non-agency market takes time to grow.
“For 2019, we expect the strong primary market to continue and project gross issuance volume to be around $76bn, flat versus 2018,” says Vipul Jain, head of RMBS research at Wells Fargo. “But we continue to be defensive. With the yield curve and credit curves generally flat, we believe investors are not being compensated enough for taking too much risk.”