Risky mortgage bonds are back seven years after the U.S. housing crisis – just don’t call them sub-prime
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Jody Shenn, Bloomberg News | January 28, 2015
The business of bundling riskier U.S. mortgages into bonds without government backing is gearing up for a comeback. Just don’t call it sub-prime.
Hedge fund Seer Capital Management, money manager Angel Oak Capital and Sydney-based bank Macquarie Group Ltd. are among firms buying up loans to borrowers who can’t qualify for conventional mortgages because of issues such as low credit scores, foreclosures or hard-to-document income. They each plan to pool the mortgages into securities of varying risk and sell some to investors this year. JPMorgan Chase & Co. analysts predict as much as US$5 billion of deals could get done, while Nomura Holdings Inc. forecasts US$1 billion to US$2 billion.
Investment firms are looking to revive the market without repeating the mistakes that fueled the U.S. housing crisis last decade, which blew up the global economy. This time, they will retain the riskiest stakes in the deals, unlike how Wall Street banks and other issuers shifted most of the dangers before the crisis. Seer Capital and Angel Oak prefer the term “non-prime” for lending that flirts with practices that used to be employed for debt known as sub-prime or Alt-A.
While “sub-prime is a dirty word” these days, “what everyone is seeing is the credit box has shrunk so much that there’s a lot of good potential borrowers out there not being served,” said John Hsu, the head of capital markets at Angel Oak. The Atlanta-based firm expects to have enough loans for a deal next quarter in which it retains about 20% to 33%, he said.
Reopening this corner of the bond market may lower consumer costs and expand riskier lending, aiding the housing recovery. The most dangerous slices created from the securitization of loans are also the highest-yielding, offering companies from private-equity firms to real estate investment trusts a way to increase returns as global central banks suppress interest rates to foster economic growth.
“I go to conferences and no less than a dozen investors are saying they want these assets,” said Michael Kime, chief operating officer of W.J. Bradley Mortgage Capital, a lender that started making some of the loans last year.
Securitization of home loans not backed by the government has been mostly dormant since the crisis. Only US$8.8 billion of deals tied to new loans occurred last year — all of them backed by “jumbo” mortgages to borrowers with prime credit but with balances larger than what can be financed in the government- backed market.
During the housing boom from 2005 to 2007, more than US$2 trillion of securities backed by the riskiest subprime and Alt-A mortgages were issued according to newsletter Inside Mortgage Finance. An additional US$680 billion of jumbo securities were sold during that period.
Better borrowers took Alt-A mortgages that allowed them to avoid income documentation, buy investment properties or make low payments initially that might eventually soar. Losses on loans that back bonds from the period have reached 30% for sub-prime deals and 20% for Alt-A so far, according to a Jan. 6 report by Fitch Ratings.
Angel Oak is willing to buy loans with credit scores as low as 500, though the average has been about 670, just below the 680 level some use as a cut-off for sub-prime on a scale of 300 to 850, Hsu said. The company makes sure borrowers can afford the payments and requires at least 20% down payments, he said.
Interest rates on Angel Oak’s loans, which mostly carry 30-year fixed rates, average about 8%, compared with rates on typical mortgages of about 3.6%, according to Freddie Mac surveys. Federal Housing Administration loans that allow for credit scores as low as 580 with as little as 3.5% down are also available at lower costs.
Even with signs of revival, the risky end of the mortgage- debt market may remain hampered by its past. Some bondholders were burned by issues such as trustees and servicers failing to push lenders to repurchase misrepresented debt.
“‘The reason that investors haven’t come back to the market in general is that the problems related to conflicts of interest and the lack of transparency haven’t been solved,” said Chris Ames, head of securitized products at Schroder Investment Management North America Inc.
“A few hundred million of any asset class can probably find buyers, it’s just not a meaningful amount,” he said.
Many programs targeting loans outside of the government- backed market focus on those with characteristics such as high debt burdens or large fees, which push them outside of a legal category created last year that’s known as qualified mortgages.
Non-QM mortgages expose lenders to lawsuits from borrowers who can win damages if they can prove they couldn’t afford the debt, a risk that will concern bond investors, Ames said.
Macquarie last year started buying non-QM loans from Impac Mortgage Holdings Inc., one of the few Alt-A lenders that survived the crisis. It expects the purchases to accelerate as Impac increases the number of lenders from which it buys the debt, said Eli Nafisi, a managing director in Macquarie’s fixed- income division.
The Impac products all carry minimum credit scores of 680, and require loan-to-value ratios of less than 80%. One program looks only at a borrower’s assets, such as money in the bank or investments, rather than income. Rates on the adjustable-rate loans range from a little more than those on prime mortgages to as much as 3.5 percentage points more, he said.
“It’s not that hard to look at the files and figure out if someone is a good credit,” said Karen Weaver, the head of market strategy and research at Seer Capital, which manages US$2.1 billion. “It’s not really rocket science, it’s just that people weren’t doing it before.”
While rates on Seer’s loans generally start at 8.5% and adjust after seven years, bond deals should bring their costs down and help lure more borrowers, she said. The New York- based firm has acquired enough mortgages to “do a securitization tomorrow morning if we wanted to,” though it probably won’t issue for a few months as it seeks credit ratings.
Though discussions with investors about potential bond deals have been preliminary, the momentum will probably accelerate at an annual industry conference next month in Las Vegas, said Vishal Khanduja, a money manager at Calvert Investments, which oversees about US$13 billion.
Many investors are already buying similar assets, such as securities backed by boom-era loans or risk-sharing deals issued by Fannie Mae and Freddie Mac, and “the demand for risk- adjusted yield is still there in 2015,” he said. “Product that satisfies that, there will be demand for.”