Will Mortgage Bonds Be the Next Disaster—Again?

Posted by Sana on 10/26/2016 in Weak Credit | Short Link

Will Mortgage Bonds Be the Next Disaster–Again?

For some investors, any mention of US mortgages takes them back to the dark days of 2008. But today’s mortgage bonds aren’t the devils some market participants make them out to be.

We understand why the topic provokes anxiety. In the 2000s, rapidly rising home prices prompted lenders to make risky loans, often without verifying a borrower’s income or requiring a down payment. Many of those borrowers defaulted when US housing prices started to fall.

Because the loans were bundled into residential mortgage-backed securities (RMBS), the poison was able to spread through the global financial system. The result: what might have been a simple US housing correction became a global crisis.

Mortgage Bonds Today’s Nontoxic Loans

By now, the story is well-known, thanks to countless books and the critically acclaimed film The Big Short. But just before that film’s credits start to roll, an on-screen warning darkly implies that nothing much has changed. This gives the impression that Wall Street is again busy stuffing toxic loans into a new breed of mortgage-backed securities, setting the stage for another crisis.

We disagree. The majority of today’s loans aren’t toxic. Tight lending standards mean only high-quality borrowers are getting loans. Several credit metrics, including average FICO scores and borrower debt-to-income and loan-to-value ratios, are at or near their best levels since 2006.

In other words, if there were ever a time to take on mortgage credit risk, it’s now. That’s one reason why we think new credit risk-transfer securities (CRTs) from government-sponsored housing agencies Freddie Mac and Fannie Mae offer an attractive opportunity.

Beyond having mortgages as underlying collateral, CRTs have very little in common with traditional agency debt or the precrisis non-agency RMBS that banks issued. That’s partly because these new securities have less risk layering than did their precrisis counterparts.

There is less risk because CRTs contain fewer loans to borrowers with multiple red flags. For instance, nearly 11% of the loans in the securities Freddie issued in 2006 went to borrowers with low FICO scores (weak credit) and high debt-to-income ratios. For the 2016 CRTs, only 0.7% did.

Mortgage Bonds Sharing Risk, Reaping Rewards

CRTs are different from traditional agency debt in another important way: they have no government guarantee. Before the crisis, investors assumed interest-rate and prepayment (unscheduled early return of principal) risk, but Fannie and Freddie guaranteed coupon and principal payment, even when the underlying loans would default.

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