DBRS Morningstar’s Takeaways From ABS East 2023: RTL RMBS Emerges, Non-QM Delinquencies Edge Up

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at ABS East 2023, an industry conference for the asset-backed securities sector. Residential mortgages that fall outside of the federal government’s Qualified Mortgage (QM) definition represent about $75 billion, according to Shikhar Agarwal, Non-Agency RMBS and U.S. Housing Strategist at Morgan Stanley. Most of these non-QM loans are to self-employed borrowers, and the level of income and asset documentation varies. The borrowers also tend to have lower FICO scores and higher debt-to-income ratios than those in the prime sector. Given this, DBRS Morningstar’s Corina Gonzalez, Senior Vice President, U.S. RMBS, notes that while the increases in delinquencies are within expectations for non-QM loans, they are overall higher than for other types of residential mortgage-backed securities (RMBS) backed by stronger borrowers. However, she noted the loan-to-value ratios (LTVs) remain low, in the high 60s to low 70s range, implying a strong equity position for the borrower. During the underwriting process, the low LTVs act as compensating factors against the riskier characteristics of the borrowers.

Although non-QM delinquencies are edging up from historical lows, Gonzalez said DBRS Morningstar’s model assumes higher losses to account for the riskier (or less prime) borrowers. Also, of 260+ outstanding transactions in the rated non-QM space, all but one passed their triggers, which are usually related to exceeding delinquency or loss thresholds. In the rated space, she has seen some writedowns on tranches, but they’re all nonrated junior classes so far.

The non-QM RMBS market is more of a buyers’ market than a sellers’ market. “A couple of key buyers in the space have a lot of power,” said Michael Silberfeld, Senior Director at Deloitte. They can decide the prices they want to pay on the bonds, which means it often comes down to timing. He explained that non-QM securitizations come out in batches, and typically the first issuer to market gets the most profits. The last deal of the batch is going to be a little less profitable and may not make financial sense. Sometimes the transaction is on hold and won’t come to market until months later.

HOME IMPROVEMENT: RESIDENTIAL TRANSITION LOANS
A new asset type has emerged out of the RMBS landscape and become more mainstream—residential transition loans (RTLs). These are short-term loans, typically 12 to 36 months, made exclusively to real estate investors. The borrower pays only the interest until the loan matures and then the principal becomes due. Securitizations backed by RTLs are also short term at three years. The first two years are the revolving period where eligible collateral can exit and enter the pool, and the final year is the amortization period. As Chief Executive Officer of Toorak Capital Partners, John Beacham has been part of the market since its inception in 2016 and noted how it’s changed, with “major institutional investors buying all the large lenders in this market.”

Although RTLs are similar to traditional mortgages, there are some key differences, according to Gonzalez. First, loan repayment hinges on the property being sold or converted into a rental property and refinanced, rather than on the borrower’s income. Second, these properties may be in various states of disrepair and need some level of rehabilitation or construction. During the rehabilitation project, portions of the loan are held back, and the borrower receives funds only after achieving certain rehabilitation milestones.

Three key drivers of the credit analysis, per Gonzalez, are property liquidity, the borrower’s property rehabilitation experience, and the size of the project. Property liquidity measures how marketable a repaired property is within its location. “Properties that are more expensive than the average property in that area may be harder to sell and are considered riskier,” she said. The borrower’s experience in this kind of work also matters a great deal. For example, a larger construction company presents less risk than an individual dabbling in fixing and flipping properties. Finally, the larger and more complicated a project, the riskier it becomes. Construction delays, cost overruns, and labor shortages are all more likely with larger rehabilitation projects. One way to measure this is by comparing the dollar amount of the project against the property’s value after the repairs are finished. For more information on how DBRS Morningstar analyzes RTL securitizations, please refer to “Appendix 10: Residential Transition Loan D180 Module” found in “RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology.”

Beacham is optimistic about RTL securitization and believes more issuance is on the way.

Written by Caitlin Veno

Notes:
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