8.23.24 Home Equity Debt; Imperial Fund's Jared Neale on Mortgage-Backed Securities; Powell in Jackson Hole

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Transcript

SPEAKER_01 0:03

Welcome to the Crisman Commentary, Daily Mortgage News Podcast. I'm your host, Robbie Christman. Topics on today's episode include home equity debt. My interview with Imperial Funds Jared Neal on all aspects of residential mortgage-backed securities from how they're packaged to current market demand. And what do you expect from Fed Chair Powell's speech in Jackson Hole later today? Thanks to today's podcast sponsor, Cander. Cander's authentic expert system AI has powered more than two million flawless hands-off underwrites. Every credit risk decision Cander makes is backed by a warranty, eliminating repurchase worries. To learn more, visit KanderTechnology.com. You gotta figure that many people who own their homes free and clear aren't going to obtain a home loan. But still, there's a lot of room for seconds in HELOC. In other primary market supply news, there are fewer loans to find buyers or portfolios for. We recently learned that single-family home building decreased by 6.8%, and building permits declined 4%. In the primary markets, this is bad news for home buyers as they continue to struggle with the lack of supply. FHA delinquencies are now above the pre-COVID book, but FHA foreclosure levels are still very low. These type of things impact demand and pricing for mortgage-backed securities. And for today's interview, I'm very pleased to welcome to the show, Imperial Funds Jared Neil, to talk about all aspects of residential mortgage-backed securities. From how they're packaged to current market demand. It's arguably my favorite interview I've done this year, so hopefully you enjoy it as well. Let's start with a little background. This podcast is mainly for those on the origination side of things, although certainly we have plenty of capital markets folks that listen, but I want to talk residential mortgage-backed securities or RMBS with you today. And let's start by uh let me ask you, how would you explain the RMBS space for listeners who may be involved only on the origination uh workflow or side of things?

SPEAKER_00 2:27

Absolutely, Robbie. Thanks for having me on here today. So when we're talking about the RMBS space, uh generally speaking, it's a way for financial institutions and lenders to divest of the risk that they're creating when they lend money uh to borrowers who are looking to purchase a home. Um it's a way that we're going to take the risk from the lender who's originating the loan and share that risk with other uh financial institutions who are potentially more willing and able to bear that risk for an extended duration of time. Essentially, it allows lenders like AD Mortgage to continuously refresh their capital pool by selling or securitizing their mortgages and getting capital from large financial institutions, Blackstone, BlackRock, et cetera, who are interested in investing in these residential mortgages.

SPEAKER_01 3:29

And when it comes to how mortgages are placed into RMBS, uh how do how do does one choose what mortgage goes into what security? Uh and then maybe one step further, how are those RMBS structured?

SPEAKER_00 3:43

Absolutely. So when an originator like are looking at lending a loan to a borrower or lending funds to a borrower, they're gonna go through the underwriting process, right? And certain risk measurements are gonna be taken on each individual borrower. The borrower is gonna come up with a certain amount of down payment, right, that they'll bring to the closing table. The borrower will have a credit history. Uh, what does their credit score look like, right? And the borrower will also have other facets of the loan, right? They will qualify via a certain document type, right? Whether it's a traditional full doc loan on the conventional side, whether it's a non-qualifying mortgage, business PL, bank statement. Um, all of those metrics are going into the risk measurement of an individual loan or an individual borrower. Now, hedge funds like Imperial Fund and others are able to assign risk modifiers or risk multiples to each type of loan. And effectively, what we're doing is we're structuring these pools of mortgages, the mortgage-backed securities, so that you get access to a diverse and broad range of borrowers who each provide a different type of risk, right? Uh, some borrowers have better credit scores than others. Some borrowers are going to have larger down payments than others. And by uh diversifying the different types of borrowers that we include in a securitization pool, we're able to allow our mortgage-backed security investors to receive access to cash flows from variety of different types of borrowers, profiles from different geographic areas, who are purchasing, you know, single-family homes in some places, apartments or condos in others, you know, manufactured housing in some places as well. So, really, it's a tool for diversification, right? The same way that uh residential mortgage-backed securities allow originators to recycle their capital very rapidly so they're able to provide competitive financing with competitive turntimes. It does the same thing uh for residential mortgage-backed security investors who are looking to diversify their risk over a broad variety of different borrowers and thus different residential properties across the United States.

SPEAKER_01 6:15

Yeah, there's certainly a lot of slicing and dicing going on, and it's complex. Like I said, a lot of the people that listen to the show are not intimately involved in the space. So can you take them through kind of a high-level overview of the process of actually securitizing a residential mortgage-backed security?

SPEAKER_00 6:34

Absolutely. So once the aggregator, as they're called, has aggregated or amassed enough mortgages, enough unpaid principal balance or loan amount in order for the fixed cost of a securitization to make sense for them. Um, typically that number is about $400 million to half a billion dollars that you've lent out to borrowers for them to purchase their home. Once you hit that about half a billion dollar mark, you've amassed enough collateral or mortgages to issue a securitization. Now, what's the first step involved? Well, the first step actually takes place immediately after origination of the mortgage. So what the originator is going to have to do is they're going to have to send a copy of their guidelines as well as the closing packet, right? The entire uh closing packet for that mortgage to an independent third party. The independent third party is uh known as a due diligence company, um, colloquially. And essentially what their job is to do is completely re-underwrite each loan file according to the lender's guidelines, essentially ensuring that the lender has complied with their own guidelines in the origination process of the mortgage and that there weren't any mistakes or biases associated with the origination of that file. That third-party due diligence company is then going to go ahead and create what's called a mortgage tape or a loan tape. The loan tape is simply an Excel file which contains relevant and important data and information about all of the loans that are included in the securitization pool. That loan tape that's created by the third-party due diligence company, who's going to be re-underwriting all of these loans, will then be provided to a rating agency, right? Those are the big rating agencies that we all know as the standard and poor's, the SPs, the Fitch, uh, the Kroll Bond rating agencies, the DBRS Morningstars, and the Moody's of the world, right? Who are going to assign ratings uh based on the risk metrics of the pool as confirmed by the third-party due diligence company. So when I want to issue a securitization, I don't get to create my loan tape uh however I'd like and then uh send it directly to the rating agencies for a rating. No, that tape has to come via these third-party due diligence companies who are verifying, right, that the underwriting process was done according to that originator's guidelines and that there aren't any uh surprises waiting for potential investors in the pool. Once the rating agencies receive that loan tape from the third-party due diligence companies, that's when I would say the securitization process starts in earnest, right? So everything I've spoken about up until now really isn't securitization specific. Uh, it's steps that need to be done prior to a securitization being issued. Once the rating agencies receive those loan tapes, they will assign risk metrics and then they'll give us ratings. They'll say, look, we need you to make a certain percentage of the securitization, a certain percentage of the mortgage pool subordinate to a certain amount of the outstanding principal balance. So what they'll say is, uh, look, Imperial Fund, we're going to need to see about 30% of the pool subordinate to the AAA tranche in order for us to issue a triple A rating. What does that mean for our investors? Well, it means that approximately 30% of that pool's borrowers can default, and we can lose 30% of the principal balance in that pool of mortgages prior to AAA bond buyers having negative effects and losing their principal invested in the mortgage-backed securities, right? So that's what the rating agency's job is to do, analyze the risk of the underlying pool of mortgages, and then assign uh subordinate percentages, right? How much of the principal balance of the pool of mortgages that you sent over to us do we need to have as subordinate debt to ensure that our AAA, our AA, our single A bond buyers are safe in their investments? And that's really where the rating agencies come in and play a large role. Now, once we get that rating agency feedback, we're gonna take it to the large investment banks, right? Those are gonna be your JP Morgan's, your Morgan Stanley's, your Barclays banks of the world, uh, primarily international financial institutions who are gonna help us structure the securitization. Uh, they're gonna help us with the sizing of the tranches, uh, the AAA, AA, single A tranches, and they're going to market the securitization to the largest bond buyers out there. They're gonna be knocking on BlackRock, Blackstone, or MetLife Insurance's door in order to help us market these securities, create interest and demand, and eventually sell them once we bring the securitization to the open market. So that's essentially what the process looks like. Uh, once we sell those mortgage-backed securities to large asset managers, pension funds, or insurance companies, um, there are then going to be sort of a surveillance period where we're just looking at the performance of these assets and trying to observe if there are any patterns, analyze what the performance looks like over one, three, five, 10-year periods, and make tweaks to our existing portfolio and origination pipelines to ensure that we get the best performance out of our portfolios as possible. So from start to finish, that's what the process looks like there, Robbie.

SPEAKER_01 12:49

That's incredibly comprehensive. And I'm very appreciative that you outline that for listeners. I have a quick follow-up when it comes to say a AAA rating or a double B plus or some amount of time. What is the variance like within tranches? How standardized is a triple A rating from one securitization to the next, or how much variance does that allow for?

SPEAKER_00 13:11

Absolutely. So when we're talking about a AAA rating or any letter rating, uh, the risk metric remains the same. So that rating agency is saying, you know, this is triple A risk as far as we are concerned. This is risk that is safe for retirement accounts, for short-term money markets. It's it's very safe risk. Now, what varies is what subordination the rating agencies require in order to assign that AAA rating. So, depending on the pool of mortgages that the portfolio managers, uh, the aggregators, portfolio managers have put together, um, they'll require a different amount of subordination. So, if I were to put together a pool of very, very strong credit quality mortgages, right? We're talking borrowers who have very close to perfect credit scores, who are coming in with very large down payments right out the gate, you know, very safe, secure mortgages that most people aren't going to really worry about the credit of the borrower. In that case, the rating agencies are gonna say, look, this is a really great pool that you brought us. We think that you only need to have a very small amount of subordinate debt, you know, maybe it's only three to five percent in order for us to issue a AAA rating because of how confident we are in the performance of these underlying borrowers. Now, if you were to have a similar situation, but instead of coming to the rating agency with a pool of very high credit quality mortgages, maybe you're coming to market with a pool of reperforming loans, right? Mortgages where borrowers have gone delinquent or potentially even defaulted on their mortgages and then have come back via loss mitigation or another program into paying their mortgage on a monthly basis, right? These are borrowers who certainly have a delinquency or default in their credit history. These are borrowers who have had some financial issues in the past. The rating agency is gonna look at that pool of mortgages and they're gonna say, oh wow, you know, this is not nearly as high credit quality as what we've seen in other pools. So we're gonna require a lot more subordinate debt in order to be able to issue a AAA rating. So in that case, maybe they need to see as much as 50 or 60% subordination, where only 50 or 40% of your securitization is rated AAA, whereas on the pool of much higher uh credit quality mortgages, where you only need 3% to 5% subordinate debt, right, you can have a triple A tranche that makes up 95 to 97% of your securitization. So that's really where the variation comes from the rating agencies. Uh, they're not saying, you know, a triple A rating looks different on this transaction from this transaction. Triple A risk remains the same across asset classes, uh, you know, across different industries. But what they are saying is we're gonna need some more uh subordination, some more cushion between the AAA tranche investors and potential credit losses in the event of default from the underlying borrowers.

SPEAKER_01 16:35

And that is how I intended the question. Although now I'm going to ask it a slightly different way to be a little meta here. Is there any rating of the rating agencies? Like, hey, Fitch and Moody's haven't been on top of their game lately when it comes to the ultimate borrower performance in these securities. Maybe they're that their ratings here we don't value as much as a different uh and different rating agency like SP. Is there much of that? How much checking is there of the agencies to make sure they're they stay on top of their own performance?

SPEAKER_00 17:08

Absolutely. Um the rating agencies, do they receive ratings themselves? So I'm not sure that the rating agencies receive ratings themselves. That being said, many of the rating agencies are publicly traded companies like SP, for example, whose equity will have a rating associated with it. That being said, rating agencies are primarily uh divided into two main groups, known as major and minor rating agencies. Major rating agencies, you know, pretty self-explanatory, they're going to be your larger rating agencies who have more market share, who have rated more securitizations, and who have been around for a very long time, right? Major rating agencies include SP, Fitch, and Moody's. Minor rating agencies, on the other hand, in some cases are potentially newer, right? Maybe less well known, uh, don't have the same market share as the major rating agencies do. And they're generally speaking going to be not taken into less consideration, but the ratings that they provide will typically be less uh punitive to the issuer of the securities. So that's how we typically will categorize uh rating agencies, not necessarily via their credit rating of their equity stock that trades on, you know, the New York Stock Exchange or the NASDAQ, but primarily on their market share. How stringent or strict are their um ratings, you know, methodology. Each one of these rating agencies has their own formula or uh methodology that they use to assign credit ratings to different types of debt and equity assets. So that's really how we're going to categorize them.

SPEAKER_01 18:57

And I know I'm very in the weeds here. I do want to ask you about the current market, but before I get there, how does a company, say Rocket comes to market with a securitization, how do they decide what rating agency to work with? Is there a gold standard? And then you if you don't get that, you're hoping to, you know, another rating agency will take it up. Does it all come down to money? How's that work?

SPEAKER_00 19:18

Great question, Robbie. Um, generally speaking, it's a lot of different factors that we have to take into account here. So, number one, we're gonna be looking at what does the rating agency want to charge us, right? As the issuer of the securities, we have to pay these rating agencies to rate our securities for us, right? So we want to make sure that we're getting a good value from money as the issuer of the securities. The amount that we pay them is really not the most important thing to us. What is actually more important to us than what we have to pay these rating agencies is going to be their turnaround times and their responsiveness, right? Are they very responsive to questions? Are they responsive? Um, are they able to turnaround loan tapes quickly? Does it take them a very long time to rate our securitization, which would negatively impact the reception by our investors? So those are our primary concerns when we're looking at rating agencies. When it comes to their uh ratings methodology, to the models that they use to provide the credit rating ratings, they're very similar. There are some small differences that could be arbitraged between them to potentially take advantage of differences in their rating methodologies, but that's not the typical method that's used to determine which one a potential issuer is going to go with. Generally speaking, you're looking for expertise, right? Are they familiar with these assets? Have they rated a lot of these types of securitizations? Um, are they comfortable with providing that credit rating? That's gonna be your first and foremost question when talking to a rating agency. Then you want to understand how responsive are they? Are they gonna be able to get this rating in the books in time for your deal to come to market? Or are they gonna be delaying your deal and potentially costing you and your investors, right? That's gonna be probably the second most important thing. The third most important thing will be cost, right? Everything costs money, everyone wants to get a good deal. So we want to make sure that we're not overpaying for our credit ratings. So I would say those are gonna be the three most important factors that you're looking at when determining which rating agency to go with. Now it is market standard to go with at least one major rating agency. You don't need to have a major rating agency, but it is market standard to have at least one major, and then usually you'll have one minor as well, so that each one of your issued tranches in the securitization will have. Two ratings from two different rating agencies.

SPEAKER_01 22:04

Thank you very much for indulging me on that. Let's get into the current market. What have we seen in the RMBS market recently? It comes to volume, demand, pricing, etc.

SPEAKER_00 22:17

Absolutely. It's been a very popular market. So I would say private credit in general has exploded in interest from, you know, a couple billion a few years ago to over a trillion dollars today. So the appetite for debt securities has increased significantly. We're seeing a lot of interest from asset managers and insurance companies who previously were not active in the RMBS space or specifically the non-agency RMBS space, who have moved into the non-agency RMBS space, who are looking for the additional yield that they can get from these fixed income securities, right? Going into this rate hike cycle that occurred after the pandemic, interest rates were increased rapidly, as you know, we've all beared the effects of. And what that caused was it's caused this rift where we have this what appears to be temporary and very drastic increase in short-term interest rates, right? As soon as the Fed raised interest rates, generally speaking, you expect the long end of the yield curve, uh the 10 or 30-year longer duration assets to uh give us a bit of an increase in yield to compensate us for the longer time period that we're investing in these assets. But that didn't really occur when the Fed increased interest rates over the past two years. We saw short-term rates uh yields increase rapidly uh to account for the increase in interest rates, but long-term yields remained relatively muted and haven't really increased significantly, which indicates, right, that fixed income investors believe interest rates are going to come down prior to that 10, 20, 30 year period. So the market has been operating under the assumption that the higher interest rates that we've seen right now, it's not a higher-for-longer situation. This is a temporary high interest rate environment that we're in right now that the Federal Reserve will eventually have to cut back on interest rates relatively soon. Now, with where we are today and uh the market volatility that we saw in early August, that uh Friday to Monday uh, you know, interesting scenario that occurred. We've got now got uh large banks like City and JP Morgan who are not calling for 50 basis points of easing in 2024. They're now calling for 100 basis points of easing in 2024 to help make up for the increases in unemployment that we've seen so far. So the Federal Reserve, you know, they've they've got to balance this uh dual mandate that they have between interest rates and inflation and unemployment. Um, and right now it looks like the pendulum is swinging back in the direction of high unemployment, which means that the Federal Reserve, their typical monetary policy reaction to unemployment increases, is to reduce interest rates. Now, that reduction in interest rates creates mark-to-market gains, right? It causes the prices of the bonds in our investors' portfolios to appreciate closer to par. And in some cases, even above par, if rates go down enough that new mortgage originations are at a lower interest rate than previous originations. So the reason why I think we've seen so much of this additional interest in private credit and in fixed interest rate, fixed yield investments, is because of this uh limited time opportunity that investors have to lock in higher yields so that they can capitalize on the appreciation to par or above par of those assets when the Fed does eventually start reducing interest rates.

SPEAKER_01 26:30

And that's a fantastic point about future expectations being baked in to current pricing. I'm gonna ask you to take it one step further, though, before I let you go. And I should say I've enormously enjoyed this interview thus far. Pull out your crystal ball for me, for listeners, a little bit here. What do you expect moving through the end of 2024 when it comes to the RMBS space?

SPEAKER_00 26:52

Robbie, I'm very glad that you asked me this question today and not two weeks ago prior to the August 2nd and August uh 5th uh, you know, economic turmoil that we saw, because the answer that I give you today is going to be significantly different than the answer that I would have provided two weeks ago. Um, today, what do I see as we move toward the end of 2024? Well, all eyes are on employment, right? Unemployment figures in the United States are going to be the subject of a lot of analysis, a lot of hand-wringing as analysts and pundits are trying to figure out where the Fed is moving at the end of this year. And it's all about unemployment at this point, right? Inflation seems to be under control, barring anything that gets out of control there. You know, if we have a much higher inflation reading moving towards the end of this year, things could change. Or if we have a very strong employment figure come out, you know, that unemployment has dropped significantly, that could also change. But as of right now, if things keep going the way they're going, with inflation looking like it's been defeated and close to or even below that 2% Federal Reserve target and unemployment continues kind of creeping up and up close to the 4% target and beyond the 4% unemployment target. That's when we're definitely going to start seeing the Federal Reserve very seriously look at making some significant rate cuts. All it takes is one unemployment figure or one inflation reading to come in. Uh that's outside of what we're expecting. But at this point in time, inflation seems mitigated. Unemployment is on the rise. All expectations are looking for rate cuts at the end of this year and as we move into the beginning of 2025.

SPEAKER_01 28:48

Very well put. Thank you so much for the comprehensive overview of the RMBS space. And uh hopefully I'll have you back on the show sometime soon to discuss what trends we're seeing out there. Thank you very much.

SPEAKER_00 29:01

Thank you so much, Robbie. Really appreciate being on the show today.

SPEAKER_01 29:08

As Fed Chair Powell readied his speech for this morning, treasury yields gained across the curve yesterday as markets bet that he will squash expectations for aggressive rate cuts. Fed officials are publicly saying they believe it's appropriate for the central bank to begin lowering rates soon. Boston Fed President Collins said it will soon be appropriate for the Fed to begin gradually easing to preserve a still healthy labor market. While Philadelphia Fed President Harker told multiple media outlets that the process of moving rates down should begin in September and be done methodically. Fed funds' futures markets are once again pricing in roughly a hundred basis points of easing for the remainder of the year. Existing home sales increased, as expected, by 1.3% in July, marking the first improvement in five months. Likely due to a slight dip in financing costs from the previous month. Mortgage rates averaged nearly a quarter percentage point lower in July than June and have fallen further in August, which should help home sales in the rest of 2024. The seasonally adjusted annual rate of existing home sales reached $3.95 million in July, although sales were still down 2.5% from the previous year. The median sales price of existing homes rose by 4.2% year over year to $422,600, marking the 13th consecutive month of price gains. Additionally, the inventory of unsold existing homes edged up by 0.8% from the prior month to $1.33 million, representing a 4.0 month supply at the current sales pace. Mortgage rates hit fresh year-to-date lows and the lowest since May 2023 in the latest primary mortgage market survey from Freddie Mac. For the weekending August 22nd, the 30-year and 15-year mortgage rates declined three basis points and four basis points, 6.46% and 5.62%, respectively. And are lowered by 77 basis points and 93 basis points from a year ago. Fed Chair Powell is today's highlight when he speaks on the economic outlook before the 2024 Jackson Hole Economic Policy Symposium in Wyoming. July new home sales will also be released later this morning, with estimates looking for 635,000 versus 617,000 in June. We begin the day with agency MBS prices, roughly unchanged from yesterday's close, and the tenure yielding 3.85 after closing yesterday at 3.86%. Let's wrap up with a joke and some housekeeping. You know that tingly little feeling you get when you really like someone? That's common sense leaving your body.com. Visit RobChristman.com for more information on our industry partners, access to archived commentaries, and how to subscribe to the daily mortgage news and commentary. To listen to or download past episodes of this podcast, search mortgage news on any platform you get your podcast from.