Mortgages: Don’t Be Fooled By The Averages by Michael S. Canter and Matthew D. Bass, AllianceBernstein
US mortgages today have little in common with the risky loans made before the housing crisis. But some market participants aren’t treating them all that differently. We think that’s a mistake—and an opportunity.
The confusion, in our view, stems from how people assess default risk. Before investors and analysts buy a residential mortgage-backed security (RMBS)—or assign a credit rating to one—they naturally want to know something about the quality of the underlying mortgage loans and the potential for defaults. The easiest way to do that is by reviewing average credit statistics.
For instance, there are FICO scores, which assess the overall credit strength of borrowers. Loan-to-value ratios (LTV) compare the size of the loan to the value of the property. And debt-to-income ratios indicate how much of a borrower’s monthly income goes to debt payments.
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The Problem with Averages
Here’s the problem with focusing on the top-level averages: they can be misleading. These credit statistics (and a few others) can tell you a lot about the probability of default for an individual mortgage loan. But when those same statistics are averaged across thousands of loans in an MBS, they become less meaningful.
The really meaningful aspect of loan analysis is how the different credit metrics relate and interact to define the riskiness of individual loans. For instance—do borrowers with low FICO scores also have high LTV ratios, meaning weak credit and high debt? Or do they have strong credit and more debt? And how are the different risk levels distributed throughout the RMBS?
Piling Risk on Top of Risk
The practice of having multiple high-risk red flags in an individual loan is known as risk layering. Some risk layering is inevitable—borrowers rarely have perfect credit. But even a small increase in the number of negative credit metrics in a loan pool can substantially increase default probability. In other words, risk layering—not average credit metrics—drives RMBS performance. The more risk layering there is, the higher the chances of default and the greater the potential loss.
Before the housing crisis hit, non-agency RMBS had a lot of risk layering. After all, subprime lenders routinely originated interest-only loans, and lent money to borrowers without verifying their income or even requiring a down payment. This is a big reason why so many underlying loans defaulted when the housing bubble burst. We estimate that about half the losses pre-crisis RMBS experienced were driven by risk layering.
Battle of the RMBS Vintages
Many casual observers might look at surface-level metrics on the new risk-sharing transactions from government-sponsored enterprises Fannie Mae and Freddie Mac, and assume that the underlying loans would default in large numbers if the US housing rebound were to reverse course. A closer look at the collateral suggests that isn’t necessarily true. [Risk-sharing transactions are also known as Credit Risk Transfer (CRT), and are issued under the names STACR (Freddie) and CAS (Fannie).]
Comparing pre-crisis RMBS to the new risk-sharing transactions (Display) shows that risk-sharing transactions have much less risk layering. We can see this by looking at the presence of various combinations of credit metrics that indicate riskier loans.
For example, we isolated mortgage loans where the borrowers had both low FICO scores (weak credit) and high debt-to-income ratios. In the 2006 agency RMBS, 10.3% of underlying mortgage loans had that combination; for the 2015 risk-sharing transaction, only 0.3% did. We saw the same disparity in other risky credit combinations: weak credit combined with high leverage (a high loan-to-value ratio); and high leverage combined with a high debt-to-income ratio. All of these risky cohorts were much smaller in the new risk-sharing transactions.
Today’s Mortgages Are Different
That’s because, as we’ve noted before, lending standards are extremely tight—only high-quality borrowers are getting loans. Borrowers with lower-than-average FICO scores tend to have offsetting positives: maybe they’ve made a large down payment, or have a very low debt-to-income ratio or loan-to-value ratio. As a result, we think these transactions would come through another period of market stress or housing slowdown with few defaults.
Some investors, though, are acting as if it were still 2007. They’re treating the new breed of mortgage-backed securities from GSEs as if they had a lot of risk layering. As a result, we think many risk-sharing transactions are cheap relative to the amount of credit risk being taken. If you have the patience and resources to dig deeper into the underlying loans, this presents great relative value.
As we’ve said before, we think the GSE risk-sharing transactions offer a great opportunity to get access to newly originated loans in the $10.5 trillion US mortgage market. It may be underappreciated now—but we doubt it will stay that way.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.