RMBS slowly moving back into portfolios

Institutional investors are moving back into residential mortgage-backed securities, even as lawsuit settlements are giving them back some of the money they lost on RMBS investments made before the financial crisis.

But industry executives say it's different this time.

Asset owners invested about $500 billion in mortgage-backed securities and other mortgage investments in 2014, up 25% from 2010, according to the most recent data from the Federal Reserve.

Some investors are making direct investment in RMBS. The federal government backs a so-called agency market worth $5.2 trillion, while the non-agency RMBS market was $668.5 billion as of Nov. 30, according to data from Bank of America Merrill Lynch. Investors in non-agency RMBS include the $180 billion New York State Common Retirement Fund, which in February committed $250 million to New York-based fixed-income manager Semper Capital Management LP.

Many are getting exposure primarily to agency RMBS through their core-plus fixed-income portfolios. The average exposure to RMBS in the typical core-plus bond portfolio is 23.4%, according to a report to the Oregon Investment Council by Callan Associates, its general investment consultant.

New York State Common's investment with Semper is being made as part of its fixed-income portfolio, said spokesman Matthew Sweeney. “It's structured, so requires a bit more technical expertise,” he said in an e-mail. “(Semper) has a long-standing and successful track record.”

Some 10.9% of the Salem-based Oregon Public Employees Retirement Fund's $14.9 billion fixed-income portfolio is invested in domestic agency RMBS, the Callan report shows.

The securities of 2016 are not the rapid-fire originations that totaled $2.2 trillion at their peak in 2007, investors and credit managers say. Regulatory changes have made the securities less risky, noted one institutional investor. What's more, there have been few non-agency securities issued since the financial crisis, so asset owners are investing in older securities. The advantage, managers say, is that with older RMBS investors know which borrowers are paying down their mortgages and which ones have defaulted or are in the process of defaulting.

By and large, the loans underlying post-crisis RMBS are a higher quality than the pre-crisis version of the securities, said Brian Grow, managing director, RMBS, at Morningstar Credit Ratings LLC, New York, the rating agency subsidiary of Morningstar Inc.

“There are very few subprime borrowers in post-crisis, non-agency securitizations,” Mr. Grow said. “The loans that are being securitized have real documented homeowner income, a lot of reserves. ... Underwriting is a lot tighter.”

Also, a larger percentage of the securities are being purchased by institutional investors because they're being sold as private placements rather than public offerings, which was more common before 2008. Private placement rules require buyers of the bonds to be qualified buyers, which are mainly institutional investors.

The pre-crisis RMBS are growing in popularity with credit managers. “There's definitely demand on the investor side for exposure to residential assets and a number of lenders that want to lend,” Mr. Grow said.

Many of the changes that are making RMBS more attractive to institutions were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The quality mortgage rule, for example, ensures that mortgages underlying the bonds are taken out by borrowers who understand what they're getting, Mr. Grow explained.

In addition to Dodd-Frank-based regulations, there are new truth-in-lending rules that require lenders to make very precise disclosures. More investors will take on RMBS as the industry gains additional clarity on the requirements of the new regulations, he said.

These are “regulatory clouds” that need to be resolved before the RMBS market will take off in a big way. “People are nervous and don't want to violate anything that increases the cost of the deal,” Mr. Grow said. “But all of these things are resolvable.”

Greg Parsons, CEO and investment committee chair at New York-based Semper Capital Management, said his firm has been investing strictly in post-crisis RMBS. There is more clarity around the quality of the mortgages in the new bundles and investors are getting more comfortable owning them, he said.

There's been an “emotional shift” among institutional investors, Mr. Parsons said. Until recently, institutional investors viewed RMBS as toxic; “eight years later, there's more acceptance,” he said.

Semper, a boutique investment manager specializing in mortgages and other asset-backed investments, has between $800 million and $1 billion invested in RMBS.

Still, the legacy RMBS are not without risk, Mr. Grow said. Even though there is a bias that mortgages in RMBS pools that have not defaulted are better quality, homeowners with these pre-crisis mortgages are still going through the default process, Mr. Grow said.

But Mr. Parsons said many of the homeowners who were underwater on their mortgages have already defaulted or are in the foreclosure process. Much of the remaining homeowners have been making their mortgage payments for eight years, which provides a good mortgage payment history, he said.

Marc Rosenthal, co-portfolio manager and co-head of New York-based hedge fund firm MatlinPatterson Global Advisers LLC's securitized credit team, said non-agency securities provide investors with cash flow. And since the bonds are relatively cheap, investors tend to invest the proceeds in more RMBS, which stabilizes the shrinking market. “The ability to predict the cash flows of the underlying mortgages has gotten better over time,” Mr. Rosenthal said.

It wasn't that long ago that investors were stung by RMBS investments.

In January, Goldman Sachs Group agreed to pay $5 billion in to settle a lawsuit involving RMBS. In August, the NECA-IBEW Health & Welfare Fund and the Detroit Policemen & Firemen Retirement System, on behalf of a class of institutional and individual investors, settled a separate lawsuit against Goldman Sachs for $272 million. The suit alleged the bank had made a number of misstatements about the loans in $6 billion of RMBS. J.P. Morgan Chase & Co., Bank of America and Citigroup have so far paid $37 billion to settle cases that also claimed the banks misrepresented the quality of the bonds being bundled into RMBS.

By far, the largest settlement so far has been Countrywide's $8.5 billion settlement, which has yet to be distributed to bondholder plaintiffs. Some industry insiders expect institutional investors will reinvest the settlement proceeds in RMBS.

Mr. Rosenthal said that when the Countrywide bondholders receive their settlement money, “a large portion” of institutional investors will reinvest that money back into RMBS in order to retain their allocation to the strategy.