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INVESTING

Firms resurrect non-agency RMBS market

Managers starting small; demand outpacing supply

Harrison Choi
Harrison Choi said non-agency residential mortgage securitization is far from the behemoth it once was.

Hedge funds, money management firms and alternative investment managers are doing their best to revive the non-agency residential mortgage-backed securitization market, which has been almost dead since the financial crisis.

As a result, investment in non-agency RMBS across asset classes is ticking up.

Fixed-income and other managers have loved the pre-crisis bonds for a number of years now because they can see which mortgages are performing and most of the foreclosures that are likely to happen have already occurred.

The new trend in non-agency RMBS is focused on managers trying to restart the market by issuing bonds based on new mortgages. The majority of the loans in many of the new non-agency RMBS mortgage pools are subprime.

The demand is there — from alternative investment managers, insurance companies, money managers and real estate investment trusts vying to buy the securities — but the supply isn't enough, industry executives say.

The non-agency RMBS market is really multiple markets that appeal to different buyers and sellers. In the same RMBS deal, one type of buyer — including fixed-income managers — will invest in the senior, most protected portion of the security. Another type of buyer — generally hedge funds and real estate investment trusts that can invest in high yield — will invest in the riskier junior tranches, which take losses earlier.

In the non-agency RMBS market, the prime jumbo sector was the first to come limping back to life, with banks being the main issuers. It is still a much smaller market than before 2008, because the lower housing prices relative to historical norms mean more loans qualify for agency mortgages. RMBS that hold big slugs of non-qualified mortgages are just lately being issued, with hedge funds and other alternative investment managers as big issuers.

The non-agency RMBS market is nowhere near the behemoth it was before the financial crisis, said Harrison Choi, a Los Angeles-based managing director and co-head of securitized products for TCW Group Inc.

Non-agency accounted for 56% of all RMBS in 2006, representing $1.17 trillion, according to the National Association of Insurance Commissioners. In 2015, non-agency RMBS sat at $75.9 billion, or 5.4% of the market.

Before the crisis, the non-agency market was dominated by finance companies and subprime lenders, said Mark Palim, Washington-based vice president, deputy chief economist at Fannie Mae.

“A lot of those withered up and the market switched to Fannie, Freddie, FHA and banks that hold the loans in their portfolios,” Mr. Palim said. “We are not surprised people are doing loans they don't think they can sell to us.”

But it is a hard sell, he said: “Large investors felt burned and are highly skeptical of something that doesn't meet agency standards.”

Still, a number of alternative investment firms, including Lone Star Funds, Beach Point Capital Management LP, Angel Oak Capital Advisors LLC and Varde Partners Inc., or subsidiary firms, have launched multiple issues of these non-agency bonds, with bundles of mortgages of borrowers who do not qualify for loans from the agency lenders or banks.

“These are healthy signs that the non-agency market is trying to find its way and come back,” said Mr. Choi. TCW's fixed-income strategies invest in non-agency securities, but Mr. Choi declined to say how much is invested.

“That said, it's in the very, very early stages,” Mr. Choi said. “We are very far away from where we were before the financial crisis.”

There is “decent demand” for the new RMBS issues, said Vesta Marks, portfolio manager at alternative income and opportunistic credit firm Palmer Square Capital Management LLC, Mission Woods, Kan. “The demand is being driven by the fundamentals in the housing market,” Mr. Marks said, noting that foreclosures are coming down and home sales remain strong.

Many RMBS carry floating-rate coupons, Mr. Marks said. “So, at the current level of interest rates and with the concern of interest rates rising, the floating-rate nature of the securities are attractive,” he said.

Not enough

So far, the number of new RMBS issues haven't been enough to declare that the market has come back to life, said Brian Grow, managing director of RMBS at Morningstar Credit Ratings LLC, the New York-based rating agency subsidiary of Morningstar Inc.

“All the fundamentals are there,” he said. “It seems there is an appetite for housing.”

There is a big demand for securities being sold by Fannie Mae and other agencies as they transfer the risk they hold to the private sector, Mr. Grow noted.

“There's a demand for other products ... but there is no supply,” he added.

“I've heard of credit loosening ... and higher loan-to-value (ratio) loans being originated,” he said. “But we're not seeing the volume of securitizations yet. ... You would have to see more than a few deals a year.”

Many issuers of the new RMBS are originating the loans, securitizing them — sometimes alongside loans of other lenders — and then selling some of the bonds to a subsidiary of their hedge fund or alternative investment manager parent.

For example, Angel Oak Capital, a hedge fund and mutual fund manager, has a subsidiary that originates residential mortgages and bundles them into RMBS. The firm has issued two unrated RMBS worth a combined $400 million since last year, and executives plan to launch a third, rated deal this year, said John Hsu, Atlanta-based head of capital markets for Angel Oak Capital. All of the mortgagesin Angel Oak's RMBS were originated by Angel Oak's affiliated mortgage companies.

Most of Angel Oak's homebuyers have owned a home in the past, he said. Some borrowers lost homes in the global financial crisis, while others lost homes more recently.

Angel Oak will consider lending to borrowers who have emerged from bankruptcy as recently as one day prior to applying for a new mortgage — those facing a short sale or a foreclosure — but the longer the better, Mr. Hsu said. “We are looking at the event and the facts behind the event and get our hands around it,” he said.

Angel Oak investigates each borrower to assess whether the borrower has established a certain degree of financial responsibility with the exception of a one-time event, he said. “It fits the "bad things happen to good people' adage,” Mr. Hsu said.

One investor in Angel Oak's RMBS is the firm's hedge fund, Mr. Hsu said. The hedge fund bought 10% of the first RMBS issue and 15% of the second.

Mr. Hsu acknowledges that as the private-label RMBS market ramps up, loans to borrowers that presentbad credit risk will seep into the pools. “The law of big numbers will get you,” he said. However, only 10 of the 1,300 mortgages in the pools purchased by the hedge fund are greater than 60 days delinquent on mortgage payments, he said.

Lone Star also has issued three sets of RMBS since 2015. Hudson Americas LP, a Lone Star subsidiary, is asset manager for all the assets, including residential mortgages. Another subsidiary, Caliber Home Loans Inc., originates the residential mortgages that Lone Star bundles into its RMBS.

Lone Star funds, including the Lone Star Residential Mortgage Fund I, invest in newly originated U.S. single-family residential mortgage loans.

Cutting mortgage fund

Even with origination and securitization capabilities, in July Lone Star cut the size of its residential mortgage fund in half, to $674 million, canceled future management fees, rebated 25% of already charged management fees and extended the fund's investment period by one year because of a slower than anticipated investment pace, according to a statement on its website.

“Speaking from an investor perspective, I would love for there to be (an RMBS market),” said Sean Dobson, CEO of Amherst Capital Management LLC, an Austin, Texas, alternatives manager. About half of Amherst's private fund is invested in agency residential mortgage securities, but the firm has not invested in the new private-label RMBS.

“I don't see the ills of securitizations being repaired,” Mr. Dobson said. “It's a little opportunistic and niche-y right now.”

Private lenders have to find borrowers willing to pay higher-than-market rates on their mortgages because they can't get a loan anywhere else, he said, so most of these mortgages are likely non-qualified.

“The risk for us, which we haven't gotten over as an institution, is the borrower's right to redress against the lender travels with the loans,” he said.

Under new post-crisis regulations, homebuyers have the right to sue their lenders if the borrower can show they did not have the ability to repay their mortgages when they were originated.

“That's a complete chiller of our ability to assess a risk-based price and understand the limits of our liability,” Mr. Dobson said. n

This article originally appeared in the September 19, 2016 print issue as, "Firms resurrect non-agency RMBS market".