Mortgage Market Monitor August 2017

Monthly Commentary

September 25, 2017

Market Update

The Non-Agency RMBS market had a particularly busy summer month of August in which secondary supply spiked to 7.3bn from 5.0bn in July and set the mark for the highest monthly total year-to-date. While the month’s bid list calendar was filled mostly with smaller sizes (72% of line items had less than 5mm current face), more than two thirds of the actual volume came from bonds with 10mm current face or more. The main sources behind the increase in selling were the GSEs, which put out three lists exceeding 2bn in all and were easily absorbed by end accounts. Even as a wide range of uncertainties and threats, including escalating tensions with North Korea, allowed volatility to return to other parts of the market, Non-Agencies nonetheless continued on their steady march towards tighter spreads and higher prices. Despite spreads continuing to move further beyond postcrisis tights, investors still viewed loss adjusted returns as attractive especially in a sector with growing net-negative supply and additional upside from ongoing improvements in housing. While the legacy space maintained its strong sponsorship up and down the capital structure, sentiment in credit risk transfer deals changed course alongside the rise in volatility of broader risk assets and led the credit curve to steepen. Compounded by the devastating impact of Hurricane Harvey, CAS and STACR bonds, which have higher levels of exposure to Houston as well as structural leverage relative to legacy, closed the month wider by roughly 15-25bps, 40-60bps, and 90-110bps on more recent vintage M1s, M2s, and B1s, respectively.

The primary market was relatively quiet with one risk transfer deal pricing during the month. Fannie Mae issued its sixth transaction of the year, 1.1bn CAS 2017-C06, which contained both the low and high LTV groups. The 1M1, 1M2, and 1B1 priced at 75, 265, and 415bps, respectively, while the 2M1, 2M2, and 2B1 priced at 75, 280 and 445bps, respectively.

Collateral Performance

Serious delinquencies were flat across all sectors in August with the exception of Subprime, where delinquencies rose a little. Prime increased by 1 basis point to 5.85%; Alt-A delinquencies decreased by 1 basis point to 12.98%; Option Arm delinquencies decreased by 1 basis points to 19.60% and Subprime delinquencies increased by 20 basis points to 24.04%. Roll rates from current status to delinquency continue to be held in at very low levels.

Voluntary prepayments were mixed across sectors this month. Prime CRRs came in at 15.0%, down 198 basis points month-over-month; Alt-A CRRs were 13.5%, down 170 basis points month-over-month; Option Arm CRRs were 9.4%, down 46 basis points month-over-month and Subprime CRRs were 10.0%, up 150 basis points month-over-month. Month-over-month changes in CDRs all declined. Prime CDRs decreased by 56 basis points to 1.17%; Alt-A CDRs decreased by 73 basis points to 3.38%; Option Arm CDRs decreased by 106 basis points to 4.11% and Subprime CDRs decreased by 61 basis points to 5.31%.

Case-Shiller futures indicate a continuation of slow gains in residential home prices, predicting home prices will rise two to three percent annually during the next three years. Year-over-year, home prices are up 5.7% across Case-Shiller’s 20 major city index. At the national level, changes in severities were mixed across all sectors. At the state level, California Subprime severities were up slightly to 46% this month. Florida Subprime severities decreased to 78%. New York Subprime severities were flat at 88%; and Nevada Subprime severities were increased to 71%.

Hurricane's Impact

Like other investors trying to anticipate the economic losses on credit sensitive mortgage securities stemming from hurricanes Harvey and Irma, we turn to hurricane Katrina for insight. Katrina struck New Orleans on August 29th, 2005. Levees gave way the next day, flooding 80% of homes and causing $135 billion in damage. 134,000 housing units were damaged by the storm. This resulted in a mass exodus of over half of the population. Before Katrina the New Orleans population was 484,674. By July 2006, the population had dropped to 230,172.

While the storm and subsequent displacement caused delinquencies to spike to 50% and 74% among agency mortgages and subprime non-agency mortgages, respectively, delinquencies fell back to normal levels within two years and economic losses were limited. We estimate subprime nonagency cumulative losses due to Katrina at 1.4%.

While it is still early, damage estimates for Harvey and Irma are $70 billion and $50 billion, respectively. At this point, it seems that Katrina inflicted more damage than both Harvey and Irma. We believe if credit sensitive mortgage securities are pricing in more than 1.4% of cumulative losses to exposed areas from each storm, it would be an overreaction.

We can normalize the loss expectation of these two storms by comparing the cost estimates: Harvey (70 bln) / Katrina (135 bln) = 52% * 1.4% = 0.73% normalized cumulative losses, and Irma (50 bln) / Katrina (135 bln) = 37% * 1.4% = 0.52% normalized cumulative losses. However, we also note that it is hard to find hurricane Sandy's (2012) impact in agency and non-agency mortgage credit (delinquencies and cumulative losses) despite the $70 billion cost. Hence this loss analysis is likely conservative.

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