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Why Accurate MSR Cost Forecasting Requires Loan-by-Loan Analytics

When it comes to forecasting MSR cash flows, the practice of creating “rep lines,” or cohorts, of loans with similar characteristics for analytical purposes has its roots in the Agency MBS market. One of the most attractive and efficient features of Agencies is the TBA market. This market allows originators and issuers to sell large pools of mortgages that have not even been originated yet. This is possible because all parties understand what these future loans will look like. All these loans will all have enough in common as to be effectively interchangeable with one another.

Institutions that perform the servicing on such loans may reasonably feel they can extend the TBA logic to their own analytics. Instead of analyzing a hundred similar loans individually, why not just lump them into one giant meta-loan? Sum the balances, weight-average the rates, terms, and other features, and you’re good to go.

Why the industry still resorts to loan cohorting when forecasting MSR cash flows

The simplest explanation for cohort-level analytics lies in its simplicity. Rep lines amount to giant simplifying assumptions. They generate fewer technological constraints than a loan-by-loan approach does. Condensing an entire loan portfolio down to a manageable number of rows requires less computational capacity. This takes on added importance when dealing with on-premise software and servers. It also facilitates the process of assigning performance and cost assumptions.

What is more, as OAS modeling has evolved to dominate the loans and MSR landscape, the stratification approach necessary to run Monte Carlo and other simulations lends itself to cohorting. Lumping loans into like groups also greatly simplifies the process of computing hedging requirements.

Advantages of loan-level over cohorting when forecasting MSR cash flows

Treating loan and MSR portfolios like TBA pools, however, has become increasingly problematic as these portfolios have grown more heterogeneous. Every individual loan has a story. Even loans that resemble each other in terms of rate, credit score, LTV, DTI, and documentation level have unique characteristics. Some of these characteristics – climate risk, for example – are not easy to bucket. Lumping similar loans into cohorts also runs the risk of underestimating tail risk. Extraordinarily high servicing/claims costs on just one or two outlier loans on a bid tape can be enough to adversely affect the yield of an entire deal.

Conversely, looking at each loan individually facilitates the analysis of portfolios with expanded credit boxes. Non-banks, which do not usually have the benefit of “knowing” their servicing customers through depository or other transactional relationships, are particularly reliant on loan-level data to understand individual borrower risks, particularly credit risks. Knowing the rate, LTV, and credit score of a bundled group of loans may be sufficient for estimating prepayment risk. But only a more granular, loan-level analysis can produce the credit analytics necessary to forecast reliably and granularly what a servicing portfolio is really going to cost in terms of collections, loss mitigation, and claims expenses.

Loan-level analysis also eliminates the reliance on stratification limitations. It facilitates portfolio composition analysis. Slicing and dicing techniques are much more simply applied to loans individually than to cohorts. Looking at individual loans also reduces the risk of overrides and lost visibility into convexity pockets.

RiskSpan’s cloud-native Edge Platform projects prepayment, default, severity and MSR cash flows (income and costs) at the loan level

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Potential challenges and other considerations

So why hasn’t everyone jumped onto the loan-level bandwagon when forecasting MSR cash flows? In short, it’s harder. Resistance to any new process can be expected when existing aggregation regimes appear to be working fine. Loan-level data management requires more diligence in automated processes. It also requires the data related to each individual loan to be subjected to QC and monitoring. Daily hedging and scenario runs tend to focus more on speed than on accuracy at the macro level. Some may question whether the benefits of such a granular, case-by-case analysis that identifying the most significant loan-level pickups requires actually justifies the cost of such a regime.

Rethink. Why now?

Notwithstanding these challenges, there has never been a better time for loan and MSR investors to abandon cohorting and fully embrace loan-level analytics when forecasting MSR cash flows. The emergence of cloud-native technology and enhanced database and warehouse infrastructure along with the ability to outsource the hosting and computational requirements out to third parties creates practically limitless scalability.

The barriers between MSR experts and IT professionals have never been lower. This, combined with the emergence of a big data culture in an increasing number of organizations, has brought the granular daily analysis promised by loan-level analytics tantalizingly within reach.

Striking a Proper Balance: ESG for Structured Finance

The securitization market continues to wrestle with the myriad of approaches and lack of standards in identifying and reporting ESG factors in transactions and asset classes. But much needed guidance is on the way as industry leaders work toward a consensus on the best way to report ESG for structured finance.

RiskSpan gathered with other key industry players tackling these challenges at this month’s third annual Structured Finance Association ESG symposium in New York City. The event identified a number of significant strides taken toward shaping an industry-standard ESG framework and guidelines.

Robust and engaging discussions across a variety of topics illustrated the critical need for a thoughtful approach to framework development. We observed a broad consensus around the notion that market acceptance would require any solution to be data supported and fully transparent.

Much of the discussion revolved around three recurring themes: Finding a workable balance between the institutional desire for portfolio-specific measures based on raw data and the market need for a standardized scoring mechanism that everybody understands, maintaining data privacy, and assessing tradeoffs between the societal benefits of ESG investing and the added risk it can pose to a portfolio.

Striking the Right Balance: Institution-Specific Measures vs. Industry-Standard Asset Scoring

When it comes to disclosure and reporting, one point on a spectrum does not fit all. Investors and asset managers vary in their ultimate reporting needs and approach to assessing ESG and impact investing. On the one hand, having raw data to apply their own analysis or specific standards can be more worthwhile to individual institutions. On the other, having well defined standards or third-party ESG scoring systems for assets provides greater certainty and understanding to the market as a whole.

Both approaches have value.

Everyone wants access to data and control over how they view the assets in their portfolio. But the need for guidance on what ESG impacts are material and relevant to structured finance remains prominent. Scores, labels, methodologies, and standards can give investors assurance a security contributes to meeting their ESG goals. Investors want to know where their money is going and if it is meaningful.

Methodologies also have to be explainable. Though there was agreement that labeled transactions are not always necessary (or achievable), integration of ESG factors in the decision process is. Reporting systems will need to link underlying collateral to external data sources to calculate key metrics required by a framework while giving users the ability to drill down to meet specific and granular analytical needs.

Data Privacy

Detailed analysis of underlying asset data, however, highlights a second key issue: the tradeoff between transparency and privacy, particularly for consumer-related assets. Fiduciary and regulatory responsibility to protect disclosure of non-public personally identifiable information limits investor ability to access loan-level data.

While property addresses provide the greatest insight to climate risk and other environmental factors, concerns persist over methods that allow data providers to triangulate and match data from various sources to identify addresses. This in turn makes it possible to link sensitive credit information to specific borrowers.

The responsibility to summarize and disclose metrics required by the framework falls to issuers. The largest residential issuers already appreciate this burden. These issuers have expressed a desire to solve these issues and are actively looking at what they can do to help the market without sacrificing privacy. Data providers, reporting systems, and users will all need to consider the guardrails needed to adhere to source data terms of use.

Assessing Impact versus Risk

Another theme arising in nearly all discussions centered on assessing ESG investment decisions from the two sometimes competing dimensions of impact and risk and considering whether tradeoffs are needed to meet a wide variety of investment goals. Knowing the impact the investment is making—such as funding affordable housing or the reduction of greenhouse gas emissions—is fundamental to asset selection or understanding the overall ESG position.

But what risks/costs does the investment create for the portfolio? What is the likely influence on performance?

The credit aspect of a deal is distinct from its ESG impact. For example, a CMBS may be socially positive but rent regulation can create thin margins. Ideally, all would like to maximize positive impact but not at the cost of performance, a strategy that may be contributing now to an erosion in greeniums. Disclosures and reporting capabilities should be able to support investment analyses on these dimensions.

A disclosure framework vetted and aligned by industry stakeholders, combined with robust reporting and analytics and access to as much underlying data as possible, will give investors and asset managers certainty as well as flexibility to meet their ESG goals.

Webinar: Tailoring Stress Scenarios to Changing Risk Environments

July 13th | 1:00 p.m. ET

Designing market risk stress scenarios is challenging because of the disparate ways in which various risk factors impact different asset classes. No two events are exactly alike, and the Covid-19 pandemic and the Russian invasion of Ukraine each provide a case study for risk managers seeking to incorporate events without precise precedents into existing risk frameworks.

Join RiskSpan’s Suhrud Dagli and Martin Kindler on Wednesday, June 15th at 1 p.m. ET as they illustrate an approach for correlating rates, spreads, commodity prices and other risk factors to analogous historical geopoltical disruptions and other major market events. Market risk managers will receive an easily digestable tutorial on the math behind how to create probability distributions and reliably model how such events are most likely to impact a portfolio.

Featured Speakers

Suhrud Dagli

Co-Founder and CIO, RiskSpan

Martin Kindler

Managing Director, RiskSpan

Why Climate Risk Matters for Mortgage Loan & MSR Investors

The time has come for mortgage investors to start paying attention to climate risk.

Until recently, mortgage loan and MSR investors felt that they were largely insulated from climate risk. Notwithstanding the inherent risk natural hazard events pose to housing and the anticipated increased frequency of these events due to climate change, it seemed safe to assume that property insurers and other parties in higher loss position were bearing those risks.

In reality, these risks are often underinsured. And even in cases where property insurance is adequate, the fallout has the potential to hit investor cash flows in a variety of ways. Acute climate events like hurricanes create short-term delinquency and prepayment spikes in affected areas. Chronic risks such as sea level rise and increased wildfire risk can depress housing values in areas most susceptible to these events. Potential impacts to property insurance costs, utility costs (water and electricity in areas prone to excessive heat and drought, for example) and property taxes used to fund climate-mitigating infrastructure projects all contribute to uncertainty in loan and MSR modeling.

Moreover, dismissing climate risk “because we are in fourth loss position” should be antithetical to any investor claiming to espouse ESG principles. After all, consider who is almost always in the first loan position – the borrower. Any mortgage investment strategy purporting to be ESG friendly must necessarily take borrower welfare into account. Dismissing climate risk because borrowers will bear most of the impact is hardly a socially responsible mindset. This is particularly true when a disproportionate number of borrowers prone to natural hazard risk are disadvantaged to begin with.

Hazard and flood insurers typically occupy the loss positions between borrowers and investors. Few tears are shed when insurers absorb losses. But society at large ultimately pays the price when losses invariably lead to higher premiums for everybody.

Evaluating Climate Exposure

For these and other reasons, natural hazards pose a systemic risk to the entire housing system. For mortgage loan and MSR investors, it raises a host of questions. Among them:

What percentage of the loans in my portfolio are susceptible to flood risk but uninsured because flood maps are out of date?
How geographically concentrated is my portfolio? What percentage of my portfolio is at risk of being adversely impacted by just one or two extreme events?
What would the true valuation of my servicing portfolio be if climate risk were factored into the modeling?
What will the regulatory landscape look like in coming years? To what extent will I be required to disclose the extent to which my portfolio is exposed to climate risk? Will I even know how to compute it, and if so, what will it mean for my balance sheet?

Incorporating Climate Data into Investment Decision Making

Forward-thinking mortgage servicers are at the forefront of efforts to get their arms around the necessary data and analytics. Once servicers have acquired a portfolio, they assess and triage their loans to identify which properties are at greatest risk. Servicers also contemplate how to work with borrowers to mitigate their risk.

For investors seeking to purchase MSR portfolios, climate assessment is making its way into the due diligence process. This helps would-be investors ensure that they are not falling victim to adverse selection. As investors increasingly do this, climate assessment will eventually make its way further upstream, into appraisal and underwriting processes.

Reliably modeling climate risk first requires getting a handle on how frequently natural hazard events are likely to occur and how severe they are likely to be.

In a recent virtual industrial roundtable co-hosted by RiskSpan and Housing Finance Strategies, representatives of Freddie Mac, Mr. Cooper, and Verisk Analytics (a leading data and analytics firm that models a wide range of natural and man-made perils) gathered to discuss why understanding climate risk should be top of mind for mortgage investors and introduced a framework for approaching it.

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Building the Framework

The framework begins by identifying the specific hazards relevant to individual properties, building simulated catalogs of thousands of years’ worth of simulated events, computing likely events simulating damage based on property construction and calculating likely losses. These forecasted property losses are then factored into mortgage performance scenarios and used to model default risk, prepayment speeds and home price impacts.

Responsibility to Borrowers

One member of the panel, Kurt Johnson, CRO of mega-servicer Mr. Cooper, spoke specifically of the operational complexities presented by climate risk. He cited as one example the need to speak daily with borrowers as catastrophic events are increasingly impacting borrowers in ways for which they were not adequately prepared. He also referred to the increasing number of borrowers incurring flood damage in areas that do not require flood insurance and spoke to how critical it is for servicers to know how many of their borrowers are in a similar position.

Johnson likened the concept of credit risk layering to climate risk exposure. The risk of one event happening on the heels of another event can cause the second event to be more devastating than it would have been had it occurred in a vacuum. As an example, he mentioned how the spike in delinquencies at the beginning of the covid pandemic was twice as large among borrowers who had just recovered from Hurricane Harvey 15 months earlier than it was among borrowers who had not been affected by the storm. He spoke of the responsibility he feels as a servicer to educate borrowers about what they can do to protect their properties in adverse scenarios.

FHFA Prepayment Monitoring Reports (Q1 2022) Powered by RiskSpan’s Edge Platform

To help enforce alignment of Agency prepayments across Fannie’s and Freddie’s Uniform MBS, the Federal Housing Finance Agency publishes a quarterly monitoring report. This report compares prepayment speeds of UMBS issued by the two Agencies. The objective is to help ensure that prepayment performance remains consistent. This consistency ensures that market expectations of a Fannie-issued UMBS are fundamentally indistinguishable from those of a Freddie-issued UMBS. The two Agencies’ UMBS should be interchangeably deliverable into passthrough “TBA” trades.

This week, the FHFA released the Q1 2022 version of this repo rt. The charts in the FHFA’s publication, which it generates using RiskSpan’s Edge Platform, compare Fannie and Freddie UMBS prepayment rates (1-month and 3-month CPRs) across a variety of coupons and vintages.

Relying on RiskSpan’s Edge Platform for this sort of analysis is fitting in that it is precisely the type of comparative analysis for which Edge was developed.

Edge allows traders, portfolio managers, and analysts to compare performance across a virtually unlimited number of loan subgroups. Users can cohort on multiple loan characteristics, including servicer, vintage, loan size, geography, LTV, FICO, channel, or any other borrower characteristic.

Edge’s easy-to-navigate user interface makes it accessible to traders and PMs seeking to set up queries and tweak constraints on the fly without having to write SQL code. Edge also offers an API for users that want programmatic access to the data. This is useful for generating customized reporting and systematic analysis of loan sectors.

Comparing Fannie’s and Freddie’s prepay speeds only scratches the surface of Edge’s analytical capabilities. Schedule a demo to see more of what the platform can do.

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Senior Home Equity Rises Again to $10.6 Trillion

Homeowners 62 and older saw their housing wealth grow by some $405 billion (3.8 percent) during the fourth quarter of 2021 to a record $10.6 trillion according to the latest quarterly release of the NRMLA/RiskSpan Reverse Mortgage Market Index.

The NRMLA/RiskSpan Reverse Mortgage Market Index (RMMI) rose to 370.56, another all-time high since the index was first published in 2000. The increase in older homeowners’ wealth was mainly driven by an estimated $452 billion (3.7 percent) increase in home values, offset by a $44 billion (2.3 percent) increase in senior-held mortgage debt.

For a comprehensive commentary, please see NRMLA’s press release.

How RiskSpan Computes the RMMI

To calculate the RMMI, RiskSpan developed an econometric tool to estimate senior housing value, mortgage balances, and equity using data gathered from various public resources. These resources include the American Community Survey (ACS), Federal Reserve Flow of Funds (Z.1), and FHFA housing price indexes (HPI). The RMMI represents the senior equity level at time of measure relative to that of the base quarter in 2000.[1]

A limitation of the RMMI relates to Non-consecutive data, such as census population. We use a smoothing approach to estimate data in between the observable periods and continue to look for ways to improve our methodology and find more robust data to improve the precision of the results. Until then, the RMMI and its relative metrics (values, mortgages, home equities) are best analyzed at a trending macro level, rather than at more granular levels, such as MSA.

[1] There was a change in RMMI methodology in Q3 2015 mainly to calibrate senior homeowner population and senior housing values observed in 2013 American Community Survey (ACS).

Surge in Cash-Out Refis Pushes VQI Sharply Higher

A sharp uptick in cash-out refinancing pushed RiskSpan’s Vintage Quality Index (VQI) to its highest level since the first quarter of 2019.

RiskSpan’s Vintage Quality Index computes and aggregates the percentage of Agency originations each month with one or more “risk factors” (low-FICO, high DTI, high LTV, cash-out refi, investment properties, etc.). Months with relatively few originations characterized by these risk factors are associated with lower VQI ratings. As the historical chart above shows, the index maxed out (i.e., had an unusually high number of loans with risk factors) leading up to the 2008 crisis.

RiskSpan uses the index principally to fine-tune its in-house credit and prepayment models by accounting for shifts in loan composition by monthly cohort.

Rising Rates Mean More Cash-Out Refis (and more risk)

As the following charts plotting the individual VQI components illustrate, a spike in cash-out refinance activity (as a percentage of all originations) accounted for more of the rise in overall VQI than did any other risk factor.

This comes as little surprise given the rising rate environment that has come to define the first quarter of 2022, a trend that is likely to persist for the foreseeable future.

As we demonstrated in this recent post, the quickly vanishing number of borrowers who are in the money for a rate-and-term refinance means that the action will increasingly turn to so-called “serial cash-out refinancers” who repeatedly tap into their home equity even when doing so means refinancing into a mortgage with a higher rate. The VQI can be expected to push ever higher to the extent this trend continues.

An increase in the percentage of loans with high debt-to-income ratios (over 45) and low credit scores (under 660) also contributed to the rising VQI, as did continued upticks in loans on investment and multi-unit properties as well as mortgages with only one borrower.

Population assumptions:

Monthly data for Fannie Mae and Freddie Mac.
Loans originated more than three months prior to issuance are excluded because the index is meant to reflect current market conditions.
Loans likely to have been originated through the HARP program, as identified by LTV, MI coverage percentage, and loan purpose, are also excluded. These loans do not represent credit availability in the market as they likely would not have been originated today but for the existence of HARP.

Data assumptions:

Freddie Mac data goes back to 12/2005. Fannie Mae only back to 12/2014.
Certain fields for Freddie Mac data were missing prior to 6/2008.

GSE historical loan performance data release in support of GSE Risk Transfer activities was used to help back-fill data where it was missing.

An outline of our approach to data imputation can be found in our VQI Blog Post from October 28, 2015.

Data Source: Fannie Mae PoolTalk®-Loan Level Disclosure

EDGE: Cash-Out Refi Speeds

Mortgage rates have risen nearly 200bp from the final quarter of 2021, squelching the most recent refinancing wave and leaving the majority of mortgage holders with rates below the prevailing rate of roughly 5% (see chart below). For most homeowners, it no longer makes sense to refinance an existing 30yr mortgage into another 30yr mortgage.

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But, as we noted back in February, the rapid rise in home prices has left nearly all households with significant, untapped gains in their household balance sheets. For homeowners with consumer debt at significantly higher rates than today’s mortgage rates, it can make economic sense to consolidate debt using a cash-out refi loan against their primary residence. As we saw during 2002-2003, cash-out refinancing can drive speeds on discount mortgages significantly higher than turnover alone. Homeowners can also become “serial cash-out refinancers,” tapping additional equity multiple times.

In this analysis, we review prepayment speeds on cash-out refis, focusing on discount MBS, i.e., mortgages whose note rates are equal to or below today’s prevailing rates.

The volume of cash-out refis has grown steadily but modestly since the start of the pandemic, whereas rate/term refis surged and fell dramatically in response to changing interest rates. Despite rising rates, the substantial run-up in home prices and increased staffing at originators from the recent refi boom has left the market ripe for stronger cash-out activity.

The pivot to cash-out issuance is evidenced by the chart below, illustrating how the issuance of cash-out refi loans (the black line below) in the first quarter of this year was comparable with issuance in the summer of 2021, when rates near historic lows, while rate/term refis (blue line) have plunged over the same period.

With cash-out activity set to account for a larger share of the mortgage market, we thought it worthwhile to compare some recent cash-out activity trends. For this analysis, the graphs consist of truncated S-curves, showing only the left-hand (out-of-the-money) side of the curve to focus on discount mortgage behavior in a rising rate environment where activity is more likely to be influenced by serial cash-out activity.

This first chart compares recent performance of out-of-the money mortgages by loan purpose, comparing speeds for purchase loans (black) with both cash-out refis (blue) and rate/term refis (green). Notably, cash-out refis offer 1-2 CPR upside over rate/term refis, only converging to no cash out refis when 100bp out of the money.[1]

Next, we compare cash-out speeds by servicer type, grouping mortgages that are serviced by banks (blue) versus mortgages serviced by non-bank servicers (green). Non-bank servicers produce significantly faster prepay speeds, an advantage over bank-serviced loans for MBS priced at a discount.

Finally, we drill deeper into the faster non-bank-serviced discount speeds for cash-out refis. This chart isolates Quicken (red) from other non-bank servicers (green). While Quicken’s speeds converge with those of other non-banks at the money, Quicken-serviced cash-out refis are substantially faster when out of the money than both their non-bank counterparts and the cash-out universe as a whole.[2]

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We suspect the faster out-of-the-money speeds are being driven by serial cash-out behavior, with one servicer in particular (Quicken) encouraging current mortgage holders to tap home equity as housing prices continue to rise.

This analysis illustrates how pools with the highest concentration of Quicken-serviced cash-out loans may produce substantially higher out-of-the-money speeds relative to the universe of non-spec pools. To find such pools, users can enter a list of pools into the Edge platform and simultaneously filter for both Quicken and cash-out refi. The resultant query will show each pool’s UPB for this combination of characteristics.

[1] For this analysis, we focused mortgages aged 18 to 48 months, with FICO above 700, LTV less than or equal to 80, and loan size greater than or equal to 250k. Other cuts are available. Please see us for details.

[2] For this analysis, we removed points with less than 1000 observations to reduce statistical noise.

EDGE: Recent Performance of GNMA RG Pools

In early 2021, GNMA began issuing a new class of custom pools with prefix “RG.” These pools are re-securitizations of previously delinquent loans which were repurchased from pools during the pandemic.[1] Loans in these pools are unmodified, keeping the original rate and term of the mortgage note. In the analysis below, we review the recent performance of these pools at loan-level detail. The first RG pools were issued in February 2021, growing steadily to an average rate of $2B per month from Q2 onward, with a total outstanding of $21 billion.

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The majority of RG issuance has included loans that are two to seven years seasoned and represent a consistent 2-3% of the total GNMA market for those vintages, dashed line below.

Coupons of RG pools are primarily concentrated between 3.0s through 4.5s, with the top-10 Issuers of RG pools account for nearly 90% of the issuance.

Below, we compare speeds on GNMA RG pools under various conditions. First, we compare speeds on loans in RG pools (black) versus same-age multi-lender pools (red) over the last twelve months. When out of the money, RG pools are 4-5 CPR slower than comparably aged multi-lender pools but provide a significantly flatter S-curve when in-the-money.

Next, we plot the S-curve for all GNMA RG loans with overlays for loans that are serviced by banks (green) and non-banks (blue). Bank-serviced RG loans prepay significantly slower than non-banks by an average of 9 CPR weighted across all incentives. Further, this difference is caused by voluntary prepays, with buyouts averaging a steady 4% CBR, plus or minus 1 CBR, for both banks and non-banks with no discernable difference between the two (second graph).

Finally, we analyzed the loan-level transition matrix by following each RG loan through its various delinquency states over the past year. We note that the transition rate from Current to 30-day delinquent for RG loans is 1.6%, only marginally worse than that of the entire universe of GNMA loans at 1.1%. RG loans transitioned back from 30->Current at similar rates to the wider Ginnie universe (32.3%) and the 30->60 transition rate for RG loans was marginally worse than the Ginnie universe, 30.8% versus 24.0%.[2]

Monthly Transition Rates for Loans in GNMA RG Pools: In summary, loans in RG pools have shown a substantial level of voluntary prepayments and comparatively low buyouts, somewhat unexpected especially in light of their recent delinquency. Further, their overall transition rates to higher delinquency states, while greater than the GNMA universe, is markedly better than that of reperforming loans just prior to the outbreak of COVID.

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[1] For a more detailed description of the RG pool criteria, GNMA’s original memorandum can be found here.

[2] These transition rates have been stable over different time periods. The dollar-weighted average transition rates over the last year closely match the rates over the prior six months.

Asset Managers Improving Yields With Resi Whole Loans

An unmistakable transformation is underway among asset managers and insurance companies with respect to whole loan investments. Whereas residential mortgage loan investing has historically been the exclusive province of commercial banks, a growing number of other institutional investors – notably life insurance companies and third-party asset managers – have shifted their attention toward this often-overlooked asset class.

Life companies and other asset managers with primarily long-term, risk-sensitive objectives are no strangers to residential mortgages. Their exposure, however, has traditionally been in the form of mortgage-backed securities, generally taking refuge in the highest-rated bonds. Investors accustomed to the AAA and AA tranches may understandably be leery of whole-loan credit exposure. Infrastructure investments necessary for managing a loan portfolio and the related credit-focused surveillance can also seem burdensome. But a new generation of tech is alleviating more of the burden than ever before and making this less familiar and sometimes misunderstood asset class increasingly accessible to a growing cadre of investors.

Maximizing Yield

Following a period of low interest rates, life companies and other investment managers are increasingly embracing residential whole-loan mortgages as they seek assets with higher returns relative to traditional fixed-income investments (see chart below). As highlighted in the chart below, residential mortgage portfolios, on a loss-adjusted basis, consistently outperform other investments, such as corporate bonds, and look increasingly attractive relative to private-label residential mortgage-backed securities as well.

Nearly one-third of the $12 trillion in U.S. residential mortgage debt outstanding is currently held in the form of loans.

And while most whole loans continue to be held in commercial bank portfolios, a growing number of third-party asset managers have entered the fray as well, often on behalf of their life insurance company clients.

Investing in loans introduces a dimension of credit risk that investors do need to understand and manage through thoughtful surveillance practices. As the chart below (generated using RiskSpan’s Edge Platform) highlights, when evaluating yields on a loss-adjusted basis, resi whole loans routinely generate yield.

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In addition to higher yields, whole loans investments offer investors other key advantages over securities. Notably:

Data Transparency

Although transparency into private label RMBS has improved dramatically since the 2008 crisis, nothing compares to the degree of loan-level detail afforded whole-loan investors. Loan investors typically have access to complete loan files and therefore complete loan-level datasets. This allows for running analytics based on virtually any borrower, property, or loan characteristic and contributes to a better risk management environment overall. The deeper analysis enabled by loan-level and property-specific information also permits investors to delve into ESG matters and better assess climate risk.

Daily Servicer Updates

Advancements in investor reporting are increasingly granting whole loan investors access to daily updates on their portfolio performance. Daily updating provides investors near real-time updates on prepayments and curtailments as well as details regarding problem loans that are seriously delinquent or in foreclosure and loss mitigation strategies. Eliminating the various “middlemen” between primary servicers and investors (many of the additional costs of securitization outlined below—master servicers, trustees, various deal and data “agents,” etc.—have the added negative effect of adding layers between security investors and the underlying loans) is one of the things that makes daily updates possible.

Lower Transaction Costs

Driven largely by a lack of trust in the system and lack of transparency into the underlying loan collateral, private-label securities investments incur a series of yield-eroding transactions costs that whole-loan investors can largely avoid. Consider the following transaction costs in a typical securitization:

Loan Data Agent costs: The concept of a loan data agent is unique to securitization. Data agents function essentially as middlemen responsible for validating the performance of other vendors (such as the Trustee). The fee for this service is avoided entirely by whole loan investors, which generally do not require an intermediary to get regularly updated loan-level data from servicers.
Securities Administrator/Custodian/Trustee costs: These roles present yet another layer of intermediary costs between the borrower/servicer and securities investors that are not incurred in whole loan investing.
Deal Agent costs: Deal agents are third party vendors typically charged with enhancing transparency in a mortgage security and ensuring that all parties’ interests are protected. The deal agent typically performs a surveillance role and charges investors ongoing annual fees plus additional fees for individual loan file reviews. These costs are not borne by whole loan investors.
Due diligence costs: While due diligence costs factor into loan and security investments alike, the additional layers of review required for agency ratings tends to drive these costs higher for securities. While individual file reviews are also required for both types of investments, purchasing loans only from trusted originators allows investors to get comfortable with reviewing a smaller sample of new loans. This can push due diligence costs on loan portfolios to much lower levels when compared to securities.
Servicing costs: Mortgage servicing costs are largely unavoidable regardless of how the asset is held. Loan investors, however, tend to have more options at their disposal. Servicing fees for securities vary from transaction to transaction with little negotiating power by the security investors. Further, securities investors incur master servicing fees which is generally not a required function for managing whole loan investments.

Emerging technology is streamlining the process of data cleansing, normalization and aggregation, greatly reducing the operational burden of these processes, particularly for whole loan investors, who can cut out many of these intermediary parties entirely.

Overcoming Operational Hurdles

Much of investor reluctance to delve into loans has historically stemmed from the operational challenges (real and perceived) associated with having to manage and make sense of the underlying mountain of loan, borrower, and property data tied to each individual loan. But forward-thinking asset managers are increasingly finding it possible to offload and outsource much of this burden to cloud-native solutions purpose built to store, manage, and provide analytics on loan-level mortgage data, such as RiskSpan’s Edge Platform supporting loan data management and analytics. RiskSpan solutions make it easy to mine available loan portfolios for profitable sub-cohorts, spot risky loans for exclusion, apply a host of credit and prepay scenario analyses, and parse static and performance data in any way imaginable.

At an increasing number of institutions, demonstrating the power of analytical tools and the feasibility of applying them to the operational and risk management challenges at hand will solve many if not most of the hurdles standing in the way of obtaining asset class approval for mortgage loans. The barriers to access are coming down, and the future is brighter than ever for this fascinating, dynamic and profitable asset class.

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