Since the Great Financial Crisis (GFC), the performance of loans held in Non-Agency securitizations has been pristine. We have observed a drastic difference in performance between pre-GFC originated loans (legacy) and the loans originated post-GFC (2.0). There are two main contributors to this sheer improvement in performance of loans underlying Non-Agency securitizations: a steady increase in home equity since 2011 and government oversight and regulation of underwriting and origination standards. Below is a breakout of the cumulative losses realized across different sub-sectors within the Non-Agency market. The sectors at the top of the chart in gray represent pre-GFC originations, while the sectors highlighted in green are post-GFC originations.

Cumulative Liquidations and Losses Across Sectors

Source: BofA Global Research, 1010Data

Increase in Home Equity

Steady home price appreciation since 2011 has increased the total value of the housing market, primarily by growing homeowners’ equity. This accumulation of home equity has greatly incentivized borrowers not to default on their mortgage, even during times of distress. One of the main drivers of a borrower’s performance has been the amount of equity he/she has in the home. This was never more evident than during the years leading up to the GFC as lending standards loosened to the point where consumers could purchase a house without using any personal funds for a down payment (zero down). As the housing market turned and home prices declined, these borrowers found themselves underwater, or in other words, having a larger mortgage balance outstanding than the actual value of the house. There was little incentive for these borrowers to continue paying their mortgage, resulting in widespread defaults in what became known as the “subprime crisis.” Since then, lending standards have tightened, mostly requiring a borrower to have “skin in the game” by contributing at least a 20% down payment toward the purchase of their home. This initial down payment, along with the increasing home equity resulting from home price appreciation, have pushed household equity to an all-time high of $24.2 trillion, and contributed to the stellar performance we’ve seen from mortgage borrowers since 2011.

Value of the U.S. Single Family Housing Market

Source: Federal Reserve Flow of Funds and Urban Institute. Last updated June 2021.

Mortgage Industry Overhaul

During the years preceding the GFC, many borrowers were given mortgages without regard to their ability to repay the loans. Loose underwriting standards by lenders, failure to verify the borrower’s income or debts (liar loans) and qualifying borrowers based on “teaser” interest rates, contributed to a mortgage crisis that led to the most serious recession since the Great Depression. In an effort to help the country avoid another financial crisis, there was a massive overhaul of the mortgage industry that resulted in stricter government regulation and oversight. In 2010, Congress introduced and signed into law the most important piece of legislation for the financial industry, the Dodd-Frank Wall Street Reformed Consumer Protection Act (“Dodd-Frank.”) Overall, Dodd-Frank reformed the financial system, adding new government agencies as multiple provisions from the Act took effect over the course of several years. In particular, there is the Ability to Repay/Qualified Mortgage Rule (ATR/QM) rule, which effectively makes it harder for lenders to offer loans that are not in the best interest of the applicant. It requires lenders to make a “reasonable and good faith determination” regarding a consumer’s ability to repay (ATR) their mortgage according to its terms. This now must be done for every borrower during the qualification process and before the lender originates a residential mortgage.

Below is the Urban Institute’s Housing Credit Availability Index (HCAI) which assesses lenders’ tolerances for both borrower risk and product risk, calculating the share of owner-occupied purchase loans that are likely to go 90+ days delinquent over the life of the loan. The HCAI peaked in 2006 just prior to the GFC. As evident below, product risk taken by lenders has been basically nonexistent and borrower risk significantly lower.

Source: eMBS, CoreLogic, HMDA, IMF, and Urban Institute
Note: Default is defined as 90 days or more delinquent at any point. Last updated April 2021.

With lenders now required to confirm and document a borrower’s ability to repay (ATR), the nature of the mortgages originated in recent years differs qualitatively from those originated prior to the financial crisis; for example, the graph below shows that over 70% of recently issued mortgages were for borrowers with credit scores at or above 760+, versus just a 25% share in 2006. The 2005- 2007 vintage of mortgages frequently involved reduced documentation underwriting, interest only or negative amortization loan features, and large amounts of equity withdrawal for refinance transactions – attributes that are far less common today.

Over 70% of U.S. Mortgage Originations Are for Borrowers With Credit Score at 760 or Above

Distribution of credit scores for U.S. mortgage loans by origination quarter

Source: Federal Reserve Bank of New York, Goldman Sachs Global Investment Research

Conclusion

Compared to 2007, there is more reason to have confidence today that outstanding borrowers can afford to service their mortgage debt. Higher quality performance has played out across mortgage credit products, even in times of distress. We continue to have a constructive outlook on mortgage credit and view the current trends in the housing market as supportive to the fundamental value of being invested in the sector. Expected home price appreciation combined with conservative underwriting standards, favorable housing supply/demand dynamics and near-historic low mortgage rates will continue to be supportive of valuations. While the current mortgage market is a very supportive backdrop for investing, we recognize that this type of lending landscape won’t continue forever and remain disciplined bottom-up credit investors. As always, we have a watchful eye on mortgage underwriting standards, which are still conservative and one of the few credit risk sectors where underwriting guidelines have remained significantly tighter than what we saw in the lead up to the GFC.