With the economy showing signs of a possible recession, there have been several articles focused on rising consumer debt and what that might mean for credit spreads if the U.S. does in fact enter a recession. Home mortgages accounted for two-thirds of the $13.67 trillion in U.S. household debt in the first quarter of 2019, and, in absolute terms, now exceeds the amount of mortgage debt outstanding just before the 2008 housing and credit meltdown. Additionally, there has been a push by politicians and banks to loosen credit standards for mortgages, thus risking a repeat of the “make mortgages available for all” policies that contributed to the Global Financial Crisis.
While the risk of another consumer credit meltdown might be rising, the structure of the consumer credit market, particularly with respect to residential mortgage backed securities (RMBS), is fundamentally less vulnerable than it was in the 2005-2008 period. There is less leverage, credit standards are far stricter, consumer debt is now held by “stronger hands.” As such, should there be an economic downturn, we don’t expect the RMBS market to collapse as it did in 2007-2008.
Today, banks are warehousing most non-agency mortgages on their balance sheets, and still the vast majority of residential mortgages securitized through a government channel (e.g. Fannie Mae, Freddie Mac, or FHA). In 2007, over 60% of residential mortgages were financed by way of a private label securitization, and when the market dipped for those securities, the financing channel for 60% of the market abruptly closed. Nothing like that can happen today.
We believe that an economic downturn will create opportunities to take advantage of reduced pricing on certain non-agency residential mortgage backed securities. In 2008, there was a dramatic overreaction to the financial crisis that saw bonds trading at 20 cents on the dollar for no rational reason. Today, some of these bonds are trading above par. In a downturn, we would expect some, but significantly less, overreaction than we saw in 2008; the result would be great buying opportunities. The most senior bonds in the structure should experience only small mark-to-market losses while bonds more junior in structure may get hit harder.
We believe that the pre-2008 crisis bonds have exceedingly better credit than even newer mortgages that were underwritten under post-2008 standards. The reason is that underlying loans have a 10+ year payment history. The fact that the performing loans underlying these bonds paid though the 2008 crisis and that the homeowners have more equity in their home (either through appreciation or principal payments) seems to be lost on traditional fixed income managers. We also believe a market overreaction should create buying opportunities for post-2008 bonds as perceived toxicity, without regard for the credit underlying the bonds, can drive down market sentiment.
Lastly, market disruptions or even an expectation of market disruptions create even more opportunities in the special situations space, i.e., event-driven investment strategies related to RMBS. We believe that these opportunities will present themselves over the next five years. If there is a recession, we would expect to see some of these opportunities accelerate and become even more profitable because of downward pressure on the RMBS market in general. We expect that there will be excellent value points to enter such trades when they start to materialize.
We are certainly not rooting for a downturn as we believe that today there are excellent relative value opportunities as well as special situations that will keep RMBS performance on an upward track.