New York | In this issue of The Institutional Risk Analyst, we speak with Chris Abate, CEO of Redwood Trust (NYSE:RWT). Mortgage finance professionals know RWT as one of the pioneers of non-agency, non “QM” or qualified residential mortgage production, an important market that exists outside of the heavily regulated world of Fannie Mae, Freddie Mac and Ginnie Mae. The non-QM mortgage market is also adjacent to the $2.9 trillion market for bank-owned 1-4 family mortgages and HELOCs held in portfolio, making RWT an important macro market bellwether for investors and regulators alike.
The IRA: You have seen an interesting 12 months at RWT. We started 2020 going gangbusters, then the money markets essentially melted down in mid-March. The Federal Open Market Committee responded with “shock and awe” and bought trillions of dollars in Treasury debt and agency MBS. Walk us through the past three quarters for you, both as an investor and as an issuer of private label MBS.
Abate: Interesting is one way to describe it! When the markets started to seize in March, we were in a very similar position to most in the industry. But soon the Fed stepped in and started buying Agency MBS en masse. You saw the bid for conforming loans skyrocket. Jumbos and other non-agency products were left unsupported. Ironically, the jumbo loans were higher quality and ultimately have fared better in terms of credit, but no one seemed to care at the time.
The IRA: Yes, we’ve often wondered why the Fed does not get the connection between prime non-QM loans and the bank portfolio market for residential jumbos. Kind of seems like an obvious area for Fed support in times of liquidity stress, but the economists don't seem to get it. The chart below shows the market for 1-4s and HELOCs as of Q3 2020.
Abate: We talked about it at the time. But no matter, we pounded our way out of the crisis without any government stimulus and did so without needing any outside dilutive capital. Industry volumes today have been hovering at record levels, something hard to imagine at the depths of the crisis.
The IRA: Send a thank you note to Fed Chairman Jerome Powell. But how was April of last year different from say April 2019 and the end of December 2018? Or even 2008?
Abate: When people ask what made this crisis in 2020 different than the Great Financial Crisis, we believe it was the ideological misfires by the Fannie/Freddie regulator. The major Wall Street banks, unlike the last crisis, never really wavered and supported mortgage market liquidity. But the GSE regulator appeared to approach the crisis opportunistically, as a way to prioritize GSE profitability over their role in stabilizing the housing sector, presumably in pursuit of their exiting conservatorship.
The IRA: Agreed. There is definitely a conflict of visions at work at the Federal Housing Finance Agency (FHFA). When you look at the totality of the rules and decisions taken by FHFA Director Mark Calabria, they really make no sense. We are going to take the GSEs out of conservatorship, on the one hand; but no, we are going to constrain profits and liquidity, on the other. How did you view Calabria’s moves in the middle of last year?
Abate: The decisions made in favor of the GSEs and in opposition to supporting market liquidity blindsided most of the industry. We expected the GSEs to be a countercyclical and calming presence rather than inciting panic. The FHFA response was especially bewildering when every other facet of government was working in close coordination to stave off the crisis. For our friends in banking, imagine if the Fed started margin calling the big banks in response to the market selloff rather than supporting the system! That’s how it felt to industry participants, and the trickle-down effects to the non-bank servicers and non-agency sector were unforced errors in my view.
The IRA: Well, the GSEs own the $6 trillion in conventional loans and the servicing, so you'd think that they would support their market. But let's talk a bit about the calculus used by the Fed between pushing down funding costs and the inevitable compression of yields. Where do you see yields and the Treasury yield curve over the next 12-18 months?
Abate: The Fed faced twin dilemmas when the panic over COVID-19 first erupted early last year. The first was that financial markets froze and stopped functioning. The Fed used the monetary bazooka to release an unprecedented amount of liquidity into the financial markets to stabilize things. With record low benchmarks, investors realized they needed to go further out the risk curve to earn a real return on their capital. Fear of missing out, or “FOMO,” soon became the dominant market psychology and drove financial asset prices to new highs. At this point, it seems like every class of investor has moved down the credit curve in some fashion.
The IRA: That is the idea. Twist the risk curve till it bleeds. But do continue with the Fed point.
Abate: The second dilemma was that the Main Street economy experienced a sudden and dramatic contraction and the Fed wanted some of the newly-injected liquidity to make its way to the real economy instead. So, they dusted off their Great Financial Crisis playbook and started buying agency MBS. This provided aid directly to homeowners by driving down interest rates and creating a refi boom. We could argue about the effects QE has had on the repo markets and credit, but the Agency purchases have a populist appeal that other Fed actions simply can’t replicate.
The IRA: So where do you think the Treasury yield curve goes given the policy mix and QE purchase schedule the FOMC has articulated?
Abate: We believe the curve has more room to steepen due to supply of issuance that is required to fund the increased fiscal deficits. That seems like the consensus view and those expectations are priced into the market and traders are likely positioned for that. However, widespread consensus always gives us pause. The long end is likely to be more volatile as 10-year Treasuries trade within a range of perhaps 1.50% to 0.50%. With delays in vaccination rollouts, and real economic devastation to small businesses and certain sectors of the economy (including travel, leisure, and retail), we see some real headwinds to the recovery. Right now, the market is optimistic that large scale fiscal stimulus will have a positive and lasting effect on the economy. A change in expectations could cause the curve to flatten with longer rates rallying back to the middle or lower end of the range I just mentioned.
The IRA: Well, seeing 1.5% yields on Treasury 10-year notes will likely get Treasury Secretary Janet Yellen in a tantrum. In a related point, talk about your legacy private label MBS and how that body of assets has fared in terms of credit and prepayments?
Abate: Unlike the Great Financial Crisis, where housing led to an economic collapse, housing fundamentals and credit were on solid footing before the COVID-19 crisis. Delinquencies and/or forbearance on our traditional prime jumbo loans increased in the spring and peaked at 3% in early summer. Since then, we have seen a significant decline in delinquencies, and as of the end of 2020, the rate of new delinquencies is currently similar to what it was pre-COVID.
The IRA: Your results are good for private label. Net defaults on bank owned 1-4s are still hovering around zero net charge-offs on portfolio loans because home prices and thus post-default recoveries are so strong.
Abate: We’re proud of how our loans have performed relative to the rest of the prime jumbo market. Total delinquencies on our private label MBS program have generally been lower than the market. We think this speaks well to our loan acquisition process, surveillance, and loss mitigation.
The IRA: Your experience fits with the narrative coming from the banks, namely that consumer credit is not that bad despite COVID, but volumes of new credit creation did weaken a bit in Q4. How do you think forward delinquencies will look as loans roll off forbearance?
Abate: Given the economic uncertainty, we expect industry-wide delinquencies will remain above their pre-COVID levels for quite some time as there are some borrowers who are facing significant financial hardships. Fortunately, home prices have re-accelerated due to the factors we mentioned. This means that while some hard-hit borrowers will struggle to make their monthly payments, home equity is increasing and ultimately should lead to a lower level of losses than just looking at the delinquencies in isolation.
The IRA: The big question in the world of mortgage finance is prepayments. As and when refinance volumes fall, we expect to see prepays also slow and asset values for servicing assets to rise accordingly. What is your view on servicing and prepays more generally?
Abate: Prepayments have increased for the entire market, and it’s difficult to draw conclusions on our program when you consider that nearly every jumbo borrower has a large incentive to refi. The performance and investor-friendly features of our private label MBS program allow us to execute consistently in the market. We issued new transactions in the market soon after the liquidity crisis passed and have been off to the races since then.
The IRA: There are growing signs of life in certain parts of PLS. Banks are again buying third party jumbo production after a six month hiatus. Talk a bit about how the market managed through 2020 and what you expect to see going forward. We hear a lot of traders complaining how tough it is to source new collateral for agency and private issuance. Is the secondary market tight along with the MBS markets more generally?
Abate: Because PLS markets were not supported by last spring’s substantial stimulus efforts, there was an immediate pause in issuance activity that caused issuers to seek alternative financing for loan pools that were prepped for securitization. Beginning in the late spring, with yields compressing significantly in areas supported by the government, we began to see the markets open back up as investors needed to put money to work. With substantial cash still on the sidelines, the market continued to strengthen through Q3 and Q4; in the fourth quarter alone we completed four securitizations across our jumbo and single-family rental platforms backed by loans originated since the pandemic began. Our recent deals achieved better execution than our early 2020 transactions, prior to the market dislocation.
The IRA: So the general bull market in 1-4s c/o the Powell FOMC will extend across the credit spectrum?
Abate: Given the housing market’s tailwinds, including low borrowing costs and investor demand for housing credit, we expect 2021 to be a record year for PLS issuance. As you note, a potential headwind for issuers may be the ability to consistently source collateral – essentially, the difference between a robust flow purchase program such as ours, versus reliance on the bulk market. The depth of our seller base and our discipline of being in the market every day with reliable flow pricing is an important competitive advantage for us. This is especially true now, given increased demand from traditional balance-sheet lenders trying to grow net interest margin while replenishing record amounts of runoff. And as a direct lender to investors in single-family real estate through our CoreVest platform, we can craft our products to fit borrower needs and drive higher client retention rates.
The IRA: So feast to famine and back to even bigger feast in just 12 months? What does the product mix at RWT look like in 2021?
Abate: The vast majority of our jumbo volume since mid-2020 has been traditional prime jumbo (Redwood Select), however we’ve begun to see increased engagement from sellers on our expanded prime and non-QM program, Redwood Choice. More broadly, the expanded credit sector remains a niche part of the market. Given capacity constraints at originators, the market’s been challenged to source these higher-yielding credits. This will likely evolve further in 2021 – particularly given the revised QM rule, which we expect to survive in the Biden Administration. We still aren’t convinced the rule change is the right one, but it will definitely push more non-QM loans to QM safe harbor. That will help the banks and hurt the predominant non-QM originators.
The IRA: Looking ahead over the year, how does the scene look next January for the hybrid REITs and particularly the PLS issuers?
Abate: By January 2022, the hybrid REITs will likely diverge between more traditional, passive investors, and those with more focused mortgage banking activities. For now, many remain busy securitizing pre-pandemic collateral and cleaning up their balance sheets. But with the current yield environment, investing in third party assets will become progressively more difficult as more capital piles into the sector. We saw an auction in early January for newly-issued subordinate RMBS bonds in which 25 bidders participated. A year ago, you would have been lucky to see 5-10 bidders. In my view, it’s going to put the focus on accessing the loan “raw material” at the originator level to be able to procure investments and deploy significant sums of capital. That said, we’ve seen what a difference a year can make in this business.
The IRA: That is an understatement. And we agree, the crowd around the hoop for all of these secured mortgage assets and derivatives is growing thanks to QE. We'll see what happens as and when the Fed tries to taper. Be well Chris.