Investors Fight the Last War: Relative Value in Mortgage-Land
The recent past tends to bias our expectations of the future. Nobel Laureate Daniel Kahneman says it’s due to our reliance on what he calls the Representative Heuristic. Call it an evolutionary adaptation if you like, but long-term investors might as well call it opportunity.
History shows that investors and regulators collectively overestimate the likelihood of recent low-probability events repeating themselves following periods of market crisis. The visceral experience of gut-wrenching losses typically leads investors to abandon certain risk types leaving many assets orphaned and strategies hopelessly out of favor. The abandonment of the offending risk type in preparation for the “last war” often creates attractive investment opportunities for rational, margin-of-safety investors. The unmitigated disaster that was the mortgage debacle in the mid-2000s appears to have created just such opportunity in mortgage loans today.
The benefits of loan securitization were pushed way beyond any semblance of prudence in the early 2000’s driven by misaligned incentives at every step of the process (borrowers, originators, banks, securitizers, rating agencies etc.). The steady decline in borrower credit quality and deterioration in structural protections of mortgage backed securities were enabled by the nearly insatiable demand from the institutional investor community (insurance companies, bond funds, sovereign wealth funds, etc.). With subprime risk being the input, the credit derivatives market later metastasized into a series of increasingly leveraged side bets based on the dubious assumption that housing prices countrywide (pun intended) wouldn’t fall in value simultaneously. The sheer size of this ill-fated market sparked very real solvency and liquidity issues that had ripple effects throughout the entire global economy. This saga ended in tears as most market excesses tend to, and the reputation of the securitized credit market remains damaged to this day.
Driven by investor bias and substantial new regulation, many of the traditional providers of consumer credit have effectively exited the market following the financial crisis. This limited supply of willing lenders comes at a time when the US consumer’s creditworthiness is near all-time highs by many measures. The now fragmented non-agency mortgage market appears to offer attractive prospective returns with comparatively low risk relative to traditional stocks and bonds.
One example of an opportunity created by the aforementioned supply/demand mismatch is in investor mortgages. Post-crisis, it is exceptionally difficult to obtain financing to purchase a rental property, for example. The relative scarcity of funding is hugely advantageous to lenders with only the most creditworthy borrowers having access to such loans. These types of mortgage loans are well underwritten with low loan-to-value ratios, high debt service coverage ratios, fully verified borrower statistics and, in most cases, even personal guarantees from the borrowers. These conservative mortgage loans sporting relatively high interest rates represent a sufficient “margin of safety” in our estimation.
I can envision more than a few crisis-scarred readers scoffing at the idea of non-agency mortgages and mortgage backed securities being attractive, low risk investments. That’s exactly the mindset that allows such opportunities to persist! The below table highlights just how far the pendulum has swung in favor of conservatism in non-agency mortgage lending. It would now take a truly draconian scenario for investors in recent vintage mortgage pools to experience principal losses. For example, to impair even $1 of investor principal with loans issued at 67% loan-to-value, not only would the creditworthy borrower need to default, but the collateral backing the loan would need to decline in value by an amount 1.5x worse than the declines experienced in the global financial crisis1.
At Oxford we believe that embracing complexity and capitalizing on fragmented market segments are some of the surest ways to enhance client’s risk-adjusted returns. As noted above, these scenarios are often a direct result of increased regulations and irrational market participants preparing to fight the “last war.” The opportunities we currently see in mortgage-land are a prime example of a differentiated return source offering valuable diversification not often found directly in more pro-cyclical traditional (read “60/40”) asset allocations.
As seems to be true in most aspects of life, doing the difficult thing is often right. Investing is no different. Most market participants seem biased against digging through the wreckage following market traumas. Adding to recent underperformers is emotionally difficult, and often fraught with reputational risk. But it is often in these formerly challenging sectors where market imbalances produce the best risk-adjusted return opportunities.
1S&P/Case-Shiller 20 City Composite Home Price Index
2RCO 2018-VFS1 Trust
3Long Beach Mortgage Loan Trust 2006-1
The above commentary represents the opinions of the author as of 7.24.19 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.