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RMBS: The alphabet soup may taste better this time around

COVID 19 Coronavirus

June 5, 2020

Securitized credit markets may avoid getting badly burnt by the high heat of the COVID-19 pandemic

Quickly adopted by the media through the 2008 global financial crisis, the phrase “alphabet soup” was a (largely) negative collective term for the mortgage and structured credit markets. And in fairness, there are a truly bewildering array of acronyms that dominate these markets, be it residential mortgage-backed securities (RMBS), collateralized loan obligations (CLOs) or credit risk transfer mortgage bonds (CRTs). Many of these securities played a leading role in the global financial crisis, driven by a dramatic deterioration in credit underwriting standards and aggressive structuring. Some very poor quality ingredients, and even worse cooking, had ruined the soup. Defaults ensued, contributing to a great unwinding of the financial system. The bowl dropped and shattered.

How do we expect the soup to taste this time around? Pleasingly, we feel the ingredients appear to be of better quality. Consumer balance sheets are in a much stronger position compared to the 2008 crisis having gone through considerable deleveraging.

Graph showing consumer vs corporate debt levels
Consumer vs. corporate debt levels

Source: Latest data from the Federal Reserve Bank of St Louis

Interestingly, the opposite is true for corporations, which have used the low interest rate environment to raise enormous sums of debt. The mortgage debt service coverage is at an all-time high, aided by low mortgage rates. And considerably tighter lending standards have helped materially lower running delinquency rates.

Graph showing 30-year fixed-rate mortgages
30-year fixed-rate mortgages


The bowl itself is also stronger, with a number of structural improvements aiming to provide better security to investors. Most notably this has included stricter regulatory oversight, more robust ratings agency methodologies, greater transparency and a removal of insurer guarantees (i.e. AMBAC Financial Group Inc., MBIA Inc.).

In addition, we feel the quality of loan servicing has improved from a societal perspective. Servicers are now much more aligned to longer-term loan performance of mortgage bonds and are more willing to work with borrowers to modify their loans (something we are seeing happen very early into this crisis).

Unfortunately, very little of this positive story around securitized credit has been reflected in prices, particularly given the investor risk aversion and extreme illiquidity the asset class suffered from in March. As COVID-19 spread, investors began to redeem from liquid mutual funds and other retail vehicles, including mortgage real estate investment trusts (REITS)1, which have typically provided liquidity to the real estate market. This led to price-insensitive selling as funds aimed to meet redemptions at whatever cost necessary. As prices dropped, market players who employed leverage (including mortgage REITS) began to receive margin calls, forcing even more sales and pushing prices down further. Fundamentals took a backseat to this technical selling. While some of this reversed in April amidst significant government stimulus, spreads remain wide across the majority of securitized credit.

We have discussed for many years how the nature of market liquidity has fundamentally changed. Growing retail participation, exchange traded funds (ETFs) and algorithmic trading platforms have exacerbated liquidity issues, masked in recent years amidst a continued market rally. However, these participants do not have the ability to act as shock absorbers in periods of weakness, part of the reason we have seen such a dramatic price move this year.

While the impact of the COVID-19 virus on securitized credit markets remains uncertain, it is going to have an effect on governments, corporations and individuals. We have witnessed one of the sharpest rises in unemployment in April, and we are likely to see a shock to real estate markets, leading to a contraction in the consumer balance sheet. In an attempt to counterbalance this, central banks and governments have reacted quickly in providing record levels of stimulus to the economy and consumers. This includes direct bond purchasing programs, resurrecting initiatives focused on supporting the mortgage market and direct relief aid to consumers. The new Term Asset-Backed Securities Loan Facility (TALF) 2.0 program2, which aims to provide support to consumer and small-business backed debt should help improve market liquidty though it is more focused on segments of asset-backed securities including auto and student loans as opposed to mortgages.

While acknowledging the enormous difficulty of weighing the magnitude of these negative and positive stimuli, we remain cautiously optimistic on the medium-term prospects for securitized credit, reflecting the quality of the underlying assets and greater acknowledgement amongst policymakers on the importance of supporting the mortgage market and the consumer.

This time around, the alphabet soup is made of better ingredients. And while some of those ingredients are struggling in the current heat and may turn sour, we are optimistic the soup as a whole will be more nourishing than its predecessor in 2008.


1 Mortgage REITs (Mortgage Real Estate Investment Trusts) provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments

2 TALF 2.0: Term Asset Lending Facility


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