A Perfect Storm

October 19, 2017

A Perfect Storm Photo

Before we jump into the commentary on this week’s Chart of the Week, let me first acknowledge how much of a tragedy these natural disasters have been for our country this year. The loss of lives and homes has been devastating. It is important for those of us that are personally unaffected by these events to keep in mind the struggle that so many are going through this year. However, the fact remains that many institutional investors have investment exposures to these disasters as well, so the discussion regarding the impact on portfolios must and will continue.

This week’s chart shows the average exposure to this year’s major natural disasters in the post-crisis jumbo prime non-agency residential mortgage-backed securities sector (aka 2.0 RMBS). Our database includes 86 deals of this type, which represents a statistically-significant sample of the 2.0 RMBS universe. I used information from the Federal Emergency Management Agency (FEMA) website in conjunction with metropolitan statistical area (MSA) codes available in Intex to determine exposure on a portfolio of the 86 deals in our database.

The Merriam-Webster dictionary defines a “perfect storm” as “a critical or disastrous situation created by a powerful concurrence of factors.” That idiom seems quite apropos this year, as the natural disasters listed above have devastated multiple coastal areas of the country. Thankfully for investors, this devastation does not translate directly to a credit impact on 2.0 RMBS portfolios. Property insurance will serve to reduce severities on affected loans, such that the main impact that may be seen from these events could be an uptick in involuntary prepayments. However, the credit impact will still be non-zero, such that a mild increase in delinquencies and defaults should come as no surprise.

It is still early to gauge the full impact of these events, particularly regarding the California fires, which are ongoing. I remain constructive on 2.0 RMBS credit, but these disasters should serve as a stark reminder to investors in the space to proceed with caution. Investors focused on the lower parts of the capital structure, where credit enhancement is less abundant, should ask themselves, “what’s the next shoe to drop?”

Key Takeaway:

Natural disasters have had a devastating impact in the U.S. this year, and the fires raging in California are still not 100% contained. However, investors are busy gauging the impact on their portfolios, even as the disasters keep coming. Property insurance will mitigate the impact on 2.0 RMBS portfolios, but delinquencies and defaults are still likely to experience a mild uptick in the near term. I remain constructive on the 2.0 RMBS sector. Investors concerned with the impact of recent natural disasters can mitigate this through a stronger focus on credit enhancement and perhaps moving their focus further up the capital stack.

Tags: Chart of the Week | Credit markets | Residential mortgage-backed securities (RMBS) | Property insurance | Institutional investors | Natural disasters

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