Inside the Securitized Market: Consumer Strength, Credit Risk and Hidden Opportunities

Colin Prescott (00:04):

Welcome to Understanding Edge, where we take a closer look at the trends of deems shaping today's fixed income markets. I'm your host, Colin Prescott, managing director of business development here at Diamond Hill. Today I'm joined by Douglas Gimpel, our senior portfolio specialist and author of our monthly fixed income commentary. Doug, I'm looking forward to discussing what's been driving the markets as we head into the end of the year and look ahead to 2026.

Douglas Gimple (00:28):

Yeah. Yeah, I would say thanks for having me, Colin, but this is your first time. It is. So thanks for joining me.

Colin Prescott (00:33):

It's good to be here On the podcast. I'm excited to see how this goes.

One of the things I wanted to kick off with was a little bit more on the securitized market, some background there. Obviously, our fixed income franchise has built a reputation over the years for an expertise within securitized markets, which is an area that obviously is growing a lot, frankly, one of the more compelling risk return corners of the fixed income market. My main question is, can you walk us through how the market has evolved over the years and what makes it such a fertile hunting ground for bottom up managers like ourselves?

Douglas Gimple (01:08):

Yeah, I mean, it's a loaded question because it covers quite a bit of history, but one of the things that I would say is that our investment philosophy and process, which we brought to Diamond Hill, has always been rooted in securitization. And it's not because one day we said, Hey, we're going to focus in the securitized market. It's much more when we've examined the markets and we've looked at opportunities and inefficiencies, that's where we've continually found it. So it's not to say we're not investing in credit or treasuries, we are obviously, but we feel that our strengths reside in exploiting a lot of those inefficiencies in the securitized market. So you asked how it's evolved over the years, and it's really interesting when you look at, let's say prior to the financial crisis, so leading up to 2008, it was pretty straightforward. You had the ABS market, which a lot of it was autos, credit cards, your standards stalwarts within the ABS market, you had your agency mortgages, you had your non-agency mortgages, which in 2008 created quite a bit of problem.

But coming out of the financial crisis, as banks stepped away from these various areas of consumer lending and really corporate lending, as they tightened up their balance sheets, you had these entities that were coming in, whether they were backed by private credit or private equity, or they were newer institutions, they entered into these markets. And from that point, you've seen this broadening of the breadth and the depth of, specifically in this instance, the ABS market. So you went from the autos, the credit cards, et cetera, to now you have timeshares, you have auction securities from Sotheby's, you've got device payment plans, which are your cell phones, consumer unsecured. So the market has grown and grown and expanded, and that's created more and more opportunity. And so when you look at something like the benchmark, which broadly speaking is the Bloomberg aggregate index, it's still to this day does not include a lot of these.

More, esoteric is probably not the right word, but these newer, although now 15, 20 years later, not as new, but just not including those. And so that creates an opportunity as well because there are managers that are looking to replicate the index or look very similar to the index. And so in doing that, they're going to stay away from some of these areas of the market. And so the expansion of the securitized market has really created these opportunities and made them ongoing. Again, prior to our time at Diamond Hill, we would focus in this part of the market, but it's just continued to grow and evolve. And if we look at just the last couple of years in ABS, we saw record issuance last year, depending on who you read, 315 to 320 billion in issuance this year we're on pace to surpass that. And as you read, everyone's projections for 2026, you see more and more that they're projecting another record year. But you take that with a grain of salt.

Colin Prescott (04:22):

It seems to line up with the feedback we get from clients. And if I'm thinking back close to 10 years ago when we were bringing these strategies to market here at Diamond Hill, it felt like many of our conversations were trying to describe what securitized is and why it should have a place in portfolios versus today we are experiencing the term securitized almost as a buzzword, and many of our clients are using securitized. But from my discussions with you and our discussions with clients, although it's a term that's thrown around a lot, not all securitized is created equal. And it's my understanding that parts of this market aren't conducive for certain types of managers, and you can't be a tourist in a lot of these certain sub-sectors. Is there any nuance to assessing someone's securitized exposure, and how do we think about that?

Douglas Gimple (05:15):

Oh, without a doubt. And really quick, I mean, you mentioned when we first got here, a lot of what we talked about was securitized. And I can tell you a lot of my work in the early years was education. It was education internally, but also education externally. Because to your point today, securitized is kind of this buzzword, and I think we've benefited from everyone talking about it and how there's an opportunity there When we raise our hands and we say, well, we've always felt there was opportunity there. And so there is a distinction between what you called the touristy approach where a manager just gets the allocation to securitize, whether they do it through what I'll call plain vanilla, just saying that they've got the exposure and using examples in the ABS space, something like in the auto space, they're looking at gm, they're looking at Ford in credit cards, they're looking at AMEX.

They perform really, really well. They issue a ton. So there's a lot out there, but there's definitely the nuance in not only understanding what you own, but where the opportunities exist. And I think that's one of our strengths when we talk about the team here and our research analysts, is that we're not necessarily looking for the plain vanilla because the plain vanilla is not going to get you that much more spread or what you earn over kind of a comparable duration treasury that you would get from something that takes a little more effort. So I think that nuance part of it is the importance of that bottom up security selection, understanding what you own, understanding what's in the collateral, how it's put together, who issues it, how long they've been doing it. And so yes, it's something that has become trendy, I would say. And there's a lot of delineation within ABS, something like CLOs, which get a huge run nowadays. Those are technically considered ABS, but the underlying collateral are all left loans, junk bonds, bank loans, below investment grade type of structures that give you exposure to the corporate market, but don't get to what we believe ABS really is, which is more consumer focused. And that's one of the reasons why you're not going to see CLOs in our portfolios, but other managers could list them as a BS. And yes, technically they are ABS, but it's a little bit of a misnomer because they're very different than your typical ABS structures.

Colin Prescott (07:51):

So if I'm hearing you right, it's a very large market. Certain parts of the market require or provide sort of a difficulty premium, and that's an area where skilled managers can really provide their value. It's a great place to find opportunities. It's also not just the evolution of the market, but also the characteristics of the securities themselves that provide a lot of the value. What is it about the structure of some of these securities that make them especially compelling, particularly when it comes to investor protections and risk mitigation relative to say like corporates or treasuries?

Douglas Gimple (08:28):

Yeah, I mean, from the high level, we'll start with the fact that corporates and treasuries, very straightforward. Treasuries are US government. You get paid twice a year. Corporate's very similar. You get paid twice a year. Your risk is tied to a company, and in most cases, it's unsecured debt in the securitized market, whether we're talking about mortgages, whether we're talking about asset-backed securities, commercial mortgages, there's just different components when you're analyzing this that makes these securities much more complex. And don't get me wrong, I'm not saying that credit is easy and treasury management is easy. I'm not saying that at all. What I'm saying is, is that the nuances within securitized create layer upon layer of complexity. And I'll give you an example. So if we look at non-agency commercial mortgages, so think about office buildings, apartment complexes, whatever example you want to use, and we look at how they're structured.

And so there's conduit deals which are kind of the least complex. There's 50 to 60 bonds or portfolio of bonds in there. You get a lot of information in the top 10, you get kind of a line item for everything else. So not a lot of transparency. There's single asset, single borrower, an area of the market that has really exploded in growth in the last couple of years. One of the reasons being is that you get a lot of transparency. It's either as it says, a single asset or a single borrower. And so you can look at that office building or that apartment complex and really understand what's going on. And in the office space in particular, we know there's been a lot of noise last couple of years, but you can still find opportunity there. You can find a class A property, meaning that it's top of the line, it's more recent.

It has a broad diversification in the number of tenants as opposed to having two. And you can find those opportunities because you can dig into those details. Single borrower. The example I always use is something like Motel six. You've got a hundred different hotels, they're all very homogenous in structure, but you've got one borrower. And then CRE CLOs are the other part of the non-agency CMBS market. And those are even more complex. They tend to be shorter term, five years floating rate, a lower number of total loans. But you know what those loans are for. It's an apartment building that's putting in an energy efficient air conditioning system or a pool or a gym to theoretically then increase rent. And so those become more and more complex. They require more effort. And so that's an area that we think offers a lot of value as well.

But I want to get back to what you originally asked me as I go off on this tangent about the protections, the risk mitigations and these credit enhancements that we talk about are integral to understanding the securitized market and what you're buying on the corporate side. On the treasury side, the treasury side, as long as the US government continues to function their money good, but as we've seen, the government was shut down for whatever it was, 45 days, 43 days corporate, you're exposed to corporate risk, meaning that someone could get hacked or you could have fraud, and you're just exposed to that. On the securitized side, we've got these four areas of credit enhancement that we always talk about, and they're present in most deals. They're not present at all deals, but most deals, and those are excess spread. So when we look at a pool of loans, and let's just use auto loans as an example, I've got 10,000 auto loans in a pool.

Those borrowers, I'm paying on an average, let's just say 15% interest rate. And I am as an issuer, cumulatively paying out to the investors in those deals, let's call it 8%. So I'm bringing in 15%, I'm paying out 8%. That means I'm getting 7% in excess spread every month when people are making their payments. In theory, I'm getting seven extra percent that is kind of set aside for losses or meant to deal with losses as they pop up. Then you have overcollateralization in that same example, I've got a hundred million in auto loans. I'm only going to securitize, let's say 80 million. So that means I've got 20 million in loans sitting on my book as the issuer that I own where the losses hit first. So that means that I've got more collateral than what I'm actually putting out in the marketplace. So that's the most basic credit enhancement is just a reserve account that's essentially anywhere from 50 basis points to 2% of the value of the deal set aside in cash. And it's literally just put into an escrow account. And as the deal pays down, that reserve account becomes a higher and higher percentage of the overall balance.:

And so that is another area that's used to help mitigate losses.

Colin Prescott (13:27):

So it's not as simple as just saying, well, a lot of headlines about the weakening US consumer, these securities must be taking impairment because you don't necessarily know the enhancements that each of these deals are coming to the market with.

Douglas Gimple (13:41):

That's exactly right. And the last one which flows right into that is subordination. And that's one of the benefits of investing in the securitized market. You get to pick and choose where you want to be. And subordination is the idea that in this auto deal that we've been going through, you have tranches or sleeves deals, let's call it A through D. The A tranche is the front pay, meaning that it gets paid off first, and then you have the B, the C, and the D tranche, they're paid sequentially. So every month, each tranche receives interest, but in the beginning, only the A tranche receives principle. And so that gets paid off first. Once that's paid off, then the B tranche starts receiving principle, then the C and then the D. And so what we find is that as an investor, we can decide where we want to be in that capital structure.

If it's an issuer that we know very well, that we understand how they think about risk, then maybe we're looking at the C tranche or if it's an issuer that they've done two deals a year for the last two years, we're going to be a little more cautious. We're going to stay in that A or that B trench to make sure we get paid off. Because one of the keys in understanding securitization is that no one is perfect at underwriting if it's a credit situation. So if it's non-agency resi, non-agency commercial A BS, there's a credit risk associated with that. But when these deals are underwritten, they're underwritten with the idea that no one's perfect at underwriting. There are life events that impact consumers, and there will be defaults and there will be delinquencies. And it's the trade-off of what kind of protections can you get put in place based on where you want to invest that dictate where you want to be in the stack. And that gets to your point about I open up the, well, I don't open up the newspaper anymore, nobody does. I pull up the internet and I look at news stories. And those news stories are consumers are behind on their auto loans or consumers are behind on their credit card. Yes, they are. Subprime auto borrowers are, I think six and a half. 6.6% of them are 60 days delinquent. But if you're looking at a deal where the assumed default rate is 12%, you're still in a good position

Because these are built to withstand those instances. So we see the headlines, people get concerned, but you have to look at it from the lens of those credit enhancements and how we're protected.

Colin Prescott (16:13):

I think what you're describing perfectly articulates why you cannot be a tourist in this arena and why there's more of an art form than just pure math form and why clients would be prudent to continue to focus their securitized exposure with people who don't minor in securitized, they major in securitized. But you brought up the consumer element, and despite the protections and enhancements, it's still something we monitor closely, I'm assuming. And it's been an area that we've received a lot of questions from clients, and certainly everyone's seen the headlines. How do those consumer dynamics today, like savings rates and employment trends or credit health, how do those feed into the way that we're thinking about our investments today and positioning the portfolios?

Douglas Gimple (17:01):

Yeah, I mean, you look at, we all know the labor market is starting to weaken a little bit. I mean, we've seen the numbers, although apparently just found out today we're not going to get the October non-farm payroll at all. They're just not going to report it, which we kind of thought was going to happen, but we look at these things and that does kind of influence or inform our decisions when we're looking at this exposure to consumer risk. And what does that mean? Well, that means that if we're looking at where there's hard collateral, so think of again, autos. Autos. We tend to have focused in kind of the subprime part of the market. Reason being the prime market, which are your highest quality borrowers, perform really, really well. The default rate going back to I think 1991 is 48 basis 0.0 0.48%, so minimal.

And because of that, the spreads are very tight. You're not getting paid a lot to take on what is perceived as not a lot of risk. On the subprime side, you could be very selective. Again, thinking back to what I talked about with tranches, where you want to be positioned in the cap structure, things like that, that can help inform where you're going to be. But also with hard collateral like autos, you have another kind of layer of protection. And that's the idea that if someone defaults on the car, they're going to repossess that turn around and sell it at auction, and you're going to get some kind of recovery value. I mean, they even have shows about men going out and repossessing cars. So that's different than something like credit card or consumer unsecured where there is no hard collateral. It's just the receivables there.

You've got to be a little more cautious. And that's why for the most part, we're staying in kind of that near prime and prime part of the market because you don't have that extra layer of hard collateral. And so yes, we look at and we see delinquency rates are increasing, but it's important to note, and I've talked to our A BS analyst, Jing, we about this quite a bit. When I ask him about, we see the headlines, we see the delinquency rates increasing, how worried do we get? And his response is, that's not really the part of the market that we're looking at. Even within near Prime within credit card and consumer, we're still sticking to the higher part of the capital structure. Are there some where we take a little more risk? Without a doubt. I mean, you can't get returns without risk, but it's part of that overall analysis that they do in trying to find value in making sure that we've got some kind of mitigation.

Colin Prescott (19:46):

Well, with the headlines that we've seen, even if these are in areas that it's not necessarily a primary focus, has it created any opportunities from us or has it caused spread widening that investors should be cognizant of?

Douglas Gimple (20:00):

Yeah, I mean in just the last couple of months, so starting in kind of mid-September with Kalu, which is how it's pronounced, although it sounds very pretentious with their filing for bankruptcy. I mean, we saw some spread widening in sympathy with some of the subprime auto ABS issuers. But then beyond that, we've seen some spread widening really across the board, not just in securitized. We've seen a little bit of it in the corporate space as well. And I think part of it is the uncertainty that was going on with the government shutdown, how long it would last uncertainty around the Fed, especially once Powell came out and said, December is not a foregone conclusion, which I think tweaked people a little bit. It's also the fact that seen, as I mentioned earlier, all this issuance coming to the market and for the first call it eight, nine months of the year, the market just grabbed it all up.

And I think they still are because of this emergence of securitized more broadly. But I do think there was a little bit of fatigue in late September and into October. I mean October, we saw a record month for ABS issuance at 42 billion. So at some point the market's going to pull back a little bit, but it's nothing compared to kind of historic levels on spreads. So we've had a little bit of widening, but you have to take that in the context that really since 23, beginning of 24 to now, we've just been on this spread tightening run with the exception of August of 24 with the end carry trade unwind, which was about two weeks of volatility. And then post liberation day, we saw spread widening that resolved itself within, call it maybe a month and a half.

Colin Prescott (21:50):

You mentioned the government shutdown. I think we've just ended perhaps the longest government. Is that right? The longest government shutdown

Douglas Gimple (21:57):

Longest by eight days, I believe.

Colin Prescott (21:59):

So two quick questions on that. With the disruptions that we saw with the government shutdown, what kind of impact did we notice on the actual consumers? And then the second part of that is what kind of impact does it have on the investors? You mentioned that there's some data that's not been released. What kind of data are we using in the meantime, or what should people be considering when we're not getting the formal reports people rely on?

Douglas Gimple (22:27):

Yeah, no, I think what we've seen with the consumer was, I think the biggest thing that came out of it was the consumer sentiment. Sentiment dropped considerably, which you would expect with it going on for so long. But really when you think about it, it really wasn't as impactful. Now, from an economic standpoint, yes, I think the Congressional Budget Office estimated we're going to lose a large number of just GDP, unlike last shutdown, which was 35 days where most of the agencies had enough money to keep going, this everything shut down. And so I think that the impact of the consumer is going to be kind of focused. So meaning snap payments, those went away for a month. And I think people really felt that. Anecdotally, I was in Minneapolis for business and my Lyft driver was a member of the military, and he was doing it because he had been furloughed and he wasn't getting paid. So for certain parts of the economy, it really hurt. We have a friend of ours who works on a military base outside of Dayton. He lost his job for whatever it was a month and a half, didn't know what was going to happen. They're digging into their savings. But for the rest of us, I mean, I'll ask you, did it really impact anything that you were doing outside of the craziness at the airports? Latter TTSA lines?

Colin Prescott (23:58):

The TSA lines were out of control there for a two week period, but for the most part it didn't affect me other than not seeing jobs reports and not getting a real sense for what's going on with the economy. It doesn't sound like they're going to retroactively release a lot of that data either. Correct.

Douglas Gimple (24:12):

Yeah. And that gets to your second question is what's the data that's been missed? And we're going to get a jobs number tomorrow, which is the 20th. So we'll get September's information now that we're almost done with November. We found out today we're not going to get October's non-farm payroll because if you think about it, those surveys are done during the month and no one was working in October. So you can't retroactively go back and say, Hey, a month and a half ago, what were you thinking about the jobs market? Were you looking, et cetera. So they're going to try and fold in some of that information into the November number that we'll get December 16th. So the biggest thing is the Fed is now going into their meeting on December 10th with no data about or no official data about the labor market. They can look at a DP, which is kind of a substitute, but it's always been a little wonky relative to the non-farm payroll that we get from the BBLs inflation.

They had some staffers come in and throw something together really quick. So we had kind of an idea. But in the absence of that data, I think a lot of it was just wait and see because you couldn't really get a handle on inflation on things like the ISM manufacturing numbers because there may be somewhere else you could go for that or something like that, but then you're potentially mixing apples and oranges. And so from our standpoint, it was really focusing on what the market was telling us and what we were seeing. But I think one of the interesting things that we've seen today is after the announcement that the non-farm payroll will not be released for October at all. Fed Fund futures for the December meeting have plummeted. I mean, just a couple of weeks ago, they were probably at 90% that there was going to be a 25 basis point cut in December. Today before I came in here, it was at 31%. So the market is feeling like, well, if they don't have any information, they're not going to do anything. They're going to hold the line, which is probably what they should do. We got the Fed minutes today. There was apparently a lot of discussion argument about not December, but even in October, whether they should have done anything. December is definitely on the table, has maybe a just wait and hold. So we'll have to see and they'll get more information. But I don't think it's going to be enough to really push one way or the other

Colin Prescott (26:51):

Without a lot of the data that people have historically relied upon to get a sense for where things are on key figures like inflation or employment. What other types of consumer related metrics have we been looking at to get a sense for the weakening or perhaps even strengthening consumer, and how does that impact some of the areas that we're particularly focused on?

Douglas Gimple (27:13):

Well, one of the benefits of investing in the securitized market compared to credit is we get monthly updates. So we get what are called remittance reports every month, and they're basically a financial statement for the pool of loans underlying a securitized deal. So that gives us insight into specifically how is this deal performing? But by looking at a bunch of different deals, we get a feel for how things are going. And we saw this really being beneficial in the early days of COVID. If you look to you move beyond March and April, you get to May, june, July to see how things were going. We could see that people were still paying their bills, people were still paying for their cars, they were still paying on their credit cards, and in fact they were using the opportunity of being stuck at home, not spending as much money to pay down their debt.

And so we would see, part of the remittance report is basically who asked for forbearance many what percentage of the pool asked for forbearance, meaning that, Hey, I can't make my payment. What can you do? And these issuers very broadly were basically saying, look, we'll figure something out. We're going to give you kind of a three month reprieve where you don't have to make a payment, but we're going to tack on three months to the end of your deal. So if you had 30 months left on your auto deal, you got three months where you didn't have to make a payment, but now you have 33 months until you're done. So a win-win for everybody, the consumer gets to keep their car, whatever their credit card balance and the issuers eventually get paid. They got to wait a little bit longer, but that's okay. But what we found looking back was that even those that had asked for forbearance, were still making some kind of payment. So if I had a $500 car payment was making 200, $250 payment, so I didn't have to make the whole thing, but I was still staying, not current, but I was trying to stay on top of it.

And so that's something that we can see in looking at. Some of our strategies are 80% securitized, some of them are 65% securitized. And so we see a lot of that information coming through. And I think that at times it gives us a little bit more insight because we see what people are actually doing, not necessarily what they may say they're doing in a survey. We see that data coming through and that helps us to understand, okay, some of the subprime issuers are struggling a little bit. Some of the borrowers are struggling a little bit, but they're still making their payments. And so there's no official report that we can go to, but there is that trove of remittance reports that we get between, call it the 12th and the 25th that we get every month that we can see. And so that definitely helps to inform our opinions of where there may be risk or where things are performing even better than we thought.

Colin Prescott (30:19):

What are some of the consumer metrics that maybe clients don't know even exist that we view as a nice gauge for consumer health? I know you wrote about something called credit score migration. That's not even something I'd heard of prior to the last couple of years. Is this a new stat? Is this something that's been around for a long time with just more familiarity?

Douglas Gimple (30:42):

No. So credit score migration really came about, it was February, I think, of 24. The Fed released a study and very interesting. And once you hear about it and you think about it, you're like, okay, that makes sense. But again, going back to the early days of COVID, so let's just say from March to the end of 2020, we had stimulus checks that were coming out. People were just getting money to help them get through these trying times that everybody was stuck at home. And a lot of the subprime borrowers were doing is they were rightfully using that money to pay down debt. And so what happens when you behave the right way with your credit is you're rewarded with a better credit score. And so we saw a certain cohort of that subprime market move up into near prime, some into prime. And so what happens is that maybe dilutes a little bit the quality overall of that near prime cohort, and it concentrates that subprime cohort even more.

Colin Prescott (31:52):

So

Douglas Gimple (31:52):

You've got kind of the lowest of the low

Within that subprime. And so you see that differentiation in some of that performance. And so that's something that we can look at and to help us better understand how things have behaved. And you kind of see that trend play out where the near prime has seen a little bit more in losses than you would expect because of that move. And the subprime, some of the deeper subprime have been very challenging. And so part of that is a result of that as well as other things going on in the economy. But that's one of the things that we've looked at that I think provides some insight. One other thing that I would mention is there's a company called DV oh one, and this is not an endorsement in any way, but they do a very good job in kind of consolidating a lot of these different types of loans like a, BS deals on the consumer side, on the auto side and streamline it. So you can see not just one, but you can see 50, a hundred different types of loans all pulled together, and you can see how they're performing. And so that gives you a little bit more insight as well where you may be looking at the deals that you own, which gives you kind of that tunnel vision of I know what I own and I'm looking at it, but they provide a kind of a wider view so you can see how other areas of the market are doing as well.

Colin Prescott (33:15):

The other topical headline that our clients have been asking us about has been mortgage related, and specifically this idea of 50 year mortgages, for instance. Do we have a house view on that? Do we have any thoughts on how that would impact the market or consumers in general?

Douglas Gimple (33:32):

Well, the first thing that I would say is that a lot of things have to change for that to even happen. And what I mean by that is that the agencies, Fannie and Freddie can't even buy mortgages that are beyond 30 years. I think they made some exceptions for some 40 years when they made some modifications, but you'd have to actually change law for them to be able to buy 50

Colin Prescott (33:55):

Years.

Douglas Gimple (33:56):

So that's the first thing. The other thing is that, yes, if I get a 50 year mortgage instead of a 30 year mortgage for the same mortgage, then I'm spreading those payments out over 600 payments instead of 360 payments to go from 30 to

Colin Prescott (34:14):

50 math checks out.

Douglas Gimple (34:16):

Yeah. Yeah, I hope so. Yes. My payments may go down by $300 a month depending on the size of the mortgage that you're looking at. But the amount of interest that you pay over the life of that mortgage, the 50 year mortgage is close to twice what you would pay on a 30 year mortgage.

Colin Prescott (34:32):

Well, and the time to build up any sort of equity in that home has to be

Douglas Gimple (34:36):

That's exactly right. Insane. So I ran an example of looking at, I think it was like a $410,000 mortgage at the going rate of six and a quarter or whatever it was. And to your point exactly, it would take, I think I'm thinking back, I think it was just under 10 years to get a hundred thousand in equity in a 30 year mortgage, assuming no home price appreciation. Just looking at it straight up the 50 year mortgage, it would take you 30 years to get to a hundred thousand in equity. And so it's a huge difference. And if the average home buyer now is 40, which is one of the reasons they're talking about a 50 year mortgage, the average home buyer is 40 and you get a 50 year mortgage, you're not going to be in that house when you're 90. Maybe you are, but I mean your kids are going to inherit debt. And so it sounds good when it's being put out there as it's a cheaper way to get a

Colin Prescott (35:32):

Mortgage as a tool to help younger folks get into the American way of home ownership, right? That's like a dream that they

Douglas Gimple (35:40):

Sell. But the problem that you have besides what I just talked about, is the fact that frankly, a six and a quarter percent mortgage on a 30 year is not going to be that on a 50 year because it's longer term, there's more risk. So they're going to be charging you 25, 50 basis points more, and then who are you going to get it through? If Fannie and Freddie can't do it, you have to go non-agency, which means it's going to be even higher if anyone's even willing to do that. So there are a lot of hurdles in the way, and there are probably better ways of making homes more affordable. I don't know what that is. I'm sure someone's sitting around thinking about it, but the 50 year mortgage, just the numbers just don't work. The math doesn't math as the kids say,

Colin Prescott (36:26):

Right? Sure. No. I read today that I, with mortgage rates coming down and a lot of folks looking to refinance, they have declined almost half of the refinance, the folks looking to refinance. And that a big part of it has been that the homes have declined inequity. The value that they've put that they purchased a home for maybe was overvalued at time of purchase. And in the meantime, they haven't built any additional equity and thus they're already underwater on these homes. I can't imagine slapping a longer dated mortgage on that is going to be helpful at all.

Douglas Gimple (37:04):

Right? No, that's exactly right. And we're not in any way saying there's a housing crisis in any way, but we have had a massive runup in home price appreciation. You have a large part of the population that are stuck isn't the right word, because you're benefiting from having a very low mortgage. They're not going to move anytime soon. It's what we refer to as, and we didn't coin this, but the golden handcuffs. I've got a house that my mortgage is two and three quarters, I'm never leaving.

Colin Prescott (37:37):

Is that the new flex? Is that the new suburban flex to quote your mortgage? It could

Douglas Gimple (37:41):

Be, yeah. Especially if there's somebody at a party that's like, I got six and a half percent mortgage. You can be like, Hey, I'm sub three. But that's part of the problem is that I'm not going anywhere. My kids are almost out of the house, so I would love to downsize, but if I downsize, I'm selling my house, I'm getting the equity, yes, but just the psychological aspect of going from two and three quarters to six and a quarter or even six, if it comes down, it just hurts.

Colin Prescott (38:11):

Have we seen any derivatives from that with people looking to extract equity from their homes in different ways than before? Whereas before you might say, yes, my home is doubled in value, I'm going to sell it and get a bigger home. Are they doing that today because they're reluctant to give up their 2%, 3% mortgage, or are they doing other things like home equity lines of credit?

Douglas Gimple (38:33):

No, that's exactly right. It's equity lines of credit. It's second liens because again, if I've got, let's just say a 3% mortgage, I'm not going to refi to pull equity out of my house to go into a six and a half or 6% mortgage. But if I can get a home equity line of credit at seven and a half percent for 50 grand of the equity in my home, that's a pretty good deal. So we see

Colin Prescott (38:56):

That. We see those deals in the market, right?

Douglas Gimple (38:57):

Oh, yeah. Yeah. So that part of the market has grown exponentially over the last two years. If you look at the amount of issuance in the non-agency residential mortgage market, the other category, which is where all this falls, that's grown about 400% over the last two years. And so you've got home equity line of credit, second liens, home equity loans. You've got what are called reverse mortgages, which are for those that are 62 and over. That's a great innovation in that if I'm not there yet, but if I'm 62, I want to get money out of my home, I can get an equity line or loan, and I don't make a payment, so I don't make a payment from the time I get it to the time I either refinance my house, I die, I move, whatever it is. But for that older generation that's cash rich or house rich cash poor, it's a way to tap that equity and you don't change your budget. Now, the interest accrues over time and let's just say are using arbitrary numbers. If I sell my house 10 years after I get the reverse mortgage and I had gotten a $50,000 loan, let's just say I pay back $75,000, but that comes out of my equity,

It's not coming out of my pocket. So it's almost rewarding homeowners for earning that equity in their home. And so my parents did it a couple of years ago. They ended up paying it off when they moved. But it's a great tool to your point, to tap that equity in your home without having to refinance everything.

Colin Prescott (40:32):

And how are these new securitized structured vehicle, how are they represented in the benchmark, if at all?

Douglas Gimple (40:40):

Good question. They're not. So when we look at the benchmark and the benchmark being the Bloomberg Ag non-agency residential mortgages are not included at all. So you don't see non-qualifying mortgages, which are those that are mortgage sizes too big to be covered by the agencies, the home equity lines of credit, residential transition loans, all of this part of the market is not included in the benchmark.

Colin Prescott (41:06):

So is it fair to say then that those sub-sectors have a more limited buyer base because there's a lot of managers out there who cannot buy securities that are not included in the benchmark, and how does that benefit potential investors in some of these sub-sectors?

Douglas Gimple (41:23):

Yeah, I'll go one further. I mean, there's a part of that market that for the longest time, the securities that were issued were not rated. And so to your point, these larger investors, some of them cannot buy a bond unless it's rated by Moody's s and p or Fitch. The index only includes bonds that are rated by Moody's s and p and Fitch. And so the fact that they're not in the index, the fact that some of them aren't rated means that the issuers lose a large part of the market that they could sell into. And that means that those that are interested in buying, those are going to get compensated with more spread than what you would see in other parts of the market because frankly, you have to entice the investors to come in and buy those because you can't market to insurance companies. You can't market to pension plans. And so it makes the opportunity set a little bit bigger because it's a smaller market or a smaller buyer's market,

Colin Prescott (42:25):

You

Douglas Gimple (42:25):

Don't have as many buyers. You don't have as much money moving to that part of the market. And so you have to be enticed to buy by getting these higher spreads.

Colin Prescott (42:33):

So if I'm hearing you correctly, these are securities that may be rated comparably if they had a rating, but for whatever reason they do not have one because maybe the deal is too small to even warrant getting a rating or it's an off benchmark area where people who require ratings won't even consider them, and so they're able to pass along that cost savings to investors and reward the investors for buying those subsectors.

Douglas Gimple (43:05):

Yeah, I mean, look at, let's look at residential transition loans. For the longest time, the entire area just was not rated rating agencies didn't want to look at 'em. More importantly, the issuers didn't want to pay for it. So you have to pay to get rated, and then that, to your point, flows through to the end investor because you've got to recoup that cost. And so what we've seen more recently, really last year we had the first rated residential transition loan, and subsequently the majority of them are now rated. And if you look at those before the ratings, and you look at them now you've seen a compression and spread

Because you're now opening up to a broader market that can buy these securities that rely on the rating agencies. It's important to note that on the not rated side, for us in particular, if we're buying not rated securities, we have to rate those internally and we have to view those internal ratings as official ratings. So in our core portfolios, we can't own below investment grade. We have call it three and a half percent in not rated. That not rated component must be rated investment grade, and it's something that we review on a monthly basis or as needed with our risk management team and compliance. But back to your original point is that yes, you're going to get paid a little bit more spread just because it's a more opaque part of the market because it doesn't have those ratings.

Colin Prescott (44:31):

As we talk about the consumer, one of the other areas that our clients have asked us about has been focused on student loans. My question is for student loans in particular, has that been expressed in our portfolios over the years? Yes or no? And coming out of the COVID area and coming out of the Biden administration's pause on student loans, how has that shaped our thinking and allocations over the years? So we have

Douglas Gimple (44:59):

Not owned government student loans. The only student loans we've owned have been what I refer to as kind of high-end private student loans. So think of SoFi 5, 6, 7 years ago. College Avenue is another one. So yes, we have owned those in the past, but we don't own the government student debt just because of what we've seen. You don't have to make any payments for whatever was three years. But what we do consider and has been very important is as soon as those payments started up, again, that impacts the consumer because that goes into their budget, hopefully, of what they have to pay. They haven't had to pay it for however long it was. Now they've turned that back on. You've got to start paying it. It's going to start feeding into your credit report. So that's how we've thought about it. But we have not invested in the government student debt just because of that worry of exactly what happened.

Colin Prescott (45:57):

So from our point of view, it's had an impact on the overall balance sheet of the consumer, but from an investment standpoint, it hasn't really impacted our view on student loans and whether or not they're exciting enough to be in any of our portfolios.

Douglas Gimple (46:11):

Correct. I would say that they will never be exciting enough for them to be in our portfolios because of just the uncertainty around what could happen with them. So yeah, that's exactly right. We haven't invested in and I wouldn't expect that we will anytime soon.

Colin Prescott (46:26):

Doug, it's been great to join you today. I really appreciated hearing your perspectives and hearing your take on many of the current events that are impacting our clients and our client's clients. Thanks to all of you for listening. And you can read Doug's full fixed income commentary along with other insights from our investment team@diamondhill.com. We'll be back soon with more conversations on the trends shaping the fixed income markets. But until then, take care and thanks for listening. Thanks, Colin.