In the 16 years since the peak of the Global Financial Crisis, the structured products industry has transformed from a market dominated by large banks to one that has room for new players. New relationships are being formed between underwriters seeking long-term debt investments and managers specializing in the origination, custody, and sale of mortgage-backed securities. This new trend has encouraged many investors to look to other assets for yield, fueling growing interest in the subprime mortgage space.
Non-QM loans are used primarily by entrepreneurs and other self-employed individuals who do not have the necessary documentation to qualify for Freddie and Fannie loans. Non-QMs are attractive because they have strong credit quality, low loan-to-value ratios, and stable origination volumes. And next year, we predict more players will jump into the game.
Historically, life insurance companies avoided investing in home loans. But, thanks to the influence of private investors, cash-strapped insurance companies are increasingly drawn to private debt assets that pay high premiums because of their illiquidity. These premiums have increased in recent years as traditional banks have scaled back their private lending operations amid regulatory pressure, consolidation, and recent moves to subsidize wholesalers fueled by retail deposit cuts. All this has left a gap for insurance companies, which have stepped in to fill that gap and, in doing so, have collectively become “one of the world’s largest private equity investors”. (Foley-Fisher et al, 2020, p.2). While the 2022 data shows that only 10% of that private debt was focused on mortgage debt in 2022, the majority of that 10% was directed to non-QM loans. (IMF Global Financial Stability Report, April 2023, p73).
The previous reluctance of investment companies to invest in residential mortgages is partly due to the complex nature of the asset class, which creates high operational costs. However, the growth of non-QM loans has encouraged insurance companies to switch to them. The strict regulatory framework created by Dodd-Frank and other regulations of the post-GFC era put investors at ease. It has encouraged significant business growth in the non-QM space, flagging the sector as an attractive asset class for long-term investors.
Non-QM market share to grow from less than 3% of US loans in 2020 to 5% in 2024. (The Scotsman’s Guide). Non-QM losses due to delinquency are rare due to strong borrower profiles and strong underwriting standards. The cumulative loss since 2018 has been less than 0.02% (BofA Global Research, Loan Performance as of 12/31/23). These assets can be purchased as wholesale loans or collateralized debt, with annual non-agency, non-QM RMBS issuance at $66 billion last year. (Guggenheim Investments – Non-Agency Real Estate-Based Securities: Finding Value Amid High Prices). Home mortgages can be financed with FHLB funds, another reason insurance companies view them as an attractive asset.
But insurance companies aren’t the only potential players here, and we could see banks re-entering the non-QM space. Incoming executives have supported deregulation in the past, particularly at small and medium-sized regional banks that have consolidated in recent years. Indeed, during the incoming administration’s first term, a series of laws were passed to loosen the limits on regional banks’ risk exposure. Since then, the designation of a systemically important bank has been increased from $50 billion to $250 billion. This change meant that fewer banks were subject to stricter requirements and more had access to a larger set of revenue generation strategies. Much of the barrier to the bank’s greater involvement in the non-QM area is the financial management of the underlying products. RWA requirements set by regulators determine how much money a bank must reserve based on the asset-liability ratios on their balance sheets. Therefore, looser RWA requirements, such as those proposed by Fed Vice Chairman Michael Barr in September, will reduce the reserves required for banks to invest in non-QM.
What would a bank’s participation in non-QM look like? We will likely see banks prefer to lend to wholesalers, which currently offer better cash flow than subprime bonds. In addition, whole loan investments allow exposure to specific geographic regions, a useful tool for regional banks that are spread over large parts of the country. Allocations to whole loans are concentrated in specialist residential mortgage holders such as Imperial Fund, which invests in non-QM mortgages. This is particularly suitable for regional banks that need exposure at low costs. Many in the insurance space use separately managed accounts (SMAs), which are low-cost investment vehicles that offer performance costs to the SMA manager. A manager like Imperial Fund does due diligence, gets loans and manages them on behalf of its clients.
All these factors suggest that insurance companies and banks are likely to increase their participation in the non-QM area. This expected increase in investor activity suggests that 2025 will be a strong year for the non-QM market.
Victor Kuznetsov is the founder of Imperial Fund Asset Management.
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.
To contact the editor responsible for this piece: [email protected].
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