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 with space for new players. New relationships are forming between insurers seeking long-term debt investments and managers specializing in origination, securitization, and sale of mortgage-backed securities. This new dynamic has encouraged many investors to look at alternative assets for yield, raising a burgeoning interest in the non-qualified mortgage securitization space.
Non-QM loans are utilized primarily by entrepreneurs and other self-employed individuals who don’t have the necessary documentation to qualify for Freddie and Fannie’s conventional mortgages. Non-QMs are attractive because they have strong credit quality, low loan-to-value ratios, and stable origination volumes. And next year, we predict even more players will be jumping into the game.
Historically, life insurance companies shied away from investing in residential mortgages. But, thanks to the influence of private equity investors, cash-rich insurance companies are increasingly drawn to private debt assets that pay higher premiums due to their illiquidity. These premiums have risen in recent years as traditional banks have scaled back their private lending activities amidst regulatory pressure, consolidation, and a recent move to wholesale funding spurred by drop-offs in retail deposits. This all left a void for insurance companies, which have jumped in to fill that space and, in doing so, have collectively become “one of the largest private debt investors in the world” (Foley-Fisher et al, 2020, p.2). While 2022 data shows that only 10% of that private debt has been centered on real estate debt in 2022, much of that 10% has been directed toward non-QM loans (IMF Global Financial Stability Report, April 2023, p73).
Investment companies’ previous reluctance to invest in residential mortgage loans is partially due to the asset class’s complexity, which poses significant operational costs. However, the growth of non-QM loans has incentivized insurance companies to shift allocation toward them. A more rigid regulatory framework created by Dodd-Frank and other post-GFC era legislation put investors at ease. It spurred significant growth in entrepreneurial activity in the non-QM space, flagging the sector as a very attractive asset class for long-term investors.
Non-QM market share grew from less than 3% of U.S. mortgages in 2020 to 5% in 2024 (Scotsman Guide). Losses in non-QM caused by delinquency are rare because of strong borrower profiles and stringent underwriting standards. Cumulative losses since 2018 total less than 0.02% (BofA Global Research, Loan Performance as of 12/31/23). These assets can be purchased as wholesale loans or securitized debt, with non-agency, non-QM annual RMBS issuance at $66 billion last year (Guggenheim Investments – Non-Agency Residential Mortgage-Backed Securities: Finding Value Amid High Rates). Residential mortgages can be borrowed against through FHLB financing, another reason insurance companies view them as an attractive asset.
But insurance companies aren’t the only players taking note of the potential here, and we could see banks re-enter the non-QM space. The incoming administration has supported deregulation in the past, particularly for the small and medium-sized regional banks that have undergone consolidation in recent years. Indeed, during the incoming administration’s first term, a series of laws were passed loosening restrictions on risk exposure for regional banks. From this, the designation of a systemically important bank was raised from $50 billion to $250 billion. This change meant fewer banks were subject to the strictest requirements and many subsequently accessed a greater pool of revenue-generating strategies. Much of what prevents greater bank participation in the non-QM space is the capital treatment of the underlying products. RWA requirements set by regulators determine how much capital a bank has to retain based on the credit ratings of the assets on their balance sheets. Thus looser RWA requirements, such as the ones suggested by Fed Vice Chair Michael Barr in September, would reduce the capital reserves required for banks to invest in non-QM.
What would increased bank participation in non-QM look like? We would likely see banks favor wholesale loans, which currently offer better capital treatment than lower-rated bonds. Furthermore, whole loan investment enables exposure to specific geographical regions, a useful tool for regional banks that are heavily allocated to one part of the country. Allocations to whole loans have focused on specialized residential mortgage securitizers such as Imperial Fund, which invests in non-QM loans. This is particularly favorable for regional banks that need lower-cost exposure. Many in the insurance space are utilizing separately managed accounts (SMAs), which are low-cost investment vehicles that outsource operations costs to the SMA manager. A manager like Imperial Fund conducts due diligence, acquires the loans and manages them on behalf of its clients.
All of these factors suggest that insurance companies and banks are likely to increase their participation in the non-QM space. This expected uptick 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].
