Unhedged Commentary: The Case for Nonprime Mortgage Loans

December 03, 2014  

   
   Philip Weingord, Seer Capital Management
By Philip Weingord


Is there a prudent way to originate a mortgage loan that isn't prime? The answer is yes, there is, and it's time to start making nonprime mortgage loans again.

Of course, some products originated during the U.S. housing bubble made no sense; some loans should never have been made. But history is replete with examples of the pendulum swinging too far in response to crises, and that has been the case in mortgages.

You may recall arcane terms like subprime and Alt-A and Alt-B, which were used to describe mortgages but not broadly understood by the average borrower. The mortgage market today has a new mission and new monikers: qualifying mortgage, or QM, and non-QM. A QM mortgage meets new standards, including a debt-to-income limit of 43 percent and a 3 percent limit on points and origination fees; also, these mortgages don't have risky features such as interest-only payments. A QM provides lenders protection against lender-liability lawsuits. Non-QM loans do not meet QM standards and are considered riskier. (Jumbo mortgages are also non-QM, but they are not the focus of this article.)

There has been a lot of media coverage about the non-QM market, but origination volumes outside of jumbo loans won't even reach $1 billion in the U.S. this year. Why so meager? Some housing analysts have said rating agency requirements are too onerous to make securitization of non-QM loans appealing, but in fact, the economics of securitization appear quite attractive. Others have suggested that there is simply not enough demand — there are not enough borrowers with these credit profiles looking for mortgages. We find this hypothesis unlikely. Consumers are generally willing to take advantage of credit when it is offered.

Many point to the Federal Housing Administration as the reason that non-QM lending has not taken off, and this is valid to a point. FHA lending, which serves weaker borrowers, was pushed aside when subprime was in its heyday and grew back rapidly with the demise of subprime. Nonprime loans peaked at $1 trillion of origination in 2006; that year FHA originations totaled $80 billion. By the end of 2009, nonprime loans were at essentially zero, whereas FHA originations reached $451 billion.

The non-QM product, however, serves borrowers that FHA does not. FHA loans are difficult to obtain for self-employed borrowers and unavailable for second homes or investor properties, which continue to grow in share as home ownership continues to decline postcrisis. That financing has to come from somewhere. FHA loans are not available to borrowers with a recent short sale, bankruptcy or foreclosure (typically, within the preceding three years). They are not available above FHA maximum loan sizes, and although FHA programs allow fairly low credit scores, most originators won't go below a 640 FICO score because of additional scrutiny for lenders with higher default rates. Loans have to be sound, of course, and a non-QM loan needs mitigating factors that offset risk, in addition to appropriate risk-based pricing.

The greatest factor holding back volumes is that non-QM origination is simply not up and running. The nonagency mortgage origination business was decimated in the crisis and has not returned. An infamous blog called the Implode-o-Meter tracked the demise of 388 subprime mortgage lenders. The few companies that survived reinvented themselves as prime and/or agency lenders. The economics of originating agency mortgages have become more attractive with less competition, as the overall mortgage industry has shrunk. In addition, banks still dealing with the legacy of subprime are paying out huge settlements in lawsuits. For example, Bank of America Corp. is paying $17 billion.

As a result, origination platforms and brokers have been entirely committed to agency and jumbo mortgages for several years now, and with little capital flowing to the segment, nonprime has not been an area of focus. Non-QM lending is an attractive opportunity for investors because of its expected robust return profile and the market's scalability.

My firm started exploring the sourcing of non-QM mortgages in early 2013 and made our first purchases in mid-2013; we expect to do our first securitization in early 2015. We see this market growing to $150 billion over the next several years, with 80 to 90 percent of it being securitized. With return potential in the mid- to high-teens, we see the non-QM lending market as an ideal way to generate alpha.

Philip Weingord is the managing principal and chief executive officer of New York-based Seer Capital Management, a credit-focused investment firm.


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