By Philip Weingord
|| Philip Weingord, Seer Capital Management
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
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
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.