What the boom-and-bust cycle of non-QM lending can teach us

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In the history of mortgage finance, the peaks and valleys of lock volumes and loan defaults are key quantitative measures. But there is also a qualitative aspect observed in the behavior of the take-out investors for nonagency mortgage notes, the world of non-qualified mortgages that have no government guarantees and are mostly owned by banks and investors.

In the half century that modern mortgage finance and loan securitization has even been possible, in each decade there was a buyer for the marginal "fringe" market production that always exists atop the world of agency and government mortgages. This end investor — the "take-out" — was the essential ingredient to a boom in mortgage credit needed to finance the American dream.

In the 1980s, the take-out was the savings and loan industry, a sleepy patchwork of mostly mutual credit associations with no sophistication in terms of credit or risk. S&Ls were a quaint legacy from agrarian America before the 1930s. But the S&Ls could not survive the demand-pull inflation of a generation of baby boomers, a wave of people who have dominated half a century of U.S. economic history.

By 1989, when Congress created The Resolution Trust Corp., a U.S. government-owned asset management company run by one Lewis William Seidman, the S&Ls were left insolvent by rising interest rates. Fed Chairman Paul Volker was fighting inflation, you understand, but the mortgage industry, including banks, builders and everyone else, was decimated in the process.

Aside from the S&Ls, the biggest buyer of high-risk mortgage loans in the 1980s and early 1990s was none other than Citibank. Being more consumer lender than Main Street bank, Citi decided to float a product for the self-employed, alt-a type borrowers who could not get a loan at a commercial bank. And they rolled out the product worldwide, adding to the eventual impact on Citi’s earnings when the credit losses surged.

By 1991, Citi shuttered its mortgage business and the market consisted of commercial banks that processed a few loans per quarter and some scrappy brokers and nonbank lenders that arose from the ashes of the S&L industry. For most of the decade of the 1990s, mortgages were really hard to get and banks pretty much owned the market. The economy was not bad and credit costs were subdued.

By the early 2000s, however, Citi was back in the consumer finance game. Citi had merged with Travelers in 1998 and then acquired Associates Corp. in 2000, creating a vast machine for originating and securitizing no-doc consumer loans. As in the late 1980s and early 1990s, Citi again quickly became the take-out for low or no-documentation unconventional lenders. But soon other aspirants such as Countrywide came onto the scene. And finally, the GSEs themselves — Fannie Mae and Freddie Mac — became an important buyer for non-agency, alt-a loans.

By March of 2007, when Fannie Mae started to back away from the alt-a, subprime loan market, more than half of total mortgage originations were outside of the safe confines of the agency and government markets. These private-label markets quickly collapsed, followed by the conventional market of Fannie and Freddie, forcing the few remaining solvent issuers to run for the safety of government lending with the Federal Housing Administration and Ginnie Mae.

By 2009, when the U.S. banking industry charged off $60 billion in one-to-four family loans exposures, the private-label take-out for nonagency loans was gone. With the exception of the bank-owned loan market, which represents aboutone-quarter of total mortgage loans in the $12 trillion market today, there was no bid for nonagency loans in the decade of the 2010s other than a few pioneering hard money investors. For much of the decade, only fringe mortgage and consumer finance products existed outside of the world of the banks, and government and conventional loan markets.

Late in the 2010s, however, the world of non-QM loans was reborn and started to accelerate, in large part because of the overt credit market manipulation of the Federal Open Market Committee. Demand for yield pushed large institutional investors to discard caution and the safety of a federal guarantee and once again face first credit loss on private mortgage assets as well as private mortgage servicing rights.

While much of the smaller, lower FICO score residential loans tended to go into the FHA market, the private markets also attracted a diverse clientele as the credit box progressively widened, at least until the end of 2019. The major buyers of nonagency private loans were banks, who prefer larger prime credits, and the hybrid residential REITs led by Redwood Trust and New Residential. Buy side investors in nonagency loans included PIMCO and Blackstone.

After strong performance in 2019, the mortgage industry was on track to have another record year in 2020 — at least until the end of the second week in March. The relatively small market in nonagency loans (less than $100 billion, not including bank portfolio) was growing, but still nowhere near the size of 2008. These nonagency products came along with a coral reef assortment of fix-and-flip loans, marketplace and other fringe loan products.

When the private-label markets literally froze and liquidity in the private loan market essentially dried up, the heavily leveraged REITs and private investors took the brunt of the damage. One reason that the pain of the 2020 financial collapse was so intense among nonagency lenders and issuers of private RMBS was due to the fact that strategies employed to purportedly hedge exposures to private loans failed rather spectacularly.

Much like the world of commercial loans, nonagency mortgages were hedged synthetically — or not — using a combination of TBA trades and interest rate swaps. When all of the major asset classes started to move in the same direction, however, the apparent correlations behind these hedges evaporated. Many leveraged funds and REITs were forced to liquidate private-label holdings at significant losses.

The moral of the story is that take-out investors come and go, but market risk is eternal. There are more than a couple of significant lenders that three months ago were 100% committed to the nonagency, non-QM loan market.

Today these same lenders and REITs are going back to 100% agency and FHA loans, even as the remnants of the nonagency pipeline is being taken to the curb. Liquidity will return to the nonagency loan market, you can be sure, but not for some while yet. In the meantime, government lending has certainly come back into fashion.

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