Perhaps the most exciting aspect of non-QM loans is their possible securitization. The profitability of the sale of these loans into the bonds market is evident by the events leading up to the 2008 financial disaster. But because of that very same disaster, the securitization of non-QM loans in the near future remains questionable – until you dig into the trends and insights as to why non-QM loan securitization must make a comeback.
The potential upside to securitizing non-QM loans ensures their return. The most likely resurgence will be a few specialty finance servicers dipping their feet in the water, finding profits, and witnessing everyone else – those waiting on the sidelines – to jump in the pool. Bond investors especially have a need for such instruments, and a mass of buyers inevitably draws a cascade of sellers, starting from the most risk-prone but eventually attracting even the most risk-averse.
While both sides seem to have risk in a resurging non-QM market, the recreation of this market will actually help both parties mitigate risk while improving yields. For bond investors, non-QM securities should allow more diversification to their portfolios in which the most risky investment tends to be comparatively low-yield instruments, such as corporate bonds. For originators, the risk-retention provision of the Dodd-Frank Act ensures the actuaries will account for the 5% credit risk that comes with issuing non-QM securities.
The Hidden Benefits that Come with Being First
The first companies that dive into this market will be those with relatively high risk/reward profiles. The big banks will likely avoid non-QM securitization because they have lower risk tolerances and are highly discouraged by the possible downside. But many are ignoring the hidden benefit that comes with the perceived risk.
While having a 5% credit risk equates to the originator having “skin in the game,” it also all but forces that originator to become the mortgage servicer. The originator will almost certainly want to retain the mortgage servicing rights (MSR), as they will have more impetus to actually collecting payments and reducing the risk of a default. This forces originators into the mortgage servicing business, which itself is highly lucrative.
Hence the most successful companies at designing a low-risk non-QM loan business will be vertically integrated. This form of integration also saves on costs, as servicing need not be outsourced. The end result is profit from the non-QM loan securitization, profit from the MSR, and cost-saving from not having to outsource the mortgage servicing.
The Rapid Creation of a Non-QM Securities Market
The main question at the moment is how product development will take place. Deutsche Bank recently estimated $50B in volume for annual non-QM originations. This volume can easily equate into the creation of a highly liquid securitization market.
In addition, these loans will mainly be originated for the upper echelons of the socio-economic ladder, implying that less originations will be needed to bring the market to a high valuation (i.e., if the target were the middle class, more originations would be needed to create a market of equal volume). Thus, the market can be created virtually overnight with the appropriate offerings. Some public companies, such as Impac Mortgage and Ocwen Financial have already begun offering such products with the plan of securitizing the loans.
These products should be well-received by borrowers, as many lack the credit status necessary for QM loans. Urban.org estimates that 4 million loans were lost between 2009 and 2013 because of the stricter rules for loan originations. The problem is not the borrowers but the financial companies who fear lawsuits and fines.
The Decline of QM Loans
Pioneer companies will notice the void in the marketplace – a void caused by overly protective laws that do little more than lock people out of home purchases. Non-pioneer companies will inescapably be forced into an increasingly competitive environment in which the pool of borrowers has shrunk while the number of loan originators remains the same as in the 2000s. Necessarily, QM loans will become less profitable.
On the other side of QM, non-QM loans are offered by few companies but are in great demand. In the past 15 years, mortgage borrowers with FICO scores of below 660 fell by 75%; those with 660 to 720 FICO scores fell by roughly 35%. These people have been pushed out of the market by companies afraid of the risks.
Is it not illogical to remove 75% of the marketplace due to a fear that some might default? By these statistics, banks are assuming that only 25% of borrowers with FICO scores below 660 will actually make their payments. Every year, the big banks lose 1 to 2 million loans.
Banks Are Driving Away Borrowers
However, these lost loans do not simply disappear. A large proportion of aspiring homeowners look for alternative mortgage options after being rejected by the banks. Companies offering non-QM loans not only help these people become homeowners but help the housing market recover (e.g., trigger demand for new home starts).
The point we are getting at is that non-QM originators must make the non-QM securitization market by intercepting the borrowers who the big banks have lost. Reaching out to these aspiring homeowners as a service-oriented company can fill a gap in the market and allow the involved companies access to high-yield securities that can be sold in another market with a significant gap (i.e., the bond market). This is a win-win-win situation for non-QM loan originators, homeowners, and bond investors.
The resurgence of a non-QM securitization market is inevitable.
This article was written exclusively for GoRion.