The subprime mortgage-backed bond may be dead in America a decade after it helped trigger the global financial crisis, but a security with some of the same high-risk characteristics is starting to take off.
It’s called the non-qualified mortgage — basically a loan granted to borrowers whose checkered financial record made them ineligible for conventional mortgages. Lenders have bundled more than $18 billion worth of these loans into bonds this year that they then sold to investors, a 44% increase from 2018 and the most for any year since the securities became common post-crisis.
This surge in issuance of non-QM bonds, as they’re called, comes just as some initial indications of delinquency rates on the loans are starting to emerge. The short answer: They’re high. About 3% to 5% in some bonds, according to Barclays Plc. That’s multiples of the current 0.7% delinquency rate on Fannie Mae loans.
And while no one is saying these bonds are in danger of defaulting any time soon, their newfound popularity does reflect the growing risk that yield-starved investors are taking to boost returns at a time when the U.S. economy is slowing. It’s similar to the way demand for junk bonds and securities backed by fast-food franchises and private credit have all surged this year. In the case of non-QM bonds, coupons on the debt can be north of 5%. A typical Fannie Mae mortgage bond sold nowadays has a coupon closer to 3.5%.
“It’s obviously disturbing this late in the cycle to see originations for these loans at the kind of level they’ve kicked up to,” said Daniel Alpert, managing partner at Westwood Capital. “The housing market is not quite ready for a big infusion of this product.”
The non-QM bond market is for now, at least, way too small to cause the kind of broader disruptions that subprime bonds did when they soured en masse a decade ago. Moreover, the bonds are built to withstand tougher housing downturns than they used to be, and the borrowers aren’t as risky. The securities may face some sort of hit if the housing market weakens, but it won’t be severe, Alpert said.
“It’s not the subprime we remember from 2006 to 2007,” said Mario Rivera, managing director of the Fortress Credit Funds business, which has bought non-QM bonds. “It’s more of a second or third inning of non-QM. We’re getting the best collateral before the more aggressive lending comes in.”
But fund managers’ willingness to plow money into these securities shows how the intense suspicion that met mortgage bonds after the housing bubble burst last decade is starting to slowly fade. The subprime mortgage crisis triggered hundreds of billions of dollars of losses for investors.
There are more than $27 billion of outstanding bonds backed by non-qualified mortgages now, a small fraction of the approximately $10 trillion mortgage-bond market. In 2007, there were around $1.8 trillion of bonds backed by loans to non-prime borrowers.
The “non-qualified” moniker refers to any mortgages that don’t meet rules from the Consumer Financial Protection Bureau that went into effect in 2014. Many investors and issuers expect the market for non-QM bonds to grow. A temporary rule that lets Fannie Mae and Freddie Mac buy some home loans that don’t meet all the qualified-mortgage rules is set to expire in 2021. That will result in more debt being available to be bundled into non-QM bonds. Redwood Trust Inc., which issues mortgage securities, estimated in May that some $185 billion of home loans bought by the government-backed agencies annually would be considered non-QM.
JPMorgan, Angel Oak
A handful of lenders, including JPMorgan Chase & Co., Angel Oak Capital Advisors and Caliber Home Loans have been making the non-qualified mortgages and bundling them into bonds.
Borrowers’ scores in non-QM bonds are typically lower than what’s seen in other mortgage securities without government backing, like credit-risk transfer securities. But the consumers typically have relatively small debt loads compared with their incomes and the value of their homes. In many recent deals, non-QM borrowers have average credit scores in the low to mid 700s, a level credit reporting groups generally deem “good” to “very good.” Subprime borrowers typically have scores of 660 or less.
The bonds themselves also have more safeguards for investors than they used to. According to a Fitch Ratings analysis, an average of 36% of principal would have to be lost before the top-rated slice took a hit. The cushion in crisis-era “alt-A” bonds with the same rating was just 6%.
“There’s a lot more cushion, as there should be,” said John Kerschner, head of U.S. securitized products at Janus Henderson Group Plc, which manages $360 billion. “You can get some comfort that even if defaults inch up, the losses from those defaults aren’t going to be egregious.”
Real Risk
But even if non-QM bonds aren’t toxic, they have real risks. Many borrowers with non-qualified mortgages offer lenders bank statements to verify income instead of more stringent tax returns. Fitch says such documentation may offer only partial verification, and these borrowers could have unstable income because, for example, they own small businesses.
Making non-qualified mortgages can be legally riskier for lenders. If a borrower misses payments, and it turns out they shouldn’t have received the loan in the first place, they can sue the lender or even the securitization trust that owns the loan. Qualified mortgages have more legal protections for lenders and bondholders.
The strength of the housing market has helped support the bonds for now. Home-price appreciation has slowed over the past year, but the average U.S. house value still rose more than 2% in August from a year earlier, according to S&P CoreLogic Case-Shiller data. In a downturn similar to the financial crisis, when home prices contracted around 34% between 2006 and 2012, Barclays expects only the riskiest, lowest-rated portions of most non-QM bonds to lose money.
That’s partly why Barclays says the top-rated portions of non-QM bonds are a good buy at current prices. The notes tend to pay down quickly, because borrowers refinance into more conventional mortgages when they can. And the securities offer higher yield relative to alternatives like credit-risk transfer bonds.
“At least for now, credit concerns for most non-QM deals should be modest for investors who purchase the investment grade-rated classes,” Barclays strategist Dennis Lee wrote in a note in September.
