As the Mortgage Bankers Association convenes its annual secondary market conference in New York, one of the big questions on the minds of many mortgage bankers, warehouse lenders and vendors is whether the market for nonagency or non-qualified mortgages, including home equity lines of credit, will really start to grow as an asset class.
Non-QM loans have been growing very slowly since 2008, this despite enormous expectation within the mortgage industry. After rising sharply during the housing boom of the 2000s, HELOCs peaked in 2008 and have since been running off steadily. Homeowners have been decidedly reluctant to tap the equity in their homes over the past decade, causing the total balance of HELOCs owned by banks to actually decline 8.6% in 2018, as shown in the chart below.
Larger banks such as JPMorgan Chase, Wells Fargo and Bank America aggressively bid for large prime non-QM loans due to size, whether as first liens or HELOCs. Yet overall the banking industry's portfolio of HELOCs, which represents most of the asset class, has been steadily shrinking for the past decade.
Total non-QM lending in 2018 amounted to a few billion in production, basically a rounding error on the $10 trillion in total residential mortgages outstanding and the $1.5 trillion in new mortgage production in 2018. The non-QM securitizations seen to date have been mostly comprised of prime loans too large for the agency market, although the proverbial credit box is expanding to include construction and investor loans.
Some are predicting a big jump in non-QM production in 2019, but don't hold your breath. Production of both HELOCs and nonagency, non-QMs slowed when it became apparent that the Federal Open Market Committee was not going to raise interest rates further. HELOC volumes generally suffer when interest rates are falling and the mortgage refinance market is strong. But both non-QMs and special products such as HELOCs are difficult for nonbank mortgage lenders to originate due to a basic issue that is rarely discussed, namely funding.
As banks reduced participation in mortgage lending since 2008, nonbanks have come to dominate the industry. The market for jumbo loans dominated by banks, thus non-QM lending by nonbanks is limited to a few highly specialized lenders, industry veterans who hand-underwrite these loans and typically retain the servicing. These successful non-QM lenders must have a lot of cash capital and an audience of hard money investors to "take out" the loan from the underwriter.
Whereas you can finance a QM loan that has received an agency endorsement like a T-bill and get secondary market execution well over par, for non-QM loans financing is far more costly. The same financing cost barrier that inhibits the growth of non-QM lending, especially by nonbank lenders, also is an effective obstacle for the subset including HELOCs despite the potential benefits of these products. Some see HELOCs as a potential replacement for reverse mortgages, for example. So why is the HELOC market shrinking and why has the growth of non-QM loans been so anemic? Three reasons:
First, HELOCs and non-QMs are traditional bank products that are frequently treated as an unsecured, 100% risk-weight loan by prudential regulators and are typically held in portfolio and serviced by the lender. Depositories have the liquidity necessary to fund and hold a HELOC or non-QM loan. Also, banks that hold non-QMs in portfolio have legal protections that are not available to nonbank lenders or end investors.
Second, nonbanks are ill-equipped to originate HELOCs and non-QM loans because of funding costs and the lack of liquidity in terms of a natural take out by end investors. Most bank warehouse lenders investors don't like to take credit risk on a short-term facility for a nonagency residential mortgage loan, remembering the bad old days of 2008 when liquidity for these assets evaporated.
Third, investors particularly dislike the attributes of HELOCs which are priced against first-lien mortgages and do not reflect the higher credit and prepayment risk of the asset. Non-QM loans have higher coupons than agency mortgages, but the potential for credit losses and, more important, litigation by consumers over the ability to repay has limited investor demand for these loans.
With the rare exceptions of nonbank firms such as Citadel Servicing, Angel Oak Mortgage, Caliber and Quicken, the non-QM and HELOC markets are comprised of prime assets that are owned and serviced by banks and are retained in portfolio. Large banks have a cost of funds averaging 1.25% as of year-end 2018 or 3 to 4 points below the cost of funds for a nonbank. Small banks fund even lower, closer to 1%. Nonbanks simply lack the capital and liquidity to compete with banks for these loans.
So the big obstacle to the growth in non-QM loans and also HELOCs by nonbanks can be summarized in three factors: 1) high funding costs for originators, 2) high pricing and low yields due to bid from larger banks and 3) end-investor reluctance to take default or litigation risk on a HELOC or non-QM loan. Even with the impact of the FOMC's market intervention, there is simply not enough yield in most non-QMs including HELOCs to entice private investors to take the credit and legal risks embedded in these assets.
The fact of a federal guarantee on agency mortgages and regulatory requirements for banks, insurers and pensions has made buy side investors lazy over the years. Letting Uncle Sam subsidize the default risk on residential (or even multifamily) mortgages is much easier than paying for the default servicing and loss mitigation. The huge subsidy that the federal government provides to the U.S. housing finance sector allows consumers to get a mortgage with a 3% or 4% coupon in today's market. If there was no federal credit guarantee on agency mortgages, the coupon on prime mortgage loans would be double today's levels.
Ultimately the big obstacle to grow non-QMs and HELOCs is the federal government and the housing GSEs. Higher yields would be more attractive to end investors, but this would not solve the key funding issue facing many nonbank lenders seeking to originate these loans. So long as the federal government subsidizes the production of qualified mortgages, both in terms of the credit guarantee from the GSEs and the preferential risk weighting for banks and other investors that hold agency securities, there will be little incentive for investors to take the risk on non-QMs and HELOCs. Think about this fact next time you hear talk about GSE reform.
