Alternative Mortgages is a segment of the Alternative Credit asset class. Capturing the return stream in this asset class is a variant of traditional lending that banks undertake every day with clients’ deposits. In the traditional banking model, individuals and companies deposit excess capital or savings into a bank which pays them interest on those deposits. The bank uses the vast majority of deposits to make a variety of different loans to both individuals and companies. One of the types of loans made by banks is secured against real estate, which are known as mortgages. The difference between what banks gets paid from their borrowers and what they pay their depositors is known as the ‘interest spread’ which is a main source of profits for banks. This is traditional banking as it always was.
The US mortgage market, is the world’s largest mortgage market and at any one time there is more than $13.5 trillion of loans outstanding.1
Residential Mortgage Overview and Alternative Lending Opportunity
The US mortgage industry is dominated by residential mortgages. Of the nation’s $15.8 trillion total mortgages outstanding, $11 trillion or about three quarters are residential mortgages, according to historical Federal Reserve data.
About two thirds of these residential mortgages (more than $5.5 trillion are held by government-sponsored enterprises (GSE) such Fannie Mae or Freddie Mac, or in the mortgage backed securities issued by the agencies.2 As a result, a large proportion of US households benefit from low, long-term mortgage credit: the average interest rate on 30-year fixed rate mortgage across the US has is varied between roughly 2.5% and 5% over the past decade according to Federal Reserve data (as at September 2019). This also means that the core business of most mortgage originators is to generate mortgages that meet the GSE eligibility criteria.
Non-conforming loans that banks cannot transfer to agencies must be held on the bank’s balance sheet which require the bank to maintain a lot more bank capital against these loans than loans that are transferred to the agencies. Residential mortgages held on the banks’ balance sheets represent $2.64 trillion or the bulk of the non-agency mortgages outstanding.3 Following the 2008 global economic crisis, consumer protection regulations were significantly enhanced to prevent US lenders from offering unaffordable loans. US lenders are required to determine the borrower’s ability to repay based on a set of criteria and “verified and documented information”. Mortgages that meet these criteria are called “qualified mortgages” and provide US lenders with a potential “safe harbour” from liability from borrowers and regulators.
By contrast, underwriting mortgages outside of these criteria has become a higher-risk business that require more capital from the banks and the majority of US banks have stopped offering non-qualified mortgages. Unsurprisingly, lenders charge significantly higher rates for non-qualified mortgages: typically, between 7% and 9%. 4
Who are the borrowers who have to turn to these more expensive mortgage loans?
Borrowers who have other debt outstanding (student loan) or obligations (medical bills) that push their debt to income ratio beyond the prescribed 43% level, but who otherwise have documented income and even perhaps high credit scores.
Borrowers who recently arrived in the country from abroad and, as a consequence, do not have historical income or credit scores but otherwise may have cash reserves and substantial income.
Borrowers with a historic “poor credit history” but improving financial situation;
All the way down to genuinely weak credits;
Borrowers who are self-employed and as a consequence do not have the tax documents (such as form W-2) required to evidence income, but otherwise may have cash reserves, substantial non salaried income and high credit scores.
Borrowers who need cash in a hurry to close a transaction
Borrowers who have very little cash for a down payment which often include business owners, trust beneficiaries, people with deferred compensation arrangements, etc.
Some but not all borrowers who initially are ‘turned down’ may become eligible for qualified-mortgages after a time period and subsequently refinance at cheaper rates.
Alternative mortgage lenders, funded by private risk capital as opposed to deposits may find attractive risk-adjusted lending opportunities, by targeting borrowers outside of the qualified mortgage framework. However, the risk of default still exists.
The US mortgage landscape at a glance.
Mortgage debt outstanding, USD billions, Fed data September 30, 2019
Commercial Mortgage Overview and Alternative Lending Opportunity
Commercial mortgages encompass the loans secured by commercial real estate including office buildings, industrial property, warehouses, shopping malls, and multi-family apartment complexes. A borrower will use the mortgage advance to acquire, develop, build the property or leverage an already operating property.
Based on Fed data as at September 2019, there are $4.5tn of commercial and multi-family mortgages outstanding of which $ 2.3tn are held by banks. Insurance companies are large investors in commercial and multi-family mortgages and hold approximately £551bn of debt. In contrast with residential mortgages, the commercial mortgages industry is dominated by private lenders.5
There are several types of commercial mortgages. Long term GSE backed mortgages on multi-family apartment buildings, with terms up to 30 years. Three to ten years loans to finance commercial or industrial properties with existing lease or operating revenues. One to three years pre-development or construction loans.
In the third category, the borrower intends to add substantial value to the property and hopefully achieve a multiple on their initial investment. The ability of the borrower to pay interest and repay principal can often be a function of the commercial success of the development. The value of the collateral real asset can vary significantly depending on the progress or the difficulties experienced by the project. This segment is riskier than GSE conforming mortgages, but the interest rates charged by lenders can be in the teens.
Commercial real estate lending is the focus of certain banks. It requires specialized credit skills and non-standard case-by-case underwriting. The loans are non-recourse, secured only by the collateralised property, but risk lies as much with the developer or operator, as with the property itself.
For banks, commercial real estate mortgages attract a higher risk weight in relation to the risk-based capital rules than GSE conforming residential mortgages.
Non-regulated alternative lenders, funded by private risk capital as opposed to deposits or wholesale debt, operate in certain niche segments. The competitive advantage of alternative lenders vis-a-vis traditional lenders is largely a function of the specialized skill and experience of the lender’s underwriting and management teams. Strong alternative lenders tend to specialize in a specific niche market and focus on their geographic area of expertise
Opportunities for Alternative Mortgage Investors
Some of the capital coming into the Alternative Mortgage segment is concentrated on the short term/maturity end of the market. In our view, investors are looking at the relative attractiveness of short dated corporate fixed income with high liquidity and are considering alternative short dated mortgages with a dose of illiquidity.
Like any asset class one can capture returns at either end of the risk spectrum. Another key when considering an investment into Alternative Mortgages is the diversification of the underlying credits.
Alternative Mortgage lenders have opened up the potential for returns that were historically only available to banks and institutional investors and are now becoming available to private investors via new fund structures.
For those investors who can afford a degree of illiquidity in their portfolios and are comfortable with the collateral of their fixed income investment being property rather than corporates then alternative mortgages could prove an attractive alternative. In a world of low interest rates and efficient markets, ‘Illiquid Investors’ can now consider investing in Alternative Mortgage funds to attempt to capture potentially uncorrelated returns.
1. Federal Reserve Mortgage Debt Outstanding Sept 30, 2019 & https://www.statista.com/topics/1685/mortgage-industry-of-the-united-states/
2. Federal Reserve Mortgage Debt Outstanding Sept 30, 2019
3. Federal Reserve Mortgage Debt Outstanding Sept 30, 2019
4. Angel Oak Capital Advisers – Opportunities in Non-Qualified Mortgage Loans 2015
5. Federal Reserve Mortgage Debt Outstanding Sept 30, 2019
This document is for information purposes only. Nothing herein constitutes, or should be construed as constituting, investment, tax, legal or any other advice or an offer to subscribe in any particular financial instrument or asset class or to participate in any investment strategy. The views or opinions expressed herein do not necessarily reflect the views of MASECO LLP. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
Investing in this asset class is for Sophisticated and Certified High Net-Worth Investors. Always consult a Financial Adviser before making a decision to invest. Past performance is not a reliable indicator of future performance. The value of investments can fall as well as rise. You may not get back what you invest. Investment in the Alternative Mortgages asset class carries particular risks, including political and economic as well as the potential for mortgage defaults in the event that base rates increase which means that the rate charged by lenders will increase potentially leading to the risk of default by borrowers with the result that mortgage lenders may not receive back the amount lent.
Issued by MASECO LLP, a limited liability partnership registered under the laws of England and Wales (Companies House No. OC337650), which is authorized and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered in the US with the Securities & Exchange Commission as a Registered Investment Adviser. Its registered office is at Burleigh House, 357 Strand, London WC2R 0HS, United Kingdom.