What is the Draw of Whole Loan Investing?
Mortgage whole loans are having something of a moment as an asset class, particularly among insurance companies and other nonbank institutional investors. With insurance companies increasing their holdings of whole loans by 35 percent annually over the past three years, many people are curious what it is about these assets that makes them so appealing in the current environment.
We sat down with Peter Simon, founder and CEO of Dominium Advisors, a tech-enabled asset manager specializing in the acquisition and management of residential mortgage loans for insurance companies and other institutional investors. As an asset manager, Dominium focuses on performing the “heavy lifting” related to loan investing for clients.
How has the whole loan asset class evolved since the 2008 crisis? How have the risks changed?
Peter Simon: Since 2008, laws and regulations like the Dodd-Frank act and the formation of the Consumer Financial Protection Bureau have created important risk guardrails related to the origination of mortgage products. Many loan and mortgage product attributes, such as underwriting without proper documentation of income or assets or loan structures with negative amortization, which contributed to high levels of mortgage defaults in 2008 are no longer permissible. In fact, more than half of the types of mortgages that were originated pre-crisis are no longer permitted under the current “qualified mortgage” regulations. In addition, there have been substantial changes to underwriting, appraisal and servicing practices which have reduced fraud and conflicts of interest throughout the mortgage lifecycle.
How does whole loan investing fit into the overall macro environment?
Peter Simon: Currently, the macro environment is favorable for whole loan investing. There is a substantial supply-demand imbalance – meaning there are more buyers looking for places to live then there are homes for them to live in. At the current rates of new home construction, mobility trends, and household formation, it is expected that this imbalance will persist for the next several years. Demographic trends are also widening the current supply demand imbalance as more millennial buyers are entering their early 30s – the first time-homebuyer sweet spot. And work from home trends created by the pandemic are creating a desire for additional living space.
Who is investing in whole loans currently?
Peter Simon: Banks have traditionally been the largest whole loan investors due to their historical familiarity with the asset class, their affiliated mortgage origination channels, their funding advantage and favorable capital rules for holding mortgages on balance sheet. Lately, however, banks have pulled back from investing in loans due to concerns about the stickiness of deposits, which have been used traditionally to fund a portion of mortgage purchases, and proposed bank capital regulations that would make it more costly for banks to hold whole loans. Stepping in to fill this void are other institutional investors — insurance companies, for example — which have seen their holdings of whole loans increase by 35% annually over the past 3 years. Credit and hedge funds and pension funds are also taking larger positions in the asset class.
What is the specific appeal of whole loans to insurance companies and these other firms that invest in them?
Peter Simon: Spreads and yields on whole loans produce favorable relative value (risk versus yield) when compared to other fixed income asset classes like corporate bonds. Losses since the Financial Crisis have been exceptionally low due to the product, process and regulatory improvements enacted after the Financial Crisis. Whole loans also produce risks in a portfolio that tend to increase overall portfolio diversification. Borrower prepayment risk, for example, is a risk that whole loan investors receive a spread premium for but is uncorrelated with many other fixed income risks. And for investors looking for real estate exposure, residential mortgage risk has a much different profile than commercial mortgage risk.
Why don’t they just invest in non-Agency securities?
Peter Simon: Many insurance companies do in fact buy RMBS securities backed by non-QM loans. In fact, most insurance companies who have residential exposure will have it via securities. The thesis around investing in loans is that the yields are significantly higher (200 to 300 bps) than securities because loans are less liquid, are not evaluated by the rating agencies and expose the insurer to first loss on a defaulted loan. So for insurance investors who believe the extra yield more than compensates them for these extra risks (which historically over the last 15 years it has), they will likely be interested in investing in loans.
What specific risk metrics do you evaluate when considering/optimizing a whole loan portfolio – which metrics have the highest diagnostic value?
Peter Simon: Institutional whole loan investors are primarily focused on three risks: credit risk, prepayment risk and liquidity risk. Credit risk, or the risk that an investor will incur a loss if the borrower defaults on the mortgage is typically evaluated using many different scenarios of home price appreciation and unemployment to evaluate both expected losses and “tail event” losses. This risk is typically expressed as projected lifetime credit losses. Prepayment risk is commonly evaluated using loan cash flow computed measures like option adjusted duration and convexity under various scenarios related to the potential direction of future interest rates (interest rate shocks).
How would you characterize the importance of market color and how it figures into the overall assessment/optimization process?
Peter Simon: Newly originated whole loans like any other “new issue” fixed income product are traded in the market every day. Whole loans are generally priced at the loan level based on their specific borrower, loan and property attributes. Collecting and tabulating loan level prices every day is the most effective way to construct an investment strategy that optimizes the relative differences between loans with different yield characteristics and minimizes credit and prepayment risks in many various economic and market scenarios.
