Since 2015, a new tier of the private-label residential mortgage-backed securities (PLS) market has emerged, with securities collateralized by non-qualified mortgage (non-QM) loans. These securities enable mortgage lenders to serve borrowers with non-traditional credit profiles.
The financial crisis ushered in a sharp reduction in mortgage credit available to certain groups of borrowers. Funding sources, such as the PLS market, which once provided access for borrowers with credit blemishes, non-traditional income sources, or the desire for expanded product features were virtually eliminated.
The limited issuance of private-label RMBS since the financial crisis has generally consisted of new origination jumbo “prime” mortgage loans. These securities have included loans that meet the “qualified mortgage” (QM) standard with strong credit scores, pristine payment history, and fully documented income and assets. The non-QM market addresses a previously underserved market and reflects the expanding credit policies of many institutions.
What is a Non-Qualified Mortgage Loan?
Since the crisis, standards governing the majority of mortgage loan production have generally followed the restrictive credit criteria implemented by the GSEs. This has prompted some consumers and lenders to seek alternative products that may not meet the “qualified mortgage” requirements or the high-credit-quality standards of the GSEs. These tightened credit standards have restricted home ownership opportunities for certain groups of consumers. These groups include self-employed individuals and borrowers with weaker credit or a recent credit event, such as a foreclosure, short sale, or deed in lieu of foreclosure. While many of these potential borrowers can meet the criteria of the ‘ability-to-repay’ rule and have taken steps to improve their credit standing, they nevertheless are not able to meet the very high credit standards that have emerged since the financial crisis.
To meet the demand of these underserved borrowers, a number of lenders have begun to expand their credit parameters. As lenders have sought funding sources for these non-QM originations, a new tier of the PLS market has emerged. While it is difficult to create generic categories that define the origination practices of the various lenders, some high-level similarities can be observed in the following non-QM products and programs established to meet borrower demand:
- Alternative Documentation – the borrower’s income is assessed through sources other than available tax returns, business earnings, or Appendix Q requirements. Many non-QM lenders offer variations of bank statement programs (e.g., 24-month review and 12-month review) to determine a self-employed borrower’s ability to repay through analysis of their monthly cash flow.
- Borrowers with Non-Standard Credit Profile
- Expanded Credit – borrowers with weaker FICO scores, a recent delinquency on a mortgage, a debt-to-income ratio slightly above the qualified mortgage requirements, or higher loan-to-value ratios.
- Prior Credit Event – borrowers with recent foreclosure, bankruptcy, or other loss mitigation disposition that have not met the seasoning requirements established by GSE guidelines.
- Investor Program – financing for investors purchasing 1-4 family rental properties that may not meet GSE guidelines.
- Foreign National Program – financing for borrowers that are not permanent residents or do not have credit history in the United States.
- Non-QM Product Features – financing for products that do not meet qualified mortgage guidelines, such as loans with interest-only or balloon features.
Each of these programs evaluate many aspects of the loan during the underwriting process but primarily rely on an evaluation of the borrower’s ability to repay the loan to predict loan performance. These mortgage loan products and programs attempt to meet the housing finance needs of underserved borrowers while assessing the increased risk associated with the expanded lending standards.
Non-QM securities are likely to experience more performance volatility and higher realized losses than their jumbo prime counterparts in negative economic scenarios. This is due to weaker credit profiles among non-QM borrowers, product features that do not meet “qualified mortgage” requirements (e.g., interest-only, balloon payments, prepayment penalties), and alternative methods to assess the borrower’s ability-to-repay. Investors in these securities are challenged to assess the magnitude of the increased risk of loss (net of protection provided by credit enhancement levels) versus the incremental yield provided by the securities.
Overview of Non-Prime Issuers
The non-QM sector has been created and led by non-bank financial institutions that have filled the void left by regulated banking entities that have reduced their footprint in the mortgage market. Most financial institutions that have entered the non-QM mortgage space during the past five years have received financial backing from asset managers, hedge funds or private equity firms. Securitization activity for this sector of the PLS market began in 2015 and has increased slowly since. The table below reflects the strong growth in issuance activity for non-QM securitizations between January 2015 and September 2017:
Next Market Phase
The push by mortgage lenders to expand their credit criteria and provide consumers with “affordability” products combined with investor demand for higher yielding investments set the stage for the financial crisis of 2007-2008. Bolstered by strong demand from investors for mortgage-backed securities, mortgage lenders expanded underwriting guidelines to allow borrowers with weaker credit profiles, smaller down-payment amounts, and limited or no verification of income or assets to qualify for mortgages. Weakened underwriting standards were combined with product features that slowed repayment of principal through interest-only, negative amortization and loan term extension features.
History has shown that the combination of these credit guideline expansions with weaker PLS processes resulted in historic losses. As a reaction to the abysmal credit performance of mortgage loans originated between 2005 and 2007, credit availability in the mortgage market contracted dramatically. The swing of the credit pendulum resulted in significant improvement in the credit performance of loans originated since 2008. This improved performance, however, came at the cost of shutting a large segment of the population out of the mortgage market. Now almost a decade later, the pendulum appears to be swinging back in favor expanding credit criteria to accommodate more non-QM borrowers. Time will tell whether the market has learned and will remember the lessons of the financial crisis.