Are Sprout, FGMC failures a harbinger of hard times for non-QM?

Sprout Mortgage abruptly shut its doors on Wednesday, multiple LinkedIn posts from former employees confirmed.

Attempts to contact Sprout for comment were not returned.

Sprout's move closely follows the bankruptcy filing of non-qualified mortgage competitor First Guaranty Mortgage. While some online are making comparisons to the shutdown of subprime business in 2008, could this situation be more reminiscent of what happened to nonconforming lending as a result of the Russian debt crisis in the fall of 1998? Back then, investors made a "flight to quality" that impacted the debt, equity and securitization markets the subprime lenders depended on.

Several subprime mortgage lenders, including Southern Pacific Financial, United Companies Financial and Credit Depot, closed down as a result back then, while others such as Delta Funding were sent scrambling for liquidity. Delta would survive until 2007 when another liquidity crisis forced it out of business.

The industry was surprised and saddened to hear about Sprout and First Guaranty shutting down, but today’s lending environment is far different from that of 14 years ago, said Tom Millon, CEO of Computershare Loan Services and the founder of the Capital Markets Cooperative.

"Origination volume has declined but, unlike 2008, when the bond market was severely affected, activities in other areas of mortgage servicing have increased," Millon said. "We have also seen a rise in non-QM activity, as one would expect with rising interest rates."

Earlier this year, a mismatch between primary and secondary market pricing affected the private-label securitization business and some dislocation in the market remains.

"There's a price discovery process going on in the securitization markets," said Gunes Kulaligil, structured finance co-lead at investment banking firm Stout. "Non-QM mortgage current coupon needs to come up and securitization spreads need to tighten for primary supply and investor demand to meet in the middle."

The issues at Sprout and FGMC could be related to their warehouse line covenants and company liquidity, and thus probably not an indicator of broader problems with non-QM lending,  said Mike Peretz, managing principal at Capco.

"I haven't heard of any significant tightening in the buyers of [non-QM] loans outside of these two events, which doesn't mean that I won’t," Peretz said.

It is the instability in rates, not the lack of secondary market outlets driving the situation with those companies, Peretz said. Even if both had a properly hedged book of business — something difficult for non-QM originators as is — it is likely a lender will suffer losses that are consequential, Peretz said.

A convergence of factors are causing these and other lenders to take drastic measures, Kulaligil said.

"Regarding originators, the layoffs and shutdowns are a manifestation of multiple headwinds including rates sell off (and resulting duration extension), credit spreads widening, inflation and maybe most important of all: volatility which is created a large gap between investor expectations and what the sector produces," Kulaligil added. "The more an originator is dependent on a securitization or warehouse lines, the harder it will be to stay in business until volatility subsides."

But these closures aren't likely a sign of the first dominos to fall because industry conditions are much different today than in either 1998 or mid-2000s.

The purchase market remains strong, the government-sponsored enterprises don't have the same business model as they did in either of those periods of stress and the Federal Housing Administration is on sturdier financial ground.

Lenders today are stronger as well.

"The solvency and financial fitness of the largest non-depositories far exceeds what we saw in either of the other two events," Peretz said. And, "it really is the strong governance that they have in their risk tolerance and their understanding of risk."

At the end of the day, it is the people that suffer when a Sprout or an FGMC go out of business.

"The net effect to an employee and the net effect to a borrower is exactly the same and the reasons don't matter to a borrower who thought she was going to have a home or lower her interest rate by 100 basis points that now can't," said Peretz. "She doesn't really care about underlying macroeconomic conditions and that's the real unfortunate thing."