Private credit residential mortgage securitizations backed by relentless demand from underserved, higher net worth borrowers is attracting more diverse asset-based finance investors and continues to feed a notably uneven purchase market growth.
Insiders expect the strong non-agency product demand, which consistently defied macroeconomic challenges affecting mortgage finance this year, to continue beyond 2024.
The $14 trillion residential loan sector, and the largest U.S. credit market, is experiencing growth in 2024 that will persist in the near future. A Goldman Sachs forecast expects the smaller private credit market to grow 16% year-on-year while agency mortgage production declines by roughly 1% this year.
A market wide evolution
A self-adjusting residential mortgage securitization market is driving much of that growth. There is a high-quality, yet underserved borrower market, and the non-agency segment is evolving in its underwriting and credit evaluation processes to better address their needs, according to a report by Verus Mortgage Capital (VMC), a Washington, D.C. based, correspondent investor and issuer of non-agency RMBS.
Interest in non-agency residential mortgage backed security (RMBS) investing continues to grow. Especially from multi-sector private credit investors who are focusing on the broader asset-based finance (ABF) space, said VMC's president Dane Smith. Typically "to take advantage of its higher quality and diversification relative to middle market corporate debt," similarly to insurers, pension funds, and other institutional investors.
The U.S. residential loan market is the largest ABF market globally, and has seen substantial and increasing inefficiency from regulatory changes over the 15 years since the 2008-2009 Financial Crisis, Smith said.
"It provides investment-grade credit quality from senior secured loans backed by a supportive U.S. housing market."
Residential private credit represents one of the most attractive opportunities available in today's market, and deserves consideration for a featured position within an alternative credit portfolio, he said. Despite tight spreads, this market offers the potential for strong downside protection, credit diversification, and attractive pricing as banks continue to cede market share. The RMBS market provides these same favorable characteristics to bond investors, Smith added.
Increasingly diverse ABF investors
Insurance companies were among the first non-traditional investors to pivot towards residential private credit to diversify their portfolios.
In Q2 2024, 24 non-QM RMBS deals issued totaled more than $9.9 billion in debt, and 12 prime jumbo RMBS issuances amounted to nearly $6 billion, according to the MAXEX Q2 2024, Non-Agency Secondary Market Data & Insights Report.
The change resulted from the convergence of several macroeconomic events, rapidly increasing interest rates, high non-agency RMBS yields, and a significant drop in conventional mortgage originations, said Victor Kuznetsov, managing director and co-founder of Imperial Fund, a Hollywood, Fla., based mortgage investment firm.
"Short of a meaningful supply of their 'favorite' conventional assets, insurers saw an alternative in the non-QM space and show no sign of slowing down," he said.
Hedge funds, which historically have been present but not very active in the private credit RMBS market, according to Kuznetsov, have noticed the non-QM RMBS opportunity and are forging joint venture agreements with insurers and pension funds. Recent deals included the Ares-Amwest venture, and the $750 million deal between Canada Pension Plan Investment Board and Redwood Trust deals.
Investors appreciate the scale, high quality, and attractive yields of the residential loan market, Smith said. Insurers in particular see the benefits relative to their much larger holdings in corporate bonds and commercial mortgage loans.
Non-agency residential mortgages currently yield 7% to 8%, significantly higher than the 5% to 6% yields from investment-grade corporate and agency mortgage bonds, according to Smith. Yet insurance companies currently have only 0.6% of their assets in residential mortgages, he said, compared to 32% in corporate bonds and 6% in commercial mortgages, suggesting continued future growth.
Insurers saw an alternative in the non-QM space and show no sign of slowing down.
Insurers are issuing a growing number of annuities, which perpetuates their need to acquire assets, generating nearly insatiable demand for both whole loans and bonds, said Henry Broeksmit, senior associate, capital markets at MAXEX, an Atlanta-based, digital mortgage exchange for buying and selling non-agency residential loans through a single clearinghouse by connecting 330 mortgage originators and 26 institutional investors.
Residential private credit products typically consist of prime jumbo mortgages, second homes, which are typically investment properties, and non-QM mortgages. They lend to real estate investors, debt service, coverage ratio or DSCR, and other low loan-to-value, high FICO, higher net worth, self employed borrowers using alternative forms of income documentation.
Despite high home prices and elevated rates, the extreme investor demand for the whole range of non-agency loans indicates this trend will continue for the balance of 2024 and beyond, Broeksmit said.
Why underserved borrowers matter
A unique combination of relentless demand from underserved borrowers and housing investors suggest the private credit lending market remains in growth mode.
Chief among the non-agency borrower demographic is the $2.7 trillion self employed market, which constitutes 10% of the labor force and earn incomes 32% higher than salaried workers, and are relatively insulated from the affordability headwinds affecting the conventional market, according to data reported by the Federal Reserve Survey of Consumer Finances.
Similarly, U.S. Census data show the $10.2 trillion investment property market, backed by 22 million single-family rentals (SFR) is the largest growth segment since the 2008-2009 financial crisis, yet underserved, according to VMC, because borrower profiles fall in between residential and commercial lending.
The credit quality of non-agency RMBS backed by low loan-to-value, high FICO loans to higher-end borrowers priced to withstand a recessionary stress is quite strong, Smith said.
"Cumulative losses in the sector have been close to zero and lower rates would increase loan originations and RMBS issuance, as refinance activity increases."
Investor U.S. home purchases totaled $43 billion in Q2 2024, up 13.7% annually, marking the largest gain in two years, according to Redfin's "Real Estate Investors Returning to Buying Ways" report. Parents buying second homes to rent and pass on to their children, foreign nationals, fix-to-sell property buyers, and other types of investors purchased roughly 16.8% of all homes sold March through June, including 25% of all low-priced homes sold.
SFR homes represented 69.4% of investor purchases, up 6.7% year over year, while investor purchases of properties with two-to-four units, condos/co-ops, and townhouses fell 5%, 3.3% and 1.9%, respectively.
The Mortgage Bankers Association forecasts a nearly 6% year-over-year higher purchase demand in 2024 will increase the total single-family mortgage originations to $1.8 trillion, up from $1.6 trillion in 2023, and will help rebound equity products such as second liens.
Caveats to growth
The mortgage lending market recovery looks significantly uneven.
Redfin found over 85% of U.S. homeowners have interest rates below 6%, suggesting they have little incentive to refinance, and that such activity will be weak. The 30-year fixed mortgage refinancing activity may account for 18% of mortgage originations in 2024, up 1% from 2023, according iEmergent, but may grow 33% in 2025 and even more in 2026, when the mortgage market should grow to $2 trillion.
On the securitization side, Kuznetsov expects non-QM RMBS spreads to remain steady in the short term as traders already were pricing at least 25 bps lower rates for September and expect 75 bps in cuts by year end 2024.
"What could affect pricing from here on would be a material change," he said, such as resurging inflation, or a labor market boom.
The quality, scale and attractive pricing within the non-agency residential loan market positions it for strong growth over the next several years, Smith said.
RMBS issuance will continue to grow in tandem, subject to lower activity levels during periods of capital markets volatility, he added, "issuers are planning to be active while seeking to manage around the period in early November, near the election."
