Over a decade has passed since the end of the subprime mortgage crisis, and since then the stigma associated with “sub-prime,” “unconventional” and “non-agency” mortgage-backed securities (MBS) has clearly shifted. These investment vehicles are finally making a comeback. In 2018, the number of unconventional mortgages increased to the highest level since the mortgage meltdown in 2008. Unconventional mortgages include subprime loans, which are made to borrowers with blemished credit; loans made to borrowers without a Form W-2 or other standard documents; and other loans that don’t meet the standards set by the Consumer Financial Protection Bureau.
Today’s so-called “non-prime” market is still small. The great majority of the mortgage-bond market is in government-backed securities. However, banks are getting back into the business of constructing and issuing mortgage bonds. Citigroup, Goldman Sachs, Wells Fargo, and JP Morgan Chase, over the past year, have all either restarted or expanded the business of spinning new pools of mortgages into securities designed for their end-investors to target yield within their investment portfolios.
Unconventional mortgages include subprime loans, which are made to borrowers with blemished credit; loans made to borrowers without a Form W-2 or other standard documents; and other loans that don’t meet the standards set by the Consumer Financial Protection Bureau.
Today’s MBS are a different animal from the version we saw a decade ago. While some of the borrowers behind today’s private label MBS have had credit dings or other issues that make them less-than-perfect, they’re not the higher-risk borrowers that were so common in 2007 and prior. The modern truth is that for investors seeking a diversified income producing strategy, the MBS market may offer a sound opportunity in an otherwise relatively low-yield environment.
Despite recent growth in the number of unconventional mortgages, they were still less than 3% of loans made in 2018, compared with 39% in 2006, right before the housing downturn began. In addition, many of the loans are only slightly outside of conventional norms. Today, most lenders must, by law, make a good-faith effort to determine that a borrower has the “ability to repay.” And, lenders that underwrite these mortgages usually look for ways to offset risk. For example, they’ll use a high credit score and a large down payment to offset the risk of a high debt-to-income ratio, limited documentation or an interest-only loan.
The bad-apple loans that contributed to the housing crisis are not in the picture these days. For instance, loans that result in negative amortization-wherein the loan balance grows rather than shrinks-have disappeared. Interest-only loans have returned to their more traditional role as short-term loans for wealthier people buying expensive homes with lower LTV’s.
And, as the Trump administration tries to reduce the government’s role in housing finance, the role of the so-called private-label market for mortgage bonds appears set to expand significantly.
Agency MBS are created by one of three quasi-government agencies: Government National Mortgage Association (known as Ginnie Mae), Federal National Mortgage (or Fannie Mae), and Federal Home Loan Mortgage Corp (Freddie Mac). GNMA bonds are backed by the full faith and credit of the U.S. government and thus are free from default risk. While FNMA and Freddie Mac securities lack this same backing, the risk of default is negligible. Securities issued by any of these entities are referred to as “Agency MBS.”
Private entities, such as financial institutions, can also issue mortgage-backed securities, referred to as “non-agency” MBS or “private label” securities. These bonds are not guaranteed by the U.S. government or any government-sponsored enterprise, since they often consist of pools of borrowers who don’t meet Agency standards. In conjunction with the lack of government backing, non-Agency MBS contain an element of credit and default risk not present in Agency MBS. These securities tend to pay higher interest rates than their agency counterparts, commensurate with the added risk.
Last year, about $70 billion of mortgages ended up in private-label mortgage bonds, according to the Urban Institute. Though that is far below the peak, it is the most since 2007. And this market could continue to grow if Fannie Mae and Freddie Mac are pared back, opening up more room for private players to take over the middleman role of packaging and selling mortgages. The Trump administration this month proposed privatizing the two government-sponsored mortgage giants, and the administration is expected to shrink them even if it can’t return them to private hands.
The Aloha Fund can be classed as a MBS as well, given that it’s a private placement security with 80 or so mortgages in it, designed to produce a consistent, low volatility yield for its investors. The categorical difference in Aloha vs. the overview outlined above is that we operate strictly in the commercial/business-to-business lending space of real estate investors–instead of in the consumer, owner-occupied real estate sector. As we referenced in last month’s letter, the non-bank lending sector has been growing at a very rapid pace, one that eclipses the slower re-emergence of the conventional MBS market. But it’s nice to see the broad-based return of this asset class occurring on both the consumer and business lending sides.
The Fund’s fifty-five month run of positive performance since inception continues. Our track record continues to produce sound results, even while the capital markets are experiencing a volatility expansion and struggle to find new highs. We enjoy earning these consistent and attractive returns, as well as sending regular income distributions to our valued investors.
As always, please reach out with your questions and interest in working with Aloha Capital in this excellent investment–Aloha LTD Income Fund.