REITs Emerge as Saviors for Misfit American Borrowers

Andrew Harrer/Bloomberg

Borrowers struggling to get home loans are catching a break from an unfamiliar benefactor.

Mortgage-focused real estate investment trusts, including those affiliated with Western Asset Management Co. and Pine River Capital Management LP, are backing loans to Americans who don’t meet banks’ requirements.

These borrowers have been shut out of the housing recovery since traditional lenders tightened credit standards following the 2008 housing crash. REITs, facing a decline in yields from government-backed mortgage bonds, are seizing the opportunity to serve these borrowers and boost profits. The firms are investing in lenders, forming partnerships or acquiring them, and agreeing to buy the new loans they make.

“They’re looking at where the needs are, at borrowers in the market where funding is not available,” said Steven Delaney, a San Francisco-based analyst with JMP Securities. “There is demand out there for a broader credit box than what banks are providing.”

Delaney estimates the volume of these misfit mortgages could be as high as $75 billion annually, giving a lift to the market for mortgages without government backing, where issuance was $200 billion last year, mostly jumbo loans.

Qualified Mortgages

Western Asset Mortgage Capital Corp., which has about $4.7 billion in assets, is partnering with lenders to make loans that don’t meet the qualified mortgage guidelines established to curb reckless lending, said Gavin James, chief executive officer of the firm. It may work with as many as eight lenders across the U.S. to ensure geographic distribution of the loans, Travis Carr, the REIT’s chief operating officer, said in June.

“There’s a lot of due diligence that goes along with buying these loans,” James said. “It’s still a fledgling market.”

The REIT will focus on backing loans to borrowers with strong credit, such as those shut out because they’re self-employed, said Anup Agarwal, head of mortgage and asset-backed securities at Pasadena, California-based Western Asset Management.

Borrowing costs on loans through Western’s partners will be as high as 3 percentage points above conforming interest rates, Agarwal said. The average rate for a 30-year fixed mortgage was 3.66 percent this week, Freddie Mac said in a statement Jan. 15.

QM rules

The QM rules, which the Consumer Financial Protection Bureau rolled out in January 2014, make lenders take steps to ensure borrowers can repay their loans. Lenders will have greater legal risks if the mortgages have terms such as interest-only periods or debt-to-income ratios above 43 percent and don’t qualify for purchase from Fannie Mae, Freddie Mac or the Federal Housing Administration.

Banks had already started tightening standards before QM took effect. As many as 1.2 million borrowers whose FICO scores were high enough to buy a home in 2001 could no longer qualify for a mortgage in 2012, according to a March report by the Urban Institute.

“Lots of borrowers who fit the traditional profile and were kind of banned because of the QM rule were and are good credit,” Agarwal said. “That’s the new mortgage market.”

The U.S. homeownership rate declined to 64.4 percent in the third quarter of 2014, an almost 20-year low, according to the Census Bureau. Renter-occupied residences grew by 1.2 million while owner-occupied households fell about 657,000 in the 12 months through September.

“Some REITs could be important in the non-QM sector, or more broadly in expanding access to mortgage credit,” Raj Date, a former official at the CFPB, said in an email. “That will require either partnering with origination specialists who obsess over this kind of non-QM risk or buying origination specialists.”

Non-prime borrowers

Zais Financial Corp., which has about $722 million in assets, bought mortgage originator GMFS last year for access to new loans and to diversify its revenue stream, according to a third-quarter presentation by the Red Bank, New Jersey-based REIT.

GMFS is licensed in 29 states and originated about $991 million in mortgages for the first nine months of 2014, according to Zais. The purchases give the REIT “increased sourcing capability with control of the origination process” and the lender’s management team adds “strategic insight into credit expansion,” Zais said in the presentation.

Two Harbors Investment Corp. began working with lending partners after the third quarter to reach non-prime borrowers, CEO Tom Siering said during a November call with investors.

Average Credit

Non-prime borrowers are those who can’t qualify for traditional loans because of factors including a credit score below the average of 692 or uneven income.

The Minnetonka, Minnesota-based mortgage REIT, which is managed by hedge fund Pine River, targets borrowers with average credit quality who have been unable to get a loan due to tightened standards, executives said during the call.

The average FICO score on purchase loans backed by Fannie Mae or Freddie Mac as of November was 754 on a scale of 300 to 850, according to mortgage technology company Ellie Mae.

Two Harbors is also expanding its program for borrowers who want to make smaller down payments on jumbo mortgages, more than $417,000 in most areas.

“There continues to be a huge national cohort of people able to responsibly purchase a home that simply haven’t been able to get a mortgage,” Siering said on the call.

‘Strategic Investments’

Ellington Financial, an investment firm that operates like a REIT, has invested in at least two lenders. Larry Penn, CEO of the company, said during an August earnings call that the firm had hired two senior professionals to find “strategic investments” in originators and develop its non-QM business.

“These will be relatively small investments to start with, but they should have the potential to generate a large pipeline of new investments for us, especially in the non-QM, non-prime space,” Penn said on the call. The firm has about $4.1 billion in assets.

In December, Ellington made a subordinated debt investment in Skyline Financial Corp., which owns NewLeaf Lending, an originator that plans to offer non-prime loans. Earlier in the year, the firm said it took a minority stake in Longbridge Financial, a lender of reverse mortgages, which let homeowners age 62 and older convert the equity in their houses to cash.

Falling Yields

The REITs have traditionally bought government mortgages and other bonds including those backed by jumbo or subprime loans. By law, they must pay out at least 90 percent of taxable earnings to shareholders as dividends. REITs don’t have to pay federal income taxes on those earnings and most of them distribute all of their earnings to get the full deduction.

The firms have lured investors with returns of about 70 percent over the span of the last five years including reinvested dividends, according to a Bloomberg index of 42 mortgage REITs. The index has declined 0.6 percent this year through yesterday.

The REITs are struggling with falling yields on mortgage securities issued by government-controlled Fannie Mae, Freddie Mac and Ginnie Mae as tumbling oil prices crimp the outlook for inflation and spur speculation the Federal Reserve may delay an interest-rate increase. The debt returned 6.8 percent through yesterday since the start of 2014, driving yields down by more than a percentage point to 1.95 percent, according to Bank of America Merrill Lynch index data.

Quality Partners

While mortgage REITs need to find incremental yield, the firms shouldn’t underestimate how difficult lending could be, according to Date, who is now a managing partner at consumer finance advisory firm Fenway Summer.

“Buying loans is pretty decidedly not the same as buying bonds,” he said. “You need a different kind of diligence, a different kind of process, and, frankly, often a different kind of staffing.”

The firms also have to be careful about the quality of their lending partners. Unlike government-backed mortgages, there’s no safety net if their loans default, said Jason Stewart, a Washington-based analyst at Compass Point Research & Trading.

Some REITs are avoiding the small market for non-QM loans, at least for now. Gary Kain, president of Bethesda, Maryland-based American Capital Mortgage Investment Corp., with $7.1 billion in assets, said his firm weighed getting into origination and buying companies but decided against it.

“We didn’t feel that it was scalable at this stage of the game,” Kain said. “It would be better to see if this really works and if it becomes a larger market and if there are any precedents around legal risk.”

Issuance of bonds tied to new loans that aren’t backed by the government was only about $8.8 billion last year, down from $1.2 trillion in each of 2005 and 2006, according to data compiled by Bloomberg.

“Last year was supposed to be the year where the start of non-agency/non-QM took off and it came in so much below expectations,” said Stewart of Compass Point. “People are looking at 2015 and saying now this is our year.”

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