The strongest market agitator in the first half (H1) of 2025 is not likely to be either U.S. unemployment or inflation caused by monetary or fiscal policy. Based on the latest readings, inflation is consistently decreasing, reacting as expected to the Federal Reserve’s interest rate hike campaign that sent mortgage rates higher than they have been since the start of the millennia. However, this era is ending, leading to an expected increase in mortgage lending and an uptick in RMBS issuance, especially in H1 2025.
What is the catalyst that may cause it all to fall apart? Not mismanagement of monetary or fiscal policy on behalf of the U.S. government, but rather foreign trade disruptions. Global events destabilizing the world’s oil supply could kick inflation back into high gear and make the FOMC’s QE and QT campaigns fail. Any supply chain disruption to critical trade routes worldwide could cause the same issues with manufactured goods and technology price increases due to a lack of supply from foreign producers. A recent example is those seen recently on the US East and Gulf coasts due to the short-lived Longshoreman’s union strike.
Non-QM will almost certainly grow and thrive in a lower rate environment where the borrower’s cost of owning a home is lower due to the material reduction in lending rates caused by the Federal Reserve’s recent interest rate cuts.
The TAM, or total addressable market for non-QM lenders, mainly consists of small—or medium-sized business owners in the United States. According to information from the St. Louis Fed, new business applications have exploded since the COVID-19 pandemic in 2020, roughly doubling and remaining elevated ever since.
So long as many Americans continue to go independent and start their own small businesses rather than work for massive multi-national conglomerates, non-QM lenders will have strong product demand, and non-QM RMBS issuance will remain elevated. Home prices are expected to remain stable on average due primarily to the fundamentals (high demand and low supply). Still, we are already observing weakness in metro areas like Austin, Texas, where fundamentals do not support high real estate prices. With housing inventories up over 30% year over year and not enough demand to absorb the supply, Austin has seen home price retracement of about 19% from 2022 highs (~5% decrease in home values in the last year).
Collateral composition is about to become exceedingly important! Consumer financial conditions in the U.S. have deteriorated, with most Americans having burnt through their pandemic savings and personal savings rates hitting close to GFC-era lows.
The issuers whose underwriting and valuation procedures are more accurate/conservative will win the differentiation battle and become known as top-tier issuers. Also, with the 50 basis point September rate cut and more cuts expected in December and into 2025, there is an expectation for borrower prepayment rates to increase. Prepayments can cause considerable pain for investors who, initially expecting the duration of an asset to be 2 or 4 years of attractive coupon payments, are now only going to receive half as many coupon payments due to this increase in prepays. Deals with higher non-owner-occupied collateral concentrations will become more attractive as pre-payment penalties on investment property loans de-incentivize borrowers from prepaying their mortgages.
Macro and volatility risk are always a part of the equation for issuers. Experienced issuers have seen more than one market cycle by now and know that the best way to control these risks as a programmatic issuer (in addition to the traditional rate hedges that are commonplace at any sophisticated MBS issuer) is by using the same principle that retail investors use in their portfolios.
Issuing multiple securitizations throughout the year allows issuers to effectively average dollar costs into capital markets. Most deals are profitable, but when macro volatility strikes, it may knock a deal off course. That securitization’s poor returns can then be averaged out with other more profitable deals to provide investors with attractive returns.
Insurance demand for non-QM RMBS resulted from the convergence of more than one event coinciding.
Interest rates increased rapidly, increasing yields on non-QM RMBS, and conventional mortgage originations decreased significantly.
What do you do when your usual “favorite” asset has no meaningful supply? Find an alternative! For insurance companies, this is the non-QM space. They have been heavily acquiring non-QM assets and show little sign of slowing down. Hedge funds have always paid attention to the non-QM space, but now the hedge funds (and their even more important patrons) are getting involved directly. Indeed, Atlas Merchant Capital, A&D Mortgage and Imperial Fund recently announced a joint venture partnership. The venture, using both internal and third-party capital, will fund the purchase and securitization of non-QM mortgage loans originated by A&D. Other prominent examples include the Ares-Amwest deal and the CPPIB – Redwood Trust deal, which show how hedge and pension funds are also beginning to notice the opportunity in the burgeoning non-agency, non-QM mortgage origination and securitization space.
Victor Kuznetsov is the Managing Director and Co-Founder of Imperial Fund
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