Editor’s note: This feature originally appeared in the August issue [1] of MReport, out now.
Non-Qualified Mortgages (non-QM) are still a small part of the overall mortgage origination market. They represented only about 4% of the total originations market in 2018, according to CoreLogic, yet, in the current lending environment, this segment has seen much more traction, expanding a full percentage point between 2017 and 2018. And their popularity continues to grow.
A recent Standard & Poor’s (S&P) report indicated that the segment has gained significantly from the time that non-QM was introduced in the market. In fact, it was the fastest growing market in non-agency residential mortgagebacked securities in September 2018 and was on track to double or even triple in size this year.
“We’re seeing a lot more non-QM products and similar types of loans coming to the market,” Jeff Taylor, Founder and Managing Director of Digital Risk, told MReport earlier in 2019. “People are looking to expand their credit box and see what types of different loans they can put in the marketplace and what the appetite might be from the investor base.” He added that, “the higher the interest rate, the higher the payment, the more risk tolerance people will be willing to take
from a non-QM type loan, and the expansion of these mortgage products into different areas.” However, the path hasn’t been an easy one for non-QM products, which are often compared to the subprime loans of the 2000s.
The Origins of Non-QM
Non-QM loans were first introduced as B&C lending in the late 1990s. “The way it was taught to me, you had your A Lenders like Fannie and Freddie, and mortgage rates were at around 6-7%,” said Robert Senko, President of ACC Mortgage, while explaining the foundations of non-QM loans during a webinar. “This was a boom time in the industry. There was a refi wave and if you couldn’t get a loan through one of the Fannie Mae lenders, there were a number of institutions such as Ford Financial, Option One, GE Capital, and Advana who were willing to step in.”
Eventually, B&C lending gave way to newer terms for the same product, such as subprime or nonprime lending, which were at the core of equity-based products.
“These were products where people were putting down 20-30% to buy or refinance a home. They had equity and they were using that money to put down and that’s how you judged it,” Senko said. “Looking at the big picture, these were the wild wild west days. Things were different and money was flying all around.”
Soon these products evolved and borrowers were presented with state income loans where they had to have a five-year selfemployment, stellar credit, an 80% max LTV, and had to get letters from CPAs and extensive other documentation in order to qualify for a mortgage.
In 1998-99, however, a Wall Street crisis related to long-term capital management saw a number of banks and mortgage companies closing down. As a result, lenders pulled back and there wasn’t much innovation. However, when things started looking up again in 1999-2000 with new lenders such as Lehmann Brothers coming into the market, This was the time when lenders were also offering loan products with 100% stated income, as well as Alt-A loans for people with excellent credit scores and light documentation to prove income.
As competition for these products increased, lenders began offering them to people with lower credit scores. By the early 2000s, these had transformed into the subprime loan products that are still often confused with being non-QM, according to Rick Allen, VP, Business Transformation at Optimal Blue.
“The origins of non-QM started with what the industry called subprime loans or Alt-A loans in the 2000s, but the reality is that they are very different. By definition, non-QM did not form until we had QM, which was in 2014, as part of the regulations implemented through the Dodd-Frank Act,” Allen said. “Back in 2004 and 2005, the subprime market reached about 40% of the total market.” That all changed with the market crash. “The market really dried up until folks started to realize that non-QM could come with reasonable risk and higher profits.”
Like most mortgage programs, once the need was identified, the mortgage market began developing loan programs to serve that need.
“That’s what has happened with the non-QM loans,” said Fobby Naghmi, SVP and Eastern Division Manager for Planet Home Lending. “More and more real estate and mortgage professionals began to see non-QM, not as a fallback for customers who wouldn’t otherwise qualify, but a product for creditworthy customers who have been excluded from the mortgage market by Dodd-Frank.”
The biggest development that has helped non-QM loans to evolve, according to Tom Hutchens, EVP, Angel Oak Solutions, has been the ability to securitize these loans.
Giving insights into what it was like before securitizations, Hutchens said, “At least the first two years that we were originating them, they were balance sheet loans. There was no permanent capital. And because of that, frankly, the interest rates had to be higher because people were having to carry them on their books.”
With securitizations, Hutchens said that pricing has improved because of the influx of investors. “We’ve seen more products because of that, and because of the performance of the loans, the number of products have also expanded.”
Yet, the growth of these loan products has been slow this time around.
Non-QM Is Not Subprime
Addressing a misconception that has plagued non-QM since the time these loans were first introduced, Aaron Samples, CEO of First Guaranty Mortgage, said, “Simply put, the term ‘subprime loan’ still resonates from the financial crises. Not only for people that were negatively affected in the downturn but also their kids who are now millennials and watched their parents or others struggle.”
Borrowers frequently—and erroneously—equate non-QM loans with the pre-crisis subprime loans that were of lower credit quality, and which are cited as one of the causes behind the 2008 financial crisis.
“There is an argument to be made that virtually everybody could purchase a home with the pre-crisis loan products. However, non-QM affords financing options only for credit-qualified borrowers,” said Denis Kelly, SVP, Correspondent/National Wholesale for Sprout Mortgage. “The risk is mitigated in non-QM through a variety of measures, including demonstrating the ability-to-repay, increased down payment require ments, appraisals, and collateral valuations through independent third parties, and more sophisticated and better fraud controls, to name a few.” “For a decade, private securitization has been a non-factor, and most people understand mortgage lending as a loan that only fits into agency guidelines as defined by automated underwriting,” Samples added. Further diving into the difference between QM and non-QM loans, Allen said, “The Non-QM group is, by definition, anything that is not QM as defined under the Dodd-Frank regulations.” However, this doesn’t necessarily equate to higher levels of risk. “It just means it’s outside of the definition of QM.”
Additionally, there’s more “skin in the game,” for non-QM products now, according to Hutchens.
“Pre-crisis, almost every loan originated was through 100% financing, where the borrowers made zero down payments. Today, our average loan-to-value is around 77%,” he said. As such, these borrowers are making larger down payments. “That has a big factor on performance,” Hutchens added. The fact that many loan officers are still unable to make this distinction between subprime and non-QM loans is another cause of concern for most lenders. According to Michael Brenning, Chief Production Officer for Deephaven Mortgage, loan officers have displayed “some concern and lack of understanding on these products.” Additionally, Naghmi said that much of the resistance to the acceptance of non-QM lending early on was based on the fact that many didn’t understand that non-QM programs have their own guidelines. “It’s important that loan officers and lenders understand those guidelines versus viewing the products as products of last resort,” he said.
Education is, therefore, an important aspect of clearing up these misunderstandings both for loan officers and consumers.
Train, Train, Train
Education is the key to the expansion of this product and the expansion of homeownership,” Samples . “Consumers need to understand that there are other options based on sound lending practices and credit decisioning which still ensure that TRID and ATR requirements are followed.”
Kelly observed that while lenders today have many methods to educate borrowers about these products, they are primarily focused on “training the trainers”—in other words, training the loan originators. Kelly told MReport that Sprout Mortgage has to date trained more than 10,000 mortgage loan officers on non-QM products.
“Since non-QM loans have different guidelines from one investor to another, all mortgage professionals have to be trained accordingly,” Naghmi explained. “Offering non-QM programs without proper training can be disastrous for the mortgage lender for a variety of reasons, the biggest being a loan that cannot be sold to a secondary market investor after it is closed.”
To ensure that loan officers thoroughly understand the underwriting guidelines for the non-QM products, Naghmi said that Planet Home Lending has appointed a national non-QM sales director “for the sole purpose of training our mortgage loan originators and branch managers as well as doing presentations for real estate professionals.”
Apart from loan officers, lenders are also looking at educating borrowers, many of whom still believe that non-QM products are the return of the no-income, noasset (NINA) documentation loans of the 2000s that eventually led to the housing crisis a decade ago.
“The biggest challenges lenders face today are around the stigma of the product being misunderstood as a sub-prime product,” Samples said, adding that many loan officers have mostly processed agency loans over the past decade and are largely uneducated on non-QM loans themselves. As a result, they often shy away from educating customers about these products.
However, according to Deephaven’s Brenning, borrowers don’t think the way mortgage professionals do.
“They don’t think FNMA, FHA, non-QM. They think in terms of, ‘I want to buy a home, cash out, and consolidate debt.’ I don’t feel that consumers have any real misunderstandings about these types of loans. Sure, they may have a few hesitations on an ARM loan or the slightly higher rates, but, in general, consumers don’t really think about mortgage programs the way we do.”
Hutchens agreed, suggesting that borrowers don’t really know what non-QM means, or what they need to know about the topic. “They just need to know that there are loans that are outside of agency guidelines that are available,” Hutchens noted. “We’ve been on an education mission since we began. We just educate people, primarily originators, but also realtors and everyone in the real estate space about non-QM loans. We just want to make people aware that these loans are available and they perform well.”
Technology to the Rescue
Another challenge that most loan officers face with non-QM products is the underwriting process. So far, because of the nature and the documentation needed for non-QM loans, the underwriting process has largely been manual.
“Today’s non-QM loan is more transactional in nature,” Samples explained. “There is no automated system to run these loans through. They take more hand holding, so if loan officers can do a conventional loan with little friction versus an alternate product, they will. Unfortunately, that conventional loan is likely a third of the ALB and margin of a non-QM solution.” As such, many borrowers “never find a solution and are left out.”
That is changing as technology impacts the non-QM space. Samples says that his organization is focusing on these products through a proprietary technology that can create a lowfriction, low-stress lending process for non-QM borrowers.
Additionally, as a technology services provider, Allen views non-QM as a growth market. “There is increased activity in the market with new entrants and expanded programs from lenders that are already in the market,” he said. “Lenders are looking for ways to do all loans more efficiently, including non-QM, which means it’s important for technology vendors like Optimal Blue to improve the related technology and how non-QM loans are handled.”
Opportunities Abound
Today, these products are helping lenders reach a wider set of borrowers, many of who may be creditworthy and well-qualified but are still not eligible for traditional mortgage products.
In fact, “non-QM loans fulfill more borrower scenarios than most people realize,” Raymond Eshaghian, President and Founder of Greenbox Loans, Inc. recently wrote in a piece for the MReport. com. These borrowers could include self-employed borrowers, those with Individual Tax Identification Numbers (ITIN) who don’t have a Social Security number, foreign nationals, and real estate investors, according to Eshagian.
“The bottom line is that there are millions of deserving borrowers out there who need someone to help them overcome their homeownership barriers,” he wrote.
Samples agreed. “Products have evolved to fit consumer needs, growing numbers of self-employed borrowers, and changing lifestyles. Additionally, broader secondary market opportunities including private securitization have made this product more accessible,” he said.
The advance of non-QM loans has led to a wider set of borrowers and translated into increasing demand from selfemployed borrowers and others who might not have the qualifying characteristics required under the QM rules, according to Allen.
Thus, there’s ample opportunity for growth in this space. “We believe, looking at just historical data from the late ‘90s and right around 2000 when non-agency was kind of the right guidelines and the right percent, it was about 10-12% of the business,” Hutchens said. “If you look at today’s originations and say 10% of the business is non-QM, we’re looking at $200 to $300 billion a year in originations. And last year, this number was less than $20 billion.”
“As the market has evolved, and rates have come down in non-QM, just-miss prime types of programs have become more prevalent and account for more volume in today’s market,” Brenning said. “Additionally, bank statement loans have become the most popular non-QM product segment catering to the self-employed.”
And these aren’t the only borrowers that today’s non-QM products cater to. Naghmi listed some examples where non-QM is making it possible for homebuyers to achieve their American Dream:
- Non-warrantable condominium loans for condominiums that don’t meet the agency requirements for owneroccupied units to nonowneroccupied units in that
condominium project.
- Foreign national loan programs for consumers that don’t have legal status in the United States but wish to purchase a second home or even an investment property in the United States.
- No-ratio investor loans, utilizing the rental income only to qualify for the purchase of an investment property.
The consumer creditworthiness for non-QM is apparent in Morningstar’s delinquency ratings for various mortgage products, which indicated that, in early 2019, the 60-day delinquency for non-QM loans was around 4%, which is in line with the conventional loan 60-day delinquencies.
“Compared against the FHA loan program which has a 60-day delinquency closer to around 9%, the non-QM loan looks even more attractive to secondary market investors,” Naghmi pointed out. “Some in the industry see the non-QM market increasing as much as 400% in annual production in the foreseeable future.”
Responsible lending will be the bottom line for lenders looking for long-term gains from non-QM products too.
“Provided that the lenders and the products that they offer continue to practice follow responsible lending principles, non-QM loans are expected to perform well in both the near-and long-term,” Kelly said.