14 November 2019

The Western Asset Approach to Non-Qualified Mortgages

By Sean Johnson

Under the current Dodd-Frank legislation, mortgages in the US are deemed qualified or non-qualified. A qualified mortgage (QM) is one where the lender qualifies a borrower using a prescribed and narrow set of underwriting rules to establish the borrower’s ability to repay (ATR). When a loan is deemed QM, the lender is then protected (has a “safe harbor”) from a borrower’s ATR claims.

If a borrower is unable to meet the standards of this prescribed, but narrow, approach to credit worthiness, the loan is deemed non-qualified (non-QM). For example, (A) loans with debt service amounts above 43% of a borrower’s income, (B) loans where a borrower’s income is established through alternate income documentation or (C) loans with interest-only, 40-year maturity or balloon features would all be considered non-QMs.

Importantly, a non-QM designation does not necessarily mean a lower quality mortgage such as a sub-prime mortgage as we explain below.

The non-QM market is varied in the types of income qualification required of borrowers. These include loans underwritten based on profit and loss reports, bank statements, rental income and other non-traditional sources of income. Loan programs often focus on certain sectors of the market such as the self-employed, those with a prior credit event or multiple income sources, real-estate investors, etc. Some aggregators own an originator while others buy from several banks and independent originators.

Western Asset has been active in the non-QM market for a number of years and in the past two years alone we have securitized $3.5 billion of loans. We continue to be active in the market, as we add select new originators and purchase more loans with the intent to securitize them. Our approach is slightly different than others in the market as we target higher quality borrowers.

We prefer lower risk loans, via higher borrower credit scores, lower loan to value and solid underwriting practices from the banks and originators with whom we have established relationships. We compete on price, not credit, so our borrowers have above average credit profiles and below average non-QM interest rates. Our selective approach lowers our prepayment exposure and reduces default risk, which we have seen in the collateral performance of the non-QMs in which Western Asset has invested. We primarily purchase non-QMs from a small set of banks and originators and prefer to buy loans with the servicing retained by the originator, aligning the servicer’s interest in loan performance with our own. What’s more, our use of securitization is with a financing focus, as we retain credit exposure to the loans via securities that we believe offer attractive long-term value.

There are more than $27 billion of securities outstanding backed by non-QMs in the market today. We anticipate at least that much being produced next year alone and growth in non-QMs to continue.

While the market has been growing organically, as originators build the skill set required to underwrite these loans, we see a structural change that will increase the opportunity set in the near future. Fannie Mae- and Freddie Mac-backed loans are exempt from the 43% DTI non-QM rule until January 2021. When this exemption expires, a portion of the non-QM market in agency pools will be captured by private issuers and investors in the market. As a result, we remain active in the non-QM market focused on the higher quality segment that provides compelling investment opportunities.