2025 will be a year of diversification of non-QM players

In the sixteen years since the height of the global financial crisis, the structured products industry has transformed from a market dominated by big banks to one with room for new players. New relationships are forming between underwriters seeking long-term debt investments and managers specializing in originating, securitizing and selling mortgage-backed securities. This new dynamic has prompted many investors to look to alternative assets for returns, creating a growing interest in non-qualified mortgage securitization.

Non-QM loans are primarily used by entrepreneurs and other self-employed individuals who do not have the necessary documentation to qualify for Freddie and Fannie’s conventional mortgages. Non-QMs are attractive because they have strong credit quality, low loan-to-value ratios and stable production volumes. And next year, we predict even more players will jump into the game.

Historically, life insurers have shied away from investing in residential mortgages. But thanks to the influence of private equity investors, cash-rich insurance companies are increasingly gravitating toward private debt that pays higher premiums because of its illiquidity. These premiums have risen in recent years as traditional banks have scaled back their retail lending activities under pressure from regulators, consolidation and a recent move to wholesale financing fueled by the decline in retail deposits. All of this left a void for insurance companies, which have stepped in to fill that space, collectively becoming “one of the largest private debt investors in the world.” (Foley-Fisher et al, 2020, p.2). While 2022 data shows that only 10% of that private debt was real estate debt in 2022, much of that 10% went to non-QM loans. (IMF Global Financial Stability Report, April 2023, p.73).

Investment companies’ previous reluctance to invest in residential mortgages is partly due to the complexity of the asset class, which entails significant operating costs. However, the growth of non-QM loans has prompted insurance companies to shift allocation to them. A stricter regulatory framework created by Dodd-Frank and other post-GFC era legislation put investors at ease. It stimulated significant growth in entrepreneurial activity in the non-QM space, establishing the sector as a highly attractive asset class for long-term investors.

Non-QM companies’ market share grew from less than 3% of US mortgages in 2020 to 5% in 2024 (Scotsman guide). Non-QM losses due to delinquencies are rare due to the strong borrower profile and strict underwriting standards. Cumulative losses since 2018 total less than 0.02% (BofA Global Research, Loan Performance as of 12/31/23). These assets can be purchased as wholesale loans or securitized debt, with annual non-agency, non-QM RMBS issuance reaching $66 billion last year (Guggenheim Investments – Non-Agency Residential Mortgage-Backed Securities: Finding Value at High Interest Rates). Residential mortgages can be borrowed through FHLB financing, another reason why insurance companies consider them an attractive asset.

But insurance companies aren’t the only players taking note of the potential here, and we could see banks re-enter the non-QM space. The new government has supported deregulation in the past, especially for small and medium-sized regional banks that have undergone consolidation in recent years. During the first term of the new government, a series of laws were passed that relaxed restrictions on risk exposure for regional banks. From this, the designation of a systemically important bank was increased from $50 billion to $250 billion. This change meant that fewer banks were subject to the strictest requirements and that many banks subsequently had access to a wider range of income-generating strategies. A large part of what prevents greater bank participation in the non-QM space is the capital treatment of the underlying products. RWA requirements from regulators determine how much capital a bank must hold based on the credit ratings of the assets on their balance sheets. So looser RWA requirements, like those proposed by Fed Vice Chairman Michael Barr in September, would reduce the capital reserves banks need to invest in non-QM.

What would greater bank participation in non-QM look like? We would likely see banks favor wholesale lending, which currently offers better capital treatment than lower-rated bonds. In addition, investing in loans allows exposure to specific geographic regions, a useful tool for regional banks that are heavily focused on one part of the country. Whole loan allocations are mainly focused on specialist residential mortgage securitizers such as the Imperial Fund, which invests in non-QM loans. This is especially beneficial for regional banks that need lower costs. Many in the insurance industry use separately managed accounts (SMAs), which are low-cost investment vehicles that outsource operating costs to the SMA manager. A manager like Imperial Fund conducts due diligence, acquires the loans and manages them on behalf of its clients.

All these factors suggest that insurance companies and banks are likely to increase their participation in the non-QM space. This expected uptick in investor activity suggests that 2025 will be a strong year for the non-QM market.

Victor Kuznetsov is the founder of Imperial Fund Asset Management.

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