Non-QM vs Non-Agency 2.0 – What You Need to Know

For more than a century, homeownership has been the bedrock of the American Dream. And home mortgage finance, in turn, has been contoured by the path of American history. This evolution, frequently in response to and occasionally the cause of major historic events, continues to this day with the re-emergence of the non-agency 2.0 market. This second iteration departs meaningfully from the original non-agency market in a number of important ways; rather than focusing on the lower end of the credit spectrum, the 2.0 market today is increasingly the source of innovation to serve high quality homeowners who might otherwise get left behind due to credit benign circumstances that hinder the efficacy of conventional underwriting practices. While these circumstances can vary, they are united by their strong credit quality, need for funding from outside the agency paradigm, and the growth opportunity they represent for lenders in 2024 and beyond.

But to truly understand where we’re going, we must understand how we got here.

In the Beginning

At the turn of the 20th century, many owner-occupied residential mortgages were semi-commercial in nature—such as a family farm or mixed-use shop-house—and the tax deductibility of mortgage interest today is a relic of that fact. At that time, American mortgage finance in many ways resembled the home loan markets that persist in many other countries today—loans were provided by community banks and typically short, such as a 10-year term, with fluctuating interest payments and the principal due as a lump sum at maturity. This required most borrowers to “roll-over” most of the principal into a new loan at the end of the term.

Lenders Dealt a New Deal

A popped speculative bubble triggered bank runs at the beginning of the great depression, and many mortgage borrowers suddenly found themselves being refused the refinancing they needed as their mortgages approached maturity, leaving most with no option other than to default regardless of their income. Families around the country “lost the farm” and triggered a cascading acceleration in economic deterioration.

This prompted one of the first—but not the last—major government interventions into mortgage markets, in a raft of legislation that (among other things) overhauled practices and regulations in capital markets, banking, and mortgage lending that are collectively considered the “New Deal.” In particular, the federal government sought to encourage mortgage loans where borrowers could make regular payments for 30 years and after the final payment, the mortgage would be fully paid off. These loans protected borrowers from the need to roll-over the debt and the risk of adverse changes in interest rates. At the same time, the government offered programs to buy these loans from banks, to mitigate any reluctance to tie up capital for such a long period. These new loans became increasingly popular with returning servicemen from World War II, who were offered a version of the new “30-year, fixed rate” mortgage through the Veterans Administration.

The Age of the Agency

While the end of World War II popularized the 30-year loan, the onset of the Vietnam War threatened to destroy it. As the costs of that war began to mount, Congressional opposition began to explore including these 30-year loans—which the government acts as guarantor for—as part of the national debt as a ploy to call attention to ballooning government spending.

Partly in response to this perceived threat, the government reorganized the lending program in a fairly novel and idiosyncratic way. Loans made as part of special government programs (such as the popular VA program) continued to be supported by a government-owned corporation known as the Government National Mortgage Association (GNMA, commonly referred to as “Ginnie Mae”). “Conventional” 30-year loans that were not associated with special government programs would be supported by two private corporations specially chartered by the government and afforded certain market advantages—the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). Collectively, these three corporations have come to be referred to as “the agencies” and the lending programs they support known as “agency mortgages.” Since the 1970s, these three corporations and their lending programs have defined and dominated American mortgage lending, with roughly 80% combined market share. Measured in terms of dollars in profit per employee, Fannie Mae and Freddie Mac are the most profitable companies on earth.

A Market Defined by What it is Not

The agencies were never the only game in town, however. Prior to the 2008 financial crisis, mortgage loans sold to the private capital markets rather than the agencies (commonly referred to as “non-agency”) were substantial mortgages made to borrowers who fell below the prime credit standards defined by the agencies (“subprime”). And between 2005 and 2007 there was a speculative boom in this subprime mortgage investing. In 2007 alone, $1.2 *trillion* of these types of loans were created and sold to investors, which was almost 10x the amount of non-agency loans created and sold to investors during the refi boom of 2021. The surging demand for these loans led to pervasive predatory and fraudulent lending practices in the market and directly imperiled the global financial system.

In the wake of the financial crisis that the non-agency 1.0 market caused, Congress passed the Dodd-Frank Act to address the many perceived shortcomings of the financial system up until and during the crisis, and part of this bill created the Consumer Financial Protection Bureau (CFPB) in 2011 that was tasked with creating and enforcing standards on consumer loans, including mortgages. The CFPB went on to develop a set of rules (called Regulation Z) that mandated lenders must make a reasonable determination that potential borrowers have the ability to repay (ATR) their mortgages using reliable third-party documentation of income, assets and employment. The new regulation imposed substantial punitive financial penalties in the event of non-compliance with the ATR requirements, so the CFPB defined a set of lending practices that offered guaranteed compliance if followed to make things less ambiguous for lenders. The loans that adhered to these lending practices were known as Qualified Mortgages (QM), and this “QM rule” went into effect at the beginning of 2014.

The original QM rule had two key parts. First, the rule gave fairly prescriptive instructions on acceptable ways to document a potential borrower’s finances. The second part, known as the “debt-to-income test,” stated that a mortgage with properly documented finances will receive the QM designation if a borrower would spend no more than 43% of their income on financial liabilities, including the new mortgage. The rule had a major problem, however, in that about 15% of agency loans could not pass the DTI test, and the agencies also deviated from the documentation requirements. To mitigate this impact, agency loans were temporarily granted an exemption.

Then in 2021, the QM rule was changed such that the documentation requirements became less rigid and the 43% test was replaced with a price-based test. Now, if a mortgage borrower receives a rate that is no more than 1.5% higher than the agency mortgage rate, it is considered QM. With this change, the exemption for agency loans was retired with little to no impact on compliance.

Everybody Loves a Sequel

With the post-crisis regulatory landscape finally solidifying into place, we feel a new nomenclature is needed to differentiate the non-agency market from its past as well as the broader market. Whereas in the past, loans with alternative documentation may have been broadly grouped together as non-QM, the changes to the QM rule have made this differentiation less accurate. Moreover, the term “non-qualified” belies the fact that these loans typically are of higher credit quality and equally thorough as the standards in the qualified loan market. For this reason, we feel the most accurate designation is also the most simple—non-agency 2.0.

As we move into 2024, we believe making the distinction between loans that are non-QM, non-agency and non-agency 2.0 will help all stakeholders involved in the selling of and investing in this sector better understand the levels of risk involved. These designations are more reflective of the loans’ true characteristics both in terms of their eras of inception and what they truly are – financing instruments that are properly vetted, backed with documentation, and that can be deemed “qualified” by today’s standards.

 

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