We think these assets have grown more compelling. In our view, residential mortgages represent an opportunity that we believe has years to run. We see two attractive investment avenues for insurers.
Buying in Bulk: Banks are sitting on thick books of loans originated at yesterday’s low rates. This inhibits their ability to make new loans at today’s higher rates and dulls their desire to hang on to the existing ones. Managers with strong underwriting capabilities can acquire pools of performing loans at a discount and repackage them into portfolios that meet specific insurer requirements. This might mean excluding mortgages with loan-to-value ratios above, and FICO scores below, certain thresholds.
Forward-Flow Arrangements: An asset manager can agree to purchase a predetermined amount of newly originated mortgages from a bank or a private lender for a certain time. In exchange for this forward-flow commitment, investors get a steady pipeline of loans at today’s high rates.
What Mortgages Offer—Including Yield and Capital Efficiency
The advantages, in our view, are many: diversified exposure, predictable cash flow and coupons that range from below 3% to 8% or more, depending on loan type and credit quality. Insurers can also use residential mortgages as collateral for securing low-cost loans from the Federal Home Loan Banks (FHLB) system on favorable terms.
Durations that can help to offset insurance liabilities and low regulatory-capital charges also make these assets a highly capital-efficient investment. While it’s possible that rates will decline in 2024 if inflation ebbs and the Fed begins easing policy, we don’t expect rates to return to their pandemic-era lows.
We anticipate newly issued mortgage loans to continue generating attractive income while diversifying commercial real estate and corporate credit holdings. Meanwhile, discounted loans issued before the Fed began tightening policy last year should perform well if rates fall, helping to offset underperformance of loans purchased closer to par. Active portfolio management can help manage duration in changing market conditions.
Overcoming Operational Challenges
A strategy is only as good as its implementation. For insurers, finding a partner to execute and manage residential mortgage investments and the accompanying reporting requirements is critical. Here are some attributes to look for:
Operational Efficiency: Putting whole loan strategies into practice and tackling the legal reporting they entail have been a challenge for insurers, who would typically need to buy hundreds or even thousands of residential mortgage loans. Tracking that effectively can be daunting. A manager can make the process straightforward and seamless. Insurers should look for managers with experience in setting up the legal structures to house these assets, and cutting-edge cloud-based performance reporting and data-management services.
Sourcing and Loan Expertise: Deep and diversified sourcing networks should stretch beyond banks and boutique lenders. The list of potential sources is long and can include dealers, other asset managers and family offices that want to monetize their portfolios. Also important: robust modeling capabilities across loan types, including prime, jumbo, subprime and non-qualified-mortgage loans for borrowers who don’t meet traditional lending requirements.
Impeccable Underwriting: Private strategies that rely on private sourcing require top-notch underwriting capabilities. Buying whole mortgages in pools can involve hundreds of individual loans. Managers must have both the capability to underwrite each loan and a reliable network of servicers to collect and distribute the cash flows.
Command of Regulatory and FHLB Requirements: Insurers have choices when it comes to structuring whole loan investments. That makes it important to work with a manager who understands the various regulatory and FHLB requirements and can walk insurers through the pros and cons of each option.
Now that rates are likely to stay higher for longer, we expect more insurance companies to target the residential loan market. In our view, strategies with sourcing expertise, a strong investment structure and seamless regulatory reporting capabilities have the most potential to succeed.
