As Non-QM structures change, opportunities grow for AAA investors.

Non-qualified mortgages (Non-QM) are mortgages that fall outside traditional conforming agency mortgage guidelines. Examples of variations include lower FICO borrowers, interest-only periods and limited documentation. To balance these risks, originators typically require the borrower to pay a higher mortgage rate and have significant “skin in the game.” LTVs (loan vs. appraised home value) are usually in the 60-70% range.

Non-QM securitizations had their biggest supply year on record in 2021 with over $30 billion of issuance. The figure for 2022 may be slightly lower due to rising mortgage rates. Total outstanding issuance in the Non-QM universe is $41.5 billion.

One interesting dynamic that makes Non-QM unique in the mortgage sector is the varying callability of deals. Optional calls, which are up to the underlying manager’s discretion, can be executed after two years, three years or when the deal hits the 30% remaining pool balance. Issuers typically exercise these call options to increase returns by re-levering their residual position. Deals typically price to the call and issuers have been consistently calling deals at or near the call date. In our view, these calls should continue through 2022 as most callable deals will be from before the pandemic with a higher cost of funding versus where deals can get done currently. Post-pandemic deals that hit their call dates in 2023 – 24 may delay calls and see some extension as their cost of funding is already very low.

Structurally, AAA bonds historically shared pro-rata cashflows with the AA and single-A bonds below them. Recent issuer concern over completing deals given heavy supply has resulted in AAA investor-friendly changes. Recent new issues are making the AAA sequential, receiving all the cash flow prior to the subs. Other deals are employing a 100bps step-up in coupon at the call date to incentivize the call.

In the second half of 2021, spreads in Non-QM moved wider. AAA bond spreads to the call moved from swaps-plus-65 out to swaps-plus-100 due to heavy supply and the potential for slowing prepayments. This brought about some of the structural changes. We think that recent spread movements in Non-QM, along with the investor-friendly changes to the structure for AAA buyers, present an opportunity.

In comparison, qualified mortgages are rarely securitized in the non-agency universe. Due to the strict QM guidelines, lenders typically sell these into the GSEs. A good comparison for Non-QM might be the re-performing loan securitization universe. The AAA portion of these transactions with a similar tenor trade 20-30bps through Non-QM.