It’s a familiar theme in this era of rock-bottom interest rates: Investors want products that deliver yield, and companies are rolling out newfangled ways to meet that demand. One iteration in this quest is fixed-income vehicles backed by mortgages issued by nonbank lenders, a growing trend in the aftermath of the financial crisis.
The mortgage industry went through hell—some of it self-inflicted—during last decade’s housing meltdown. From that wreckage has emerged a stricter lending and regulatory environment where banks play a smaller role in the home-loan market and nonbank lenders are picking up the slack.
It’s somewhat akin to what has happened with loans to consumers and small businesses, where nonbank lenders have stepped into the void left by banks and created the peer-to-peer (P2P) lending industry. That has led to the rise of online P2P platforms that match borrowers and lenders on a wider scale to create a new investment opportunity for these loans that promise returns generally exceeding what’s available in the traditional fixed-income market.
Similar to P2P loan investment platforms, mortgage loan platforms offer fractional shares of loans, enabling investors to create diversified portfolios of mortgage loans with sizable yields. One new company on the scene is Income& Technologies Inc., which last month launched a platform where accredited investors—either individually or through their financial advisor—can buy fractional shares in mortgages purchased by the company. These shares are called “primos” (prime-rated individual mortgage-backed obligations), and are based on non-conforming loans that don’t meet the underwriting guidelines for prime mortgages set by government-sponsored mortgage finance agencies Fannie Mae and Freddie Mac.
“The mortgages we’re going after just narrowly miss the definition that the agencies have,” says Brad Walker, CEO of Income&, a two-year-old San Francisco-based fintech company. “In our minds, it doesn’t represent a degradation of credit quality; it’s just a tiny bit outside of the box that the agencies will buy.”
Primos are rated “A,” “AA” or “AAA,” with AAA the highest quality. Investors can buy a portfolio of all primos on offer or can adjust the risk profile by customizing a portfolio based on credit scores or higher borrower down payments. As they make customized changes, the number of loans in the portfolio and the expected return in the portfolio change. Each primo is backed by a single prime-rated residential mortgage and comes in $100 increments, and investors can purchase as little as one fractional share or can buy a diversified portfolio of loans, and can opt to receive monthly income payments or auto-reinvest in the primos. The platform doesn’t have an investment minimum.
Some of the bigger non-bank lenders in this space include Impac Mortgage Corp., Caliber Home Loans and Bayview Loan Servicing.
Through an outside limited liability company (for which Income& is the managing member), along with the backing from private investors, the company buys the mortgages originated by non-bank lenders. Through a private placement, it sells a borrower-dependent note, or primo, tied to a particular individual mortgage.
Borrowers pay rates between 5.25% and the high 6% area, and Walker says investors can expect to make about 6% on their investment. He adds that the company makes money by selling primos at a premium to par, much like bonds, though the price can vary depending on market conditions.
Income&’s criteria for buying mortgages include a minimum FICO score of 680, a maximum loan-to-value (LTV) ratio of 80 and a 43% debt-to-income ratio.
Walker references a study that found that since 1998 the default rate on fixed, prime-rated mortgages has typically been between 10 and 40 basis points in a normal year. He says it topped out at just over 1% at the height of the financial crisis. “In the worst case, you’d be looking at a default rate of about 1%” during another black swan-type market, Walker posits.
He says Income& has high hopes for the registered investment advisor channel and has included an RIA dashboard to help advisors monitor a client’s portfolio of primos. “It helps from a volume standpoint and for more efficient distribution, and it puts somebody who’s more sophisticated in between us and the clients.”
Primos are meant to be an alternative fixed-income option to bonds, but they’re tied to the life of the mortgage and aren’t particularly liquid. “We’re looking to continually improve that liquidity option, but early on that’s difficult,” Walker says, adding that for clients in need of liquidity, Income& will provide that on a “best efforts basis” from the LLC on a quarterly basis.