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. 

Different Approach

Other companies offer different ways to invest in fractionalized mortgage loans. Two of them, LendingHome and PeerStreet, for example, provide loans to fix-and-flip buyers who purchase a property with the intent of fixing it up and reselling it for a profit. 

LendingHome is a San Francisco-based direct lender that uses its own capital to originate short-duration, first-lien position loans. It started lending in April 2014, and its investor platform initially was open only to institutional investors who bought all of the original flow of loans. In January, it expanded its platform to include accredited individual investors who can buy fractionalized notes. The minimum investment to get on the platform is $50,000, and there’s a $5,000 per-note minimum.

Matt Humphrey, CEO of LendingHome, says the company lends at a gross interest rate of roughly 11%, and investors have seen returns of between 9% and 10%. “We’ll take 10% of the gross coupon, so if it’s 11% our fee will be 1.1%,” he explains.

He adds that investors should expect to remain for the duration of the one-year loans. For now, LendingHome markets its notes directly to individual investors, though it has plans to engage with financial advisors. “The RIA audience will be big for us in the future,” Humphrey says.

PeerStreet doesn’t originate loans but instead works with originators with proven track records that create and fund the loans, and says it employs advanced algorithms and big data analytics to re-underwrite the original underwriting to ensure loan quality. According to the Manhattan Beach, Calif.-based company, the loans generally are secure first-lien mortgages with short-term durations of six to 24 months and LTV ratios below 75%. 

PeerStreet started lending two years ago, and it opened up its investment platform to accredited investors in the U.S. in late October 2015. “We have a variety of investors on our platform from individuals, wealth advisors and family offices to institutions and funds,” says Brett Crosby, co-founder and COO of PeerStreet. 

The investment minimum is just $1,000. “With us, you can put $1,000 in 100 loans and get diversification across loans, lenders and geographies,” Crosby says. “And you can do it across different time frames so it resembles your own personal bond laddering.” 

PeerStreet takes a 1% servicing spread on the note, so if it’s a 10% loan the company will put it out to investors at 9%. Investors should expect to remain invested during the term of a loan.

“Investors can handpick and curate what they want to invest in—we’re kind of like an E*Trade for this asset class,” he adds. “Or you can use automated investing, which is like a Wealthfront or Betterment for this asset class, where you set up the parameters of the loans and we’ll allocate that accordingly when loans become available that match your criteria.”

PeerStreet borrowers on average pay between 6% and 12% for loans, and Crosby says investors on its platform have reaped average yields north of 8%. According to the company’s website, mortgage-backed securities have had higher Sharpe ratios, meaning they compensate investors better than other fixed-income classes for the amount of risk taken. But given that the company’s platform is so new, it remains to be seen how these investments will do during a recession.

“Defaults are predicated on how conservative the underwriting is,” Crosby says. “We’ve talked to some accounting firms to try to get a benchmark for that, and they recommended having a 50-basis-points loss reserve for their clients in this space. But given our conservative underwriting, we expect our losses to be less than that. In this space, the underwriting and how conservative you are really matters.” 

Mac & Mae

Despite the alluring high yields offered by this nascent sector, some investors looking for mortgage-based yield might prefer a wait-and-see approach and instead opt for conventional mortgage-backed securities from Ginnie Mae, Fannie Mae or Freddie Mac or for those issued by private firms. But current average coupons on these products are roughly 3.5% or less. 

Another alternative is collateralized mortgage obligations, which are complicated vehicles dishing out similarly low yields. Or there’s the iShares Mortgage Real Estate Capped ETF (REM), tracking an index composed of U.S. real estate investment trusts that hold U.S. residential and commercial mortgages, and which recently sported a distribution yield exceeding 11%.

Naturally, the principals at Income&, LendingHome and PeerStreet believe they’re offering cutting-edge products that meet a genuine market need. “We’ve almost created a new asset class because you can invest in this space in a way you really couldn’t before,” Crosby says.