Non-bank lenders in the US are spying opportunities after regulators issued the Basel III endgame proposals in late July as banks face more burdensome capital requirements. One of these lenders is Redwood Trust, a real estate investment trust company, active buyer of residential mortgages — and regular issuer of securitizations.
Redwood's chief investment officer Fred Matera spoke to GlobalCapital about these opportunities, why investors should get involved in home equity investment securitization, and the broader RMBS market ahead of the IMN and FINN's upcoming ABS East conference in Miami.
The company has issued four prime jumbo RMBS from its Sequoia shelf this year, including raising $350m on Tuesday in its latest transaction, as it accelerates the pace at which it acquires jumbo mortgages from banks.
GlobalCapital (GC): How do you feel this year has gone so far in the overall RMBS market?
Fred Matera, chief investment officer, Redwood Trust: This year the non-agency market has done a lot better than the agency market, which has really sold off dramatically. Even where supply has been pretty limited, there are just fewer buyers of agency mortgages than there have been historically, and now we're at very cheap valuations in the agency market.
But there's a reason for that, because the official channel for buying no longer exists.
In the non-agency sector, it's been different. Issuance fell off a lot during 2022, and even during the first part of 2023, but we’re seeing a pick-up in issuance now. And I think, because of the scarcity of non-agency products — particularly in jumbo — and because the credit is very strong, there’s a lot of pent-up demand.
What opportunities does the Basel III endgame proposal bring to Redwood? Are you buying more jumbo mortgages from banks?
Banks used to hold long duration mortgages on their balance sheet with minimal or no hedges. Now we know banks are no longer allowed to do that as risk weighted capital requirement goes up.
Banks are looking to offload those mortgages, although they still want to originate them because it’s one of their core products. But they don't want to hold them like they were doing during the quantitative easing era. We’ll see banks originate them and then sell them, and that's where Redwood Trust has come in. It's a big opportunity for us, and we're seeing it play out.
We have the oldest securitization franchise for this asset class, and — I would argue — the best securitization franchise in terms of how our securities are received by the market, so that's a significant intangible asset for us.
We are in the position to help solve this problem for banks. During the quantitative easing period, when banks were generally portfolio-ing the loans they originated, we had more than 170 active loan sellers that were primarily independent mortgage banks. Now we're also focusing on commercial banks' depositories, so the number of people who are selling us loans is growing significantly.
[Therefore], even though even though industry volumes are dropping and will probably continue to drop with the jumbo rate approaching 8%, we're offsetting that kind of in terms of how we're attacking the market.
But jumbo, I think, is a bigger thing, because it has all the duration risk [and] they have higher risk weightings, so a lot of banks are looking to take them off their balance sheet. Some banks might have a big securitization franchise on their own, but most banks don't, so that's where Redwood comes in.
What about your business purpose lending segment? Is it going to benefit from the new capital requirement rule as well?
We are seeing this same dynamic play out in our business purpose lending segment too, which is where we originate loans for developers or new sponsors who are rehabbing existing properties, or who are seeking term financing on single family rentals.
Unlike jumbo mortgages, which is a core product for the banks, these are more commercially oriented loans, and banks have generally stopped offering this product. As a direct originator, when banks step back, these investors turn and come to us. We're seeing larger loans from larger sponsors, more institutional clients than we did a year ago, so it's really a cool dynamic that's taking place across both of our businesses.
Can you tell me a bit more about your securitization outlook for the fourth quarter and for 2024?
I think our plan is to get back to being a consistent securitizer of mortgages, and that's going to be a growing part of our business. While we can’t give a number, I think we're pretty optimistic.
In September Redwood launched its in-house home equity investment (HEI) origination platform. What is the strategy there and why now?
I personally have been a big believer in this idea, even when I joined the Redwood board back in 2018. Now our estimate is that there is approximately $28tr of untapped home equity, which is a huge asset class that is owned generally by individuals. It's been an asset class that exhibits lower correlation to corporates, but it can be a very additive asset class to a diversified macro portfolio.
Here’s the investment thesis in terms of why an institution would want to get access HEI: With the interest rates going up, it’s hard for homeowners to take on additional home equity debt, and the monthly payments that come with that. Back when interest rates were low, HEI was competing with low second mortgages or cash out refinance. Now, it's upside prohibitive for people to borrow at these rates.
With HEI, you can sell off part of the upside in your home value without an interest rate payment, effectively bringing in equity partners and taking cash which doesn't impact your debt burden. The case for this product gets stronger as rates go up, so it's a form of diversification for us to say when rates go up, maybe overall mortgage volumes go down, but the demand for HEI will be high.
We have relationships with institutional investors, we have financing partners, and we have expertise on securitization, we have good muscle memory in terms of dealing with rating agencies and working on new products, so I think we're in a good spot to be an early mover.
What do you see as the biggest challenges for HEI?
When it was first started, people thought it was an interesting idea, but people underestimated the difficulty of creating a new market that literally never existed. Now the demand is up, but I think there is a lot of work to be done by the industry on the regulatory aspect to make sure it is understood as a useful option for consumers. You want the consumer to understand what they’re getting into, and frankly also the pricing can’t be predatory.
In addition, I think there hasn’t yet been a standardization of this product. That’s where we at Redwood believe we can come in to try to standardize the terms and make this product more programmatic. We want to make the disclosures as similar as possible to what regulators require for mortgages, and I think that's very important that it is consumer-friendly for it to be sustainable. We don't want to be opportunistic; we're trying to build a real business.
HEI relies on the growth of home equity. What’s your thoughts on the housing market?
It's like a seesaw. On one hand, it is higher interest rates that make the consumer want HEI, but it might make investors more cautious because of the impact on home prices or the duration.
We were more optimistic on home prices a year ago than a lot of people, and home prices actually outperformed even our expectations. So now the question is what’s going forward? I think that rates have gone up a lot more in the past year and that is going to really slow the number of transactions that you see in the housing market. I don't see conditions that would lead to forced selling in the housing market. I think there are places where home prices will struggle but it's not going to be any big gap.
What does Redwood think of the securitization market as an option for HEI?
It's such an important option. We already have credibility in the securitization markets so it's kind of natural for us. We're very happy to see these new developments, and we're very involved in them too. We're very involved with rating agencies, on these structures, and we're involved with investors.
Final question, what other big macro trends should we watch out for in the coming year?
There are two fund flows that could be interesting. One is the foreign flows into US investment. Foreign central banks have bought more mortgages, and they could be an important player in the US agency mortgage space. The second is the fund flows out of equities into bonds. If equities were to take a hit, then bonds, funds, mutual funds will get a lot of inflows potentially from retail — and that could help mortgages. Both are trends that can help with mortgages next year.