First American Data & Analytics Sponsored Content–Demand for Alternative Products is Growing as Are the Risks

By Paul W. Harris, GM, Mortgage Analytics at First American Data & Analytics

As we near the halfway point of 2024, interest rates remain elevated and observers, including our Chief Economist Mark Fleming, believe they are “more likely to remain ‘higher for longer’ this year.” While 7% interest rates have dampened traditional first-mortgage volume, they have had significantly less impact on alternative loan categories, like non-qualifying mortgage (non-QM), investor loans and home equity. These categories have been gaining traction in the first half of this year and are on pace for dramatic — in some cases more than 2X — growth in 2024.

As a business that has spent more than two decades focused on fraud detection and loan quality, we believe that this trend, while a potential opportunity, still needs to be viewed through the lens of potential risk. Depending on the loan product(s), this risk could take several forms: fraud for property vs. profit, misrepresentation—of income, employment and/or undisclosed debt—and collateral valuation relative to LTV/CLTV. Having said that, it’s worth pointing out that mortgage fraud in general continues to be at historical lows: the result of lower volumes in general and the widespread use of more advanced loan quality tools in origination processes of traditional first mortgage lenders.  

To date, the non-QM and home equity markets have been dominated by specialty and portfolio lenders, respectively. However, as non-QM and alternative loan sectors expand, traditional mortgage banks (including wholesale and correspondent players) are likely to participate, seeking volume to offset lower volumes in conventional lending. Given the differences in the profile of alternative and conventional borrowers, and the prevailing underwriting standards used in non-QM and home equity, this raises the question: will these new entrants be exposing themselves to higher levels of risk?

What’s driving the volume?

Several factors are fueling the growth in alternative products:
Non-QM borrowers tend to be less interest-rate sensitive

Home equity products are allowing cash-strapped homeowners to tap equity without sacrificing historically low first-mortgage rates

A stable interest rate environment is enabling securitizers to price new private-label deals.

As a result, alternative products are poised to have a record year this year. For example, in 2023, total non-QM originations accounted for $32 billion in volume. One leading non-QM lender is predicting that the market will double in size this year, growing to $72 billion with an average coupon rate of 7.5%.  Ratings agency KBRA’s latest forecast for private label issuance, which is fueled by non-agency and non-QM loans, also expects this sector to double this year.  Similarly, several large national IMBs have begun aggressively originating closed-end seconds (CES), and a number of them have already seen several rated deals come to market.

Not of all of the news is positive. There are some early warning signs that more deals may mean more risk as non-QM originators work with a less-credit worthy pool of borrowers and compete by expanding guidelines. In January, for example, Fitch reported that delinquencies on its rated-non-QM deals in 2023 were higher than for its 2022 vintage, “reflecting weaker collateral attributes such as lower FICO scores, higher combined loan-to-value ratios, fewer full-documentation-type loans, higher mortgage rates and higher debt-to-income ratios.”

As non-QM and alternative products become more popular, many conventional lenders may start to offer products that they have previously shunned, either because they were considered too risky or too difficult to originate. No one is suggesting that traditional lenders would make this move without fully vetting the risks and assessing their capabilities. But these products, nonetheless, will expose mainstream lenders to a different set of borrowers and, in order to be competitive, different lending rules of the road.

Non-QM and fix-and-flip lending cater to a different customer demographic, such as self-employed, single-family investors, credit-impaired, etc. Often these loans are underwritten with very limited documentation, perhaps just a few months of bank statements. Non-QM lenders often permit higher debt-to-income ratios and increasingly expand the credit box.

Debt Service Coverage Ratio (DSCR) loans, which are a significant portion of the non-QM universe, are almost exclusively decisioned based on the property’s cash flow. Similarly, fix-and-flip loans focus heavily on “as repaired values” (ARVs) and require the ability to assess the investor’s track record in completing projects on time and on budget.

$1.8 trillion home equity market?

In addition to core non-QM products, the market for home equity loans and lines of credit has significantly expanded in 2024. Earlier this year, a handful of large non-banks began offering and either selling or securitizing CES, and a record number of securities backed by HELOCs have come to market in Q1.

In April, Freddie Mac asked its regulator for permission to begin buying CES, a move that, if approved, would open up the market to a broader universe of non-bank originators. A new report by Bank of America notes that if both Fannie Mae and Freddie Mac were allowed to buy CES, the overall market for home equity could triple in size to more than $1.8 trillion.

While CES and HELOCs are generally considered less risky loans, they also tend to be lower-margin products that originate at either no cost or at a very low cost to the borrower. These cost constraints and the need to make fast, hassle-free decisions could result in the selection of less accurate settlement services products, as well as missed steps and cut corners. Also, unlike first mortgages, equity products are less standardized in terms of documents and origination processes.

Fraud and data solutions for alternative lending

As with any loan products, alternative products can also face the risk of fraud. Some types of loans may have different kinds of fraud and misrepresentation that could affect lenders, including fake bank statements, relatives pretending to be tenants, hidden debt, etc. There are also cases of reverse occupancy fraud where borrowers are approved as investors with tenants and then after closing, they occupy the property themselves.

The good news is that sophisticated fraud tools and advanced data solutions can give lenders a more complete picture of the borrower beyond just credit and borrower-provided verification of income (VOI) and verification of assets (VOA) documents, as well as reducing collateral risk.

For example, our FraudGuard® solution can instantly show whether a borrower has undisclosed debt, unreported real estate owned, past foreclosures or short sales, is on an industry watch list, behind on taxes, or is subject to involuntary liens.

Streamlined versions of these tools are also available for home equity lending and can be calibrated to the lender’s risk criteria and can include advanced AVMs to reduce valuation risk. Lenders moving into the fix-and-flip sector might want to access building permit databases to identify issues or mistakes that could delay a project and burn through capital. To protect against reverse occupancy fraud, there are now new automated solutions that can provide post-closing occupancy analysis to improve quality and help servicers identify fraud.

Alternative lending appears to be a bright spot in the current “higher-for-longer” interest rate environment, but this different set of borrowers and lending rules of the road can also present potential risks for mainstream lenders. Relying on proven fraud tools and advanced datasets can reduce both the risk and the learning curve associated with alternative lending.

(Sponsored content includes material submitted independently of the Mortgage Bankers Association and MBA NewsLink and does not connote an MBA endorsement of a specific company, product or service. For more information about sponsored content opportunities, contact Bill Farmakis at bill@jlfarmakis.com or 203/834-8832.)