Why are non-QM lenders getting into trouble?

The collapse of two important non-QM lenders within a week of each other has raised concerns about the financial stability of firms specializing in non-prime loans, sparking fears that more closures could follow.

Texas-based First Guaranty Mortgage filed for bankruptcy on June 30 and fired 80% of its employees following losses amounting to more than $473 million, mostly owed to banks that funded the lender.

According to a Reuters report, First Guaranty Mortgage admitted it had incurred “significant operating losses and cash flow challenges due to worsening conditions in the mortgage market”, including "a dramatic collapse” of the mortgage refinance and purchase markets.

This followed the Federal Reserve’s decision to hike interest rates by three-quarters of a percentage point in June, the largest increase in almost 30 years.

Less than a week later, on July 6, Sprout Mortgage closed without warning after unceremoniously firing its 600-strong workforce in a web conference call.

Read more: Sprout Mortgage abruptly closes, lays off some 600 workers

The latest non-QM casualty is Kiavi, which last week reduced its workforce by 7%, reportedly affecting its compliance, legal, finance, business operations and marketing teams.

One of the most striking aspects so far has been the apparent lack of transparency by both Sprout and First Guaranty as staff seemed totally unaware of their employers’ true predicament, even though the former had conducted two previous rounds of job cuts.

In response, former employees at First Guaranty, angry at the way they were dismissed, have now filed a class action lawsuit against the company.

In Sprout’s case, just days earlier it had declined to provide figures on its non-QM volume for 2022 when requested to by Mortgage Professional America (MPA).

The cases have raised concerns that non-QM lenders are particularly at risk in the current economic climate, as rapid mortgage rate increases and spiraling inflation have not only made borrowing more expensive but heightened fears that the market has become more unpredictable and less stable, not least because of the escalating war in Ukraine.

Despite this, non-QM lenders have been at pains to point out that the non-prime market is safe and highly regulated, and that their loans have nothing to do with the subprime products that caused the 2008 financial crash.

That’s because, unlike subprime, non-QM has lower LTV, a much higher FICO credit score and borrowers have to prove their ability to repay (ATR) through bank statements and tax returns.

That said, non-QM loans by their very nature are often more complex and require far more manual underwriting than agency loans.

In addition, there have been reports recently that lenders have been changing loan terms at short notice, raising liquidity issues and placing non-QM firms in a difficult position with customers.

And, according to the latest reports, up to 16 non-QM lenders are having funding issues and will be required to advance a greater percentage of cash to fund loans from now on.

Read more: Beleaguered First Guaranty Mortgage Corp. files for bankruptcy

Mortgage experts consulted by MPA claim that non-QM lenders are particularly exposed to difficult economic conditions, and if the Fed decides to increase rates further next week that could add to their woes. 

Phil Shoemaker, president of originations at wholesale lender Homepoint, said: “The speed at which rates increased has created material spread risk in the non-QM market, and companies that are highly engaged in non-QM lending are severely exposed. Investors are less interested in buying a higher risk non-QM bond at a 5% coupon when they can buy an agency bond at 5% with materially less risk.”

Kirk Tatom, president of Tatom Lending, said non-QM lenders faced specific issues not common to other lenders. He said: “One of the biggest issues with non-QM is liquidity. Non-QM, just like subprime loans, are meant to be a patch. They’re short-term lenders.

“Here’s where the rub lies. I did a non-QM loan for a lady in October that was buying a house. She got 5% on the interest rate with the intent to refinance out of it as soon as she could show two years of solid tax returns.

“Now she’s thrilled to have 5% and has no intention of getting out of that loan.  Since the vast majority of these loans are held by the bank making the note (serviced in-house), at a certain point all the money dries up when none of the previous loans are getting paid off. If they’re selling those notes to an investor, at a certain point they’ll stop buying them because the money isn’t moving. This directly impacts the dreaded margin call. If the money’s not there, shop gets closed.”

Yury Shraybman, broker at Innovative Mortgage Brokers in Philadelphia, said that in times of market instability, non-QM lenders were usually the first to feel the effects.

“We saw this in 2019 during the COVID pandemic,” he said. “Not only did non-QM lenders get hit hardest by this turmoil, but many of them were forced to go out of business permanently, or temporarily halt lending on certain products.

“We also saw that the lenders who were able to weather the storm did so by being nimble and adaptive. They quickly shifted their focus to other products that were in demand and less risky, and they took steps to mitigate the impact of the turbulence on their business. As we enter a new era of market instability, it’s clear that non-QM lenders will need to be even more nimble and adaptive to survive.”

Al Hensling, president and co-founder of United American Mortgage, said companies had become “too complacent” and failed to control their operational costs.

“We’re finding that many of them cannot get small enough and scale fast enough to get ahead of the significant drop in business,” he said.

For his part, Jon Maddux, CEO and co-founder of non-QM specialist FundLoans, raised doubts the market would hit expected growth targets this year, saying “all non-QM had a setback in the overall loan volume”, due to the rapid rate increase that “came practically out of nowhere”.

He told MPA: “We all knew that there was going to be adjustments to rates, but we didn’t realize it was going to be as rapid as it was.”

He expressed surprise at Sprout’s sudden closure but suggested that the company may have taken a risk by allegedly buying and holding loans that were submarket coupons.

He insisted that non-QM was a safe product that performed “very well” but conceded that liquidity was a concern.

He said: “I think there will continue to be a strong demand in the market for it, but it just comes down to liquidity, which I agree is not perfect.

“(But) non-QM literally has a better performance than a lot of other loans, and a lot of that’s due to the higher skin in the game. It’s not like subprime, but at the same time it’s not like Fannie Mae (GSEs), where loans are purchased by the government; they’re purchased by big REITs and hedge and equity mortgage funds, so there is that risk that they can say ‘hey, we don’t want to get stuck with 90 LTV loans if there’s not a market for it’.

“That is a risk, but I don’t think it’s necessarily going to happen unless you see really big drops in real estate values.”

The Mortgage Bankers Association (MBA) and Fannie Mae both declined to comment.