Episode 286: Resident Expertise - Advice for Insurers Investing in Residential Mortgage Loans

 

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. I’m Stewart Foley, I'll be your host. Hey, welcome back. It's great to have you. We're thrilled to have a great podcast for you today. But before we get going there, I want to remind you that we have an ABF infrastructure and real estate event coming up May 7th and 8th, which is open to insurance investors. And our goal here is a two and a half to one ratio of LPs to GPs. So, if you're interested in one of those asset classes and you have responsibility there, you're a CIO or you report to one, please shoot us an email at events@insuranceaum.com and we'll get a registration packet headed your way. Thanks so much for your patience there, Dan. We have a phenomenal podcast set up for you today on a very hot topic and the title is Resi Market Roundup with Dan Pallone, Managing Director of Global Loan Operations at SS&C Technologies. Dan, you are a repeat guest. Welcome back. Thanks for joining us.

Dan: Thank you, Stewart, for having me. It's very exciting to talk about this topic, which I think is really on the forefront of many of the portfolio managers that I talk to within the insurance business. And I'm a managing director at SS&C, been here about 10 years and came from the banking world.

Stewart: We're going to get into your background in just a second, but first of all, you got to tell us where did you grow up and what was your first job, not the fancy one?

Dan: So I grew up in northern New Jersey just outside of New York City, and my first job was at a supermarket where I was promoted to produce manager. I was the produce guy and I had to break the news to them. I was going to college, which didn't go over well, but they did allow me to leave and ultimately went to college and joined Wall Street.

Stewart: That's a cool story. I think a lot of times people listening to a podcast, they're interested once you've reached the level of success that a lot of our guests have. It's helpful for folks to know how you got there. And you kind of talked a little bit about being at banking, but can you give us a quick elevator background on how you went from supermarket to the position you hold today?

Dan: Sure. So, I was an accounting undergrad major and instead of going into public accounting, I went right into a training program at JP Morgan. And I spent the next 20 years of my career at JP Morgan doing a variety of things within the firm and working overseas in Brazil and London in a variety of finance risk lending type roles, continued in the banking world for a few more years. And I think I'm unique in the fact that I actually then came to SS&C where I really now work for a service provider and many people spend their entire careers either as a practitioner, like at a bank or at insurance companies and don't have the benefit of actually experiencing what it's like being on a service provider side. But I think given my background of being a practitioner of using these software, using these services, I was able to position myself at SS&C as someone who can be sympathetic to the client, understand what the client needs.

And I've seen it both ways. I've seen very successful people at SS&C become practitioners. So they might be servicing an insurance company or servicing a hedge fund or a private equity firm, and they'll have multitudes of clients, and then what they do is they change their career and go join a firm of the type that they were servicing. And I think it gives you that perspective of both sides where you know what your client is going through and you can empathize with your client and really solve their problems in a way that other people who haven't been in their shoes can't, Stewart.

Stewart: Yeah, I mean I think it's really interesting because when you look at the title of this podcast, you assume that it's going to be all accounting and operations, but that's not at all the case, and that's really as a result of the background that you just described. So let me just start off with the broadest brush I can. What is going on in the Resi market today?

Dan: There's a lot of things happening in the Resi market. Number one is there's a very large supply shortage, which is due to the fact that people are sitting on 2% mortgages, 3% mortgages, and if they were to sell their house today, they would have to triple their mortgage payment for a like size mortgage because current interest rates are 6% to 7%. So there's a reluctance to sell, which means the supply is very short and it's driving the prices of homes up given the imbalance between supply and demand. So just in the market itself, we have this imbalance and what's going to sort of make that kind of get back into equilibrium, it's really a function of mortgage rates. And there's two ends of the mortgage rates. There's the 30-year fixed, and that's driven by the 10-year, which has been elevated between 4% and 5%. And that's really driven due to inflation expectations. 

And then the arm market, which is short-term adjustable rate mortgage market, that's driven by the Fed funds rate, and again, persistently high, the Fed made some moves last year, but still historically high. And until one of those gives, mortgage rates will stay where they are. And this supply versus demand will only come back to equilibrium just due to the natural attrition of people getting job transfers and they're forced to sell their homes or people who have passed away and a home is an inheritance and it needs to be sold. So there's not a lot of natural causes out there today that could drive that imbalance where we get more of an equilibrium between supply and demand. So that's big picture macro what's going on, Stewart.

Stewart: And so how do you translate this into an opportunity for insurance companies and is there any consistency about which insurers are most interested in risk mitigation?

Dan: So if you think about what's been going on in the insurance portfolios over the last couple years, we've seen a 100% increase in the allocation, from 1% to 2%. I'm constantly talking to insurance portfolios and insurance clients and they're all either talking about getting into it, they're into it now and expanding, or they want to embark on a new program to start investing in this asset class. And what's interesting, Stewart, is really there's a couple of things from just a pure yield perspective. If you think about an agency RMBS, so I'm talking about a residential mortgage backed security that's guaranteed by Fannie, Freddie Mac or by HUD. So it's like buying a government security, but it's backed by a pool of residential mortgages. You could earn about 5% on one of those government guaranteed RMBS’s today. Now, if I go up a bit of the credit curve there and I now buy an RMBS, let's say, issued by JP Morgan, so it doesn't have the implicit guarantee of the United States government, it's not Fannie, Freddie or HUD issued, now you're talking about 5.5% of a coupon on one of those non-agency RMBS.

So you pick up 50 basis points because you don't have the credit guarantee from the federal government. Now, if you were to just buy residential loans, you can get a yield of 7% by buying an outright pool of residential whole loans. And I think that is what is enticing many of the portfolio managers to say, hey, how can I pick up 150 basis points of yield over that alternative security, which is a residential asset exposure, but now in the form of residential loans. So we've got that going on in terms of insurers looking at a yield pickup. Now, from a risk mitigation perspective, there's a lot of reasons why residential whole loans are also risk mitigation. If you think about the comparison of a commercial real estate loan, and just use $25 million one commercial real estate loan, and you compare that to buying a hundred residential mortgages with an average loan size of $250,000. Now, on the balance sheet you've got a $25 million asset, but from a risk perspective, now you spread that risk across a hundred different assets compared to a commercial real estate loan that is one single asset.

The other thing that is also important here is historically the residential default rate has been lower compared to commercial real estate mortgages. So again, I'm making a comparison between the commercial real estate mortgage market, which insurance companies already have a pretty healthy allocation to diversify out of that and get into resi’s for a couple of those reasons. The third reason is geographic diversification, just inherent in the fact that you can pick and choose your residential mortgages across 50 different states in the United States gives you that ability to, if you're bullish on the northeast, to concentrate on cities in the northeast and states in the northeast, or if you're bullish on the south, you can pick states in the south to invest in your residential program. So there's that geographic diversification that also comes with the product. And then from an RBC perspective, it actually gets a much more favorable treatment compared to these securities.

So right now, the latest RBC is a 0.68% factor if the residential mortgages are held through an affiliated entity, and that compares to 1% to 3% for securities. So we're talking at least 50% to 500% higher RBC treatment for these residential whole loans compared to securities. And then finally, I'd say life insurance companies are a good candidate from an insurance perspective, given the fact that they need duration and a typical 30-year mortgage might have an average life of 10 years. So it is a nice duration play for them in terms of looking to add more duration to their portfolio.

Stewart: I don't know why, but I feel compelled to just say this. The podcast is giving a Resi market roundup and we're talking about markets, but SS&C is not an asset manager, and that's not your business, necessarily. You're not pitching Resi whole loans, you are talking about how they compare to other aspects of the mortgage market. And just so that folks know that you guys aren't asset managers, I think that's important to get out there just as we're talking about markets.

And can you talk a little bit about what I know is called, and I'll use the air quotes, “surveillance”. How is surveillance factoring into the market these days and why? And here's kind of the background on this. From my perspective, Dan it’s like, I've managed mortgages for a long time and I feel like I know the mortgage market a little bit, but that's not true. The reality is that the mortgage market has changed since I've been active in it, and I'd love to get current on all these different factors of the mortgage market as it is today. So with that, can you just kind of give us the background on the surveillance and how it factors into the market today?

Dan: Yeah. So Stewart, there has been the benefit of automation across the mortgage market, particularly in a Resi market, which is much more homogeneous and standardized compared to the commercial real estate market. I think as you know, SS&C, we offer services in both, and we have clients that invest in both. So we do see the evolution of these mortgage markets over time, and Resi is much further ahead when it comes to automation. So what does that mean? That means that you can basically go online and get a residential mortgage with let's say 10 clicks, and you can go to these websites, you can go to the Rockets of the world and you can literally get all the key information in on an easy-to-use intuitive form. And the next thing you know, load up the property you're interested in, you put all your financials in and you get a quote within like 30 minutes. And it's amazing. Where back in the day you'd have to go and sit with your banker, fill out reports and bring a shoebox full of documents and everything. So I think the process is completely changed on the Resi side. We have a long way to go on the commercial real estate side, Stewart.

Stewart: Yeah, I mean it's really a good point, and I mean I'm old enough to remember going to the local bank literally with an arm load of papers and you had to have, it was a conversation, it had to go to a loan committee and they didn't meet until a week from Friday. And it is dramatically different today. So when we think about insurance investors, how are they sourcing Resi opportunities in the market? How are they gaining access?

Dan: So there's a couple of channels here that an insurance investor can go down, and we see this in the market all the time. We partner with a lot of these channels. So I'll start with the originators. So originators are the front lines, the folks that are actually talking to the homeowners, the first ones the brokers and they actually originate the loans, but they don't have the ability to fund the loans. They have no balance sheet. So their role is really just to originate the loans, screen the bars, make sure that the loan is healthy, it's being underwritten to the right standards. And those standards could be agency standards. So they could be writing to what Fannie or Freddie or a HUD loan requires for one of those institutions to purchase. Or it could be underwritten to what's called non-QM or non-qualified mortgages. Qualified are the ones that are eligible to be purchased by the Fannies, the Freddys, and the HUDs, the three government agencies that guarantee residential mortgages.

So if we think about the non-QM, those are the ones that could be above the limit of the Fannie, the Freddie, and the HUD’s by jurisdiction, or there might just be people who don't want to comply with the additional underwriting requirements when it comes to federal agencies. So the originator's one channel that you can get in contact with and tell them, look, I'm looking for this type of loan and I want an LTV of 75% or better. I want only people with FICO scores of 750 or above. So that's where again, you're going to qualify what you're looking for and you can just buy flow off of them. That's one channel. Another channel are aggregators and aggregators are going to do that work for you in front of the originator. So you go to the aggregator and they're typically asset managers. They might have 6 or 7 different originators, but they're going to work on your behalf to basically go out to the originators and fill your request in terms of what you're looking for in terms of those.

And there's a whole multitude of residential mortgage types out there too. There's residential transition loans, AKA fix and flip. There's the jumbos, which are very large balanced loans. There's early buyouts, which are loans that go into fall that are getting rejected out of Ginnie Mae pools. So there's a lot of different product out there that you can even get into HELOCs if you want home equity lines of credit. And again, with an aggregator, they have access to many originators and they can then work with you to fill what you need. And the other thing the aggregators will do is they will continue to monitor and provide surveillance over those mortgages. We didn't really talk about the surveillance, but if you do get into this asset class, there are a few things that you need to ensure, which is like the timely payment of local taxes, real estate taxes.

If the homeowner is not making those timely payments, then you'll lose your first lien and most servicers will provide that as part of their service. The second thing is the property insurance. You don't want to have a California situation where the property burns down and there's no property insurance and all you have left is land. So the aggregators will monitor that with the servicers and make sure that there is adequate insurance coverage and real estate taxes are being paid on a timely basis. So that's how folks are sourcing the loans in the market, Stewart, what I see.

Stewart: It's really interesting, Dan. I mean, I appreciate your depth of knowledge in this market. The one thing that I've always heard about this asset class is that there are some key operational and infrastructure considerations that insurers need to be aware of. And so can you talk a little bit about the investment activities required or the administration that's required if you're going to buy into the RML asset class?

Dan: I think it comes down in one word in terms of volumes. So you need robust operations and accounting to deal with much higher volumes of investments. So in my example of the $25 million CRE loan, that's the equivalent of 100 mortgages. So now extrapolate that if you really wanted to get into the CRE world and now you wanted to go to $2.5 billion, now you're talking 10,000 mortgages. So now you're going to manage maybe 100-line items of CREs at $2.5 billion in my example, to 10,000 mortgages. That requires scale, that requires the ability to handle the higher volumes because now you're not just reconciling 100 positions, now you've got to reconcile 10,000 positions. And through automation technology and really data standardization and a little bit of intelligent automation, you can handle this, but you do need the proper technology and you need the proper expertise of your staff to be able to deal with the actual accounting.

One of the things that people don't realize with Resi market is all mortgage payments are due on the first of the month, right? Everyone who has a mortgage, and that's standard. The reality is that most people don't pay on the 1st, they'll pay on the 3rd, the 4th, the 5th, and everyone has about a 10-day grace period. So when you're trying to close your books, you are always on a one month lag because by the time the servicer was going to be collecting those payments on your behalf and then sending you the detail in what's called a remittance file on a monthly basis, you might not get that information until the 15th or the 20th. Now, most insurance companies I know like to close their books by the 5th business day. Well, if you can't get the information until the 15th or 20th, that means you're going to be on a one month lag. So again, there's these nuances of this product from an accounting perspective, from an operations perspective, particularly volume, Stewart, that you really need to be able to handle to take on this asset class.

Stewart: It's something that your colleague, Scott Kurland, and I have referred to as negative yield. And just for compliance sake, when you were talking about yields and spreads, it's for comparative purposes. So if there's 150 basis points pick up in buying RMLs and I don't have the infrastructure to properly account for that asset class, I'm giving up some of that spread and the more efficient my operation is, the higher amount of that spread I'm going to actually realize. Right. So can you talk a little bit about how firms like SS&C help position insurers that are perhaps Resi focused insurance investment managers for this kind of scale that you've just described?

Dan: Yeah. We do these analyses all the time, and the key is scale. That is the key because the larger the volume, the lower the cost. And we've done analyses where it can cost anywhere from 5 to 10 basis points. So we're talking about 150 basis point pickup at a cost of 5 to 10 basis points to support this asset class. So it turns into positive yield of 145 to 140 basis points of positive yield when you strip out the cost. But again, that assumes you have robust systems and you have the expertise and the technology and using artificial intelligence to get that cost down to 5 or 10 basis. The key things here are you want a turnkey operation and software that's purpose built to handle this bulk processing. And again, that's where SS&C has the expertise. We have the knowledge, we've got the software, and we've been in the insurance, and particularly in the mortgage business for over 20 years, and we've got that expertise and the proven track record to be able to support this.

Basically, the middle office function is independently reconciling all that servicer data back to system generated calcs and reconciling the cash in the bank account. And that's a heavy lift when you're talking tens of thousands potential of loans in a portfolio. The other thing that SS&C does is accounting at the loan level to support an income statement and balance sheet in any SMA accounting in case you have SMA accounts that you're investing in Resis on behalf of. We fully support the risk-based capital and the NAIC regulatory reporting with automation and standard reports. And one of the things that we are doing now at SS&C is creating a Resi loan user forum for operations and accounting to share best practices and to help those who want to get into the market. So it's really exciting to see this market grow and be part of it and see how SS&C can help solve our clients' problems and new clients who want to get into this asset class.

Stewart: That's awesome. Thank you so much. I've gotten a tremendous education, our audience has too, on the RML market and how to efficiently manage owning that asset class and to realize the most benefit that you can realize from it net. So I just want to ask you if you could just give us a couple of key takeaways before we move on to the fun questions. What would be a couple of key takeaways that you want our audience to come away with from this podcast?

Dan: I would say the two things that would take away is one, if you haven't looked at RMLs as an investment asset class, I would strongly encourage you to do that. And if you want to be introduced to any of these aggregators or originators, you can reach out to me and I will make those introductions. Second thing is if you do want to pursue this asset class, again, SS&C has the capabilities, the technology, the experience to help you get up and running and not have to make the investments in an asset class that you might just want to dabble in. And we can make it very cost effective to try the asset class. And then as you grow, you could take that in-house with our software or continue to use us as a partner to do your middle office back office accounting. So I think those would be the two key takeaways. If you haven't thought about this asset class yet, I can definitely make some introductions to the aggregators that we deal with and partner with and in terms of turning on new business. And then also once you want to learn more about the support, reach out and I can take care of that too.

Stewart: Okay. So thank you so much. I just want to kind of a couple more general questions, and that would be when you are adding people to the team at SS&C, what are the characteristics, not the skills or major, what are the characteristics that you're looking for when you're hiring someone?

Dan: So, we do like to see people that are client friendly, client-facing friendly. We also look for disciplines like accounting and finance. We look for people who have some operations background and generally we can find those sort of candidates at banks or at current loan administration shops. And then occasionally we'll go into the clients that we have and we find good candidates and insurance companies also that are performing these functions that want to sort of do what I did, which is get out of a practitioner role and get into a service provider.

Stewart: And then the last fun one for me is always this, if you could have lunch with any three people, alive or dead, lunch or dinner, doesn't matter, who would it be?

Dan: Wow. Okay. One would be Knute Rockne.

Stewart: Oh, there you go.

Dan: I don't know if you know who knew Knute Rockne was, Stewart, but football. Notre Dame, one of the most successful college football coaches in the twenties at Notre Dame.

Stewart: Yeah, absolutely.

Dan: I think the second one would be maybe Albert Einstein.

Stewart: Wow.

Dan: Someone who as bright and as brilliant as he was would be someone interesting. And he lived in Princeton, which is only about 40 minutes from where I live. And I'm a big fan of Princeton. I go to Princeton quite a bit. I think it's a great town and a great college town.

Stewart: That's great.

Dan: And let's see who the third one would be you, Stewart, I would like to go to lunch with you. I don't think we've ever been to lunch before.

Stewart: That's fantastic. This is the first time I think anybody's ever, maybe somebody maybe once before, but hey man, I'm flattered. I appreciate that. So thanks so much for being on, Dan. We really appreciate it. I just wanted to say it was a great education in the markets and appreciate you taking the time.

Dan: No, thank you for the opportunity, Stewart. It's great seeing you again, and let's go to lunch.

Stewart: Absolutely, absolutely. Happy to. The topic of today's podcast has been Resi Market Roundup, and we've been joined by Dan Pallone, Managing Director of Global Loan Solutions at SS&C Technologies. Thanks for listening. If you have ideas for a podcast, please shoot me a note at Stewart@insuranceaum.com. Please rate us like us and review us on Apple Podcast, Spotify, or wherever you're listening to your favorite shows. We'll see you again next time on the insuranceaum.com podcast.