Episode 290: An Update on the Residential Mortgage Market and Insurance Company Involvement

 

Stewart: Welcome to another edition of the insurance aum.com podcast. My name's Stewart Foley, I'll be your host. Hey, welcome back. It's great to have you. We've got a phenomenal podcast for you today, the title of which is An Update on the Residential Mortgage Market and Insurance Company Involvement. And we're joined today by Justin Mahoney who is the co-founder of Shelter Growth Capital. Justin, welcome. I want to, first of all, welcome you to the show and then I want to talk a little bit about our affiliate event that's coming up where you guys are going to be one of our future sponsors. So thanks for being on and thanks for taking the time.

Justin: Yeah, thanks Stewart. It's great to be back here for a second time. We're excited about the podcast, the platform, and we're really excited about the conference coming up.

Stewart: Thank you so much. And you actually were on when John Patton, who's the CIO at Somers Group, was our guest host doing a Due Dilly podcast, which was really well received. And so the event that Justin and I are talking about is the May 7th and 8th event that insurance AUM is hosting in Philadelphia. The topics are ABF, which is white hot right now, real estate and infrastructure. And we were hoping to build cohorts of insurance investors around those asset classes so that you can meet your colleagues and get to know folks who are your counterparts at other organizations and also meet with managers  of your choosing who  are going to be there at the same time. So, if you are interested and you're an insurance company, we are completely full on asset managers, but if  are an insurance company, please email us at events@insuranceAUM.com and we'll get a packet headed your way.

So let me just start off with, can you give us a little bit of background where you grew up? My common question is a first job, not the fancy one, but in addition to that, you've had a long career, successful career in the mortgage credit and structured products. What was the ‘aha moment’ that led you to found Shelter Growth Capital?

Justin: I grew up in Cape Cod, Massachusetts, a resort town, so pretty busy in the summer, quite a different story in the winter because it's a resort town, we could work early so I had any number of jobs starting off from landscape and movie theaters, but as we got old enough, we quickly learned that where you wanted to be was doing something like busing tables so you could be on the beach at night and then leave with a pocket full of tips afterwards. So that was really where I kind of cut my teeth there.

Stewart: There you go.

Justin: And then on the Shelter Growth side, so myself and my other two co-founders, we all worked at Goldman Sachs all in the mortgage department. We left at various times. I was there for a little over 10 years. I left in 2013. And really the impetus behind Shelter Growth was post the financial crisis. A lot of the things that banks did in the asset-based finance area, there was still a tremendous need for capital, but the roles of banks were going to change. And so we believed, and we still believe today, that there's a tremendous need for private capital in the space and for specialized managers to help clients of all types, including and especially insurance companies access this asset class.

Stewart: That's awesome, I appreciate that. So let's start with macro market conditions and RMLs today. So we've seen a significant shift in the housing market over the past few years. And from your perspective, how have recent macro trends impacted residential mortgage lending, otherwise known as RMLs, opportunities for investors?

Justin: So number one, on a fundamental backdrop, the fundamentals behind residential credit still remain in our view, and I think in general the market's views, pretty positive. If you think about US housing broadly, , we are still significantly under housed. We went through a period of 10 years post-financial crisis where we just weren't building enough homes and that's left us in a place where depending on the research you read, we're underweight anywhere from 2 to 4 million homes and that provides a real solid fundamental backdrop. Additionally, there have been a lot of positive changes post financial crisis regarding the underwriting of RMLs, and those have had a very positive impact on the quality of production as well as the credit performance. So that's really led, I think, to the trends that we're seeing now on the investing side, especially with insurance activities and RMLs.

Stewart: That kind of leads me into my next question, which is given the ongoing supply constraints and affordability challenges, where do you see home price appreciation, which in your world I believe is referred to as HPA, and credit availability trending?

Justin: Yeah, so on HPA, you've got two counterbalancing forces.  Affordability is certainly a challenge for new borrowers . On the secondary side, you've got a fundamental undersupply of homes which we think is going to continually be supportive of home prices. And so what you're seeing, is a deceleration in home price appreciation. So we've been running 4% to 6% for several years that's now come down to low single digits. That's where we predict things to be for the next year. But on top of that, you've had really disciplined credit underwriting in the residential mortgage loan space. So, that has a couple of different effects. So one that does affect credit availability, but it also factors into having very strong collateral and very strong collateral performance, which is attracting investors.

Stewart: So let's talk a little bit about, you mentioned the need for private capital in the mortgage market. What role are insurance companies playing in today's market and how do their return expectations shape product demand?

Justin: Insurance portfolios have long played a role on the RMBS side, but RML investing has really just started to take shape over the last several years. And it's a really interesting situation because you've got a very large investor base that's historically been under allocated to residential mortgage loans. And we'll talk about some of those reasons why, but the asset class makes a lot of sense for insurance portfolios. When you think about asset quality, risk adjusted return, risk-based capital and the ability to pledge those loans to the federal home loan banks, they're all really favorablefactors. And in terms of activity, a lot of the activity to date has been driven by a handful of early movers, some PE-backed insurers and large insurers who are early to the game. But if you look across the industry broadly, you'll see most insurers have a 0% to 2% allocation to RMLs. So we predict more scaling, we're going to see more activity across the board, and that's from insurers beginning RML investment programs as well as  existing players scaling up.

Stewart: That's super helpful. You touched on this, but the RML asset class, as I understand it, has a very favorable capital treatment, offers significant spread to pass throughs, and is pledgable something like 80% to FHLB? That seems like a very favorable set of circumstances for an insurance investor. Can you talk a little bit about that? Have I got that right? Where am I off? What am I missing?

Justin: Yeah, so largely I think you are correct.. We like to frame the attractiveness of RMLs for insurers across a variety of factors. And so number one, relative value and spread pickup. Depending on the time period, you're going to pick 150 to 200 basis points plus over single A rated corporates and you're going to pick between, let's call it 75 to 125 basis points over AAA or single A RMBS. So there's a significant spread pickup. The second part, less of a driver, but still important is diversification away from traditional fixed income that insurers have been investing in. Thirdly, you can get greater scalability in loans than you can in securities. And so that's been a driving factor for a number of insurers who are looking to increase allocations. And then on the risk-based capital treatment and on the federal home loan bank financing, these are two factors that are really unique to the insurance sector and they're major factors driving this.

On the risk-based capital front, especially when we talk about life insurers, RMLs require 68 basis points of risk-based capital against performing mortgage loans. And when you think about the benefit there, that's pretty self-explanatory. Generally owning high quality, high yielding assets with attractive risk-based capital tends to be good business. Then on the federal home loan bank front, there are  really two goals that get accomplished here and they're both very important. Number one, as you mentioned, I think you hit the nail on the head, it's very attractive economically. So we've been helping clients to finance with federal home loan banks and we're typically seeing 70% to 80% advance rate. And SOFR plus well under a hundred in terms of financing. But then, number two, there's been a lot of focus by federal home loan bank members, which many insurers are,  on positively contributing to the housing mission of the federal home loan banks. And pledging RMLs is a great way to accomplish that goal. So there's a lot of factors that really drive the attractiveness of the sector for insurers.

Stewart: That's very well put. So let's talk about this, and the question that I've got crafted here is beyond non-QM and Prime Jumbo, what segments of the market do you see as attractive for private capital? What I'd really prefer that you do is could you define what non-QM and Prime Jumbo is for our audience or what those two things are, and then where you see good relative value?

Justin: So on non-QM, it's become, and I'm going to get into exactly what it is, but it's become really the dominant sector of private capital investing in the non-agency space. So it is both now the largest sector of new RMBS issuance as well as the primary focus we currently see from insurance portfolios. Insurance portfolios will have the ability to shift to capture opportunities, but it's been the primary focus and there's a couple of reasons for this. So number one, what is it? These are high quality loans that for a variety of reasons do not fit Fannie or Freddie or bank portfolio guidelines, which can be very rigid. There's a couple predominant types of borrowers that fall into this asset class. Number one is self-employed borrowers. And so, in the broad the mortgage market, the borrower who  gets delivered to Fannie and Freddie and to a large extent to bank balance sheets, those borrowers have a  W2, and a steady job for the last 10 years That's a very easy underwrite for them to do.

Self-employed borrowers require a bit more of an old school credit underwriting background, which we have a lot of people on staff here that do that. And so it's really a high quality and very scalable sector that's overlooked. And then secondly, property investors. So I think if you read the Wall Street Journal, you probably think Blackstone owns every rental property in America, and that's just not true. 85% of them are owned by mom and pop who own fewer  than 10 properties, and that's not a sector that’s well served, so they don't fit either one of those two traditional places. And so you're able to get excess spread there. And one of the most important things, and really what's driven insurers to date to focus is non-bank private capital is the price setter for this market. You're not competing with the GSEs, you're not competing with JP Morgan Chase's portfolio. And so it's either securitization or RML investors that are setting the price and credit quality and performance have been really high.

Prime Jumbo loans are too big to fit into the GSE’s parameters, but they also have less underwriting complexity than non-QM. So it tends to be more W2 based borrowers. It's kind of the traditional bank product.. We do see insurers active in that right now butThere's a very strong bid from money center bank portfolios. So some of the allocation to non-QM has just been driven by spread pickup versus prime jumbo  and the ability to control pricing. And then you asked about other sectors of focus, there's a couple of others that I think are pretty interesting right now and will  continue to evolve.

And so, number one, agency eligible loans. These are loans that can go to Fannie and Freddie that they could guarantee and they would go to the MBS market. There are certain segments, I'll name second homes as a place where the GSEs have really increased their cost of capital to drive more of that section to the private markets. And so that's an area that's flowing into private capital. I would say though that concept of GSE eligible loans flowing to private capital broadly is something that's very interesting. And when we talk to insurers about RML investing, we say, look, it's not just on the spot basis. Once you have these capabilities set up and in place, you can take advantage of opportunities that arise. And with $2 trillion of average annual origination, there's always a new flow of opportunities. And we definitely keep our eye on what is going to be flowing out of what was traditionally going to the GSE guaranteed MBS markets to private capital.

And then lastly, something that's emerged over the past couple of years and will be a big trend going forward is home equity extraction in the form of whether their home equity lines of credit or second liens. And we've got record home equity in the United States. The vast majority of borrowers have a very low fixed rate first lien that they do not want to refinance at today's rates. And so taking out a second lien is a great way for them to extract home equity. And you can get very high unlevered asset yields here for very high credit quality borrowers at low updated loan to values. And so that's a sector that I'd say the securitized market has been a bit ahead of the insurance sector broadly, but we're starting to see more insurers focus on that sector as well.

Stewart: Super helpful. Let's talk about best practices for insurers while we're on it and some insurers, and this is my understanding and please tell me where I'm off, but some insurers prefer direct investments, other insurers prefer SMAs or pooled structures. What are the trade-offs between these approaches? I do know that you've recently launched an insurance dedicated RML fund, and can you help us with what problems you're trying to solve for the insurance investment community?

Justin: Yeah, so I'll answer that question, but first I think it's helpful to understand what are the complexities in RMLs and what drives the need for different solutions. And so there you've got granular portfolios of $400,000 loans that are monthly pay that have optionality around prepayments and defaults. And so, you need really specialized systems and personnel in order to get into the market. And we've been at this for 10 years building this out. It's not quick to do. It's not cheap to do. So I think you laid out the options and I'll go through what fits best for types of accounts.  The build out yourself, in our minds, is really likely reserved for the largest insurance portfolios who are going to make RMLs a core allocation. And this is because you're really building an operational business. You're not just building an investment strategy.

You've got to do all the things that I talked about before. You've got to put systems in place, you've got to put the right people in place. And they're generally not the systems and people that you have currently on staff for other asset classes. I think building it yourself is really for the largest.  Separately managed accounts can be a great option for insurers that don't want to undertake that build out, and eventually willallocate, let's call it $100 million plus to the sector. And we say that size because there are set up costs both in terms of timing and costs. And so I think ultimately you want to allocate enough to make it worth the timeframe and the money that's going to take you. But the one thing I want to highlight there is it doesn't have to be a $100 million day one, and that is a rough number, but if you're going to do this for $25 million, it probably doesn't make sense, but you can scale into that number over the course of a year or greater on it.

So I do think SMAs  are a great way for insurers to get exposure to the asset class and then utilize someone like us for the turnkey access and the operational efficiency. And then lastly, as you mentioned, there's been some changes in regulatory requirements and we're now able to structure what I call kind of insurance dedicated RML funds, where the way that we structure them will allow insurers to get look through treatment for risk-based capital. And we think this is a really interesting opportunity for folks that are not going to invest the minimums required to have an SMA or to build it themselves. And so this is something we think is going to be really exciting for 2025.

Stewart: That's very cool. Let me just ask you this, if you'll allow me a baseball analogy. What inning do you think we are in terms of this particular asset class for insurance companies?

Justin: Yeah, so I will answer your question specifically, but one of the things we like to say is we don't think you should view this like timing a trade. And really, in our view,  what you're doing is establishing capabilities to invest in one of the largest sectors in fixed income, and it's one you're probably currently  underweight. So on a spot basis, there's really interesting opportunities today, but going back to what we talked about earlier, there's over the last 10 years been $1.5 trillion to $4 trillion of annual origination and that really gives a constant flow of opportunities in the asset class. And so, once you're in the RML business and you have the capabilities, when opportunities arise, you're able to take advantage of them. But if you wait until that happens, it's going to take you a while to build this out. Even if you do set up an SMA, that doesn't happen in 30 days. It generally takes a couple months or so. And so you may miss the opportunity if you're waiting.

So our view is there's a lot of opportunity today, but getting set up allows you to be involved in a big asset class. So, getting back to your question, if you just look at the numbers, like I mentioned earlier, when you take out a handful of the largest players in the early movers, the insurance industry is still significantly under allocated to RMLs. If you look through the reporting, you're going to see a lot of0% to 2% allocations to the sector. So, a lot of conversations that we're having today are with insurers thinking about how to approach the sector, asking a lot of the questions you're asking right now. And so if that's where you are as an insurer, you're really not alone right now.

Stewart: That's awesome. I really appreciate the education, Justin, and I appreciate you being on. I know a lot more about this asset class than I did when we started, and I hope our audience does as well. I've got a couple of fun ones for you at the door. First one's not so much fun as it is informative. You've been at this for a minute. You have founded Shelter Growth Capital, which is as a fellow entrepreneur, it can be a harrowing task and who you bring on your team is particularly important. What characteristics, not skills or degrees, but what characteristics do you look for when you're adding somebody to the Shelter Growth Capital team?

Justin: As someone who's worked at a large firm that had complete pick of the litter for hiring, it's a very different task here. And as a small firm, hiring mistakes are much harder. And so we spend a lot of time screening. I think time and time again, there's technical skills, there's people skills, but I think hunger is really probably number one. So you have to fit in with the team here. I guess that's a prerequisite. You have to be able to do the parts of the job that we're hiring for, but what we're really looking for is hungry people that can contribute to the firm that want to help our clients that are really driven by investing. It's a passion of theirs, and that's where we tend to see success. And so I think that's what really drives long-term success is hunger for this business.

Stewart: I love that. Okay, last fun one. You can have lunch with up to three people, lunch or dinner, either way up to three people alive or dead. Who are you having lunch with, Justin Mahoney?

Justin: Alright, I think I leaned into the Boston scene last time, so we're going to switch it up a little bit here.

Stewart: All right. I like it.

Justin: I'm going to go with famous announcers I grew up with who I thought would be able to tell some awesome tales. So I'm going to go John Madden, Jim Lampley, and then I hope I have the next day off. I just read some legendary stories about 'em. But Bill Rafferty. So, just sitting down for dinner, hearing all these stories about the games they covered and the things they must know behind the scenes, I think that'd be an awesome dinner.

Stewart: That sounds really cool. I think you're the first person to go that way. I grew up in the St. Louis area and there was this station, this radio station called KMOX. It's still there. And they had a really powerful signal and they blasted these cardinal games all over creation in the central US, and there's Cardinal fans all around St. Louis because of that. And the person that was the broadcaster was a guy named Jack Buck, who is the father of Joe Buck, who's on Fox NFL, with Troy Aikman. And he had a very particular way of delivering the baseball game on the radio. And it really touches me that you chose those that was really well thought out. So thanks for being on. I really appreciate it. It's been a lot of fun and very educational.

Justin: Thanks for having us, and we're really looking forward to the conference coming up here in Philadelphia.

Stewart: That's great. Thank you. We've been joined today by Justin Mahoney, who is the co-founder, one of three of Shelter Growth Capital. Thanks for listening. 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, Amazon, or wherever you're listening to your favorite shows. We'll see you again next time on the insurance.com podcast.