Finding a Home in Residential Mortgages

29 November 2023

4 min read

Jess Dvorak| Managing Director—US Residential Loan Portfolios, AB CarVal

Dmytro Mukhin, PhD, FSA, CFA| North America Senior Insurance Strategist

Residential mortgages tick several boxes for life insurers: high income potential, favorable risk-based capital treatment from regulators and durations typically ranging from five to eight years. Yet these assets account for just a small slice of most insurer portfolios today. It may be time for that to change.

After plunging during the pandemic, US interest rates—and mortgage yields—have soared to multidecade highs, making the income opportunity these assets provide more attractive. And market fundamentals remain strong: average borrower FICO scores at origination are above pre-global financial crisis (GFC) levels, while new and existing home inventory is low.

Traditional mortgage investors, meanwhile, are pulling back.

Having already raised interest rates at the fastest clip in decades, the Federal Reserve has stopped buying mortgage-backed securities—a policy it adopted after the GFC—to help tighten economic conditions and tame inflation. Commercial banks are wrestling with deposit outflows and facing stricter capital requirements tied to the global Basel III regulations.

The result: lending is migrating from banks to asset managers and other private lenders. For insurers, this is an opportunity to partner with lenders who can source and underwrite new and seasoned loans while managing operational and implementation challenges that can accompany mortgage strategies.

A Durable Opportunity…with Two Avenues of Access

Large life insurers typically get US real estate exposure today through commercial loans and residential mortgage-backed securities. Residential mortgages account for less than 10% of total mortgage allocations (Display).

A Growing Opportunity for Insurers

Residential mortgages outstanding are wroth $13.4 trillion. But they account for under 10% of insurers’ mortgage exposure.

Past performance does not guarantee future results.
Residential mortgages in left chart represent “one-to-four-family” residential mortgages.
As of December 31, 2022
Source: Board of Governors of the Federal Reserve, S&P Capital IQ Pro

We think these assets have grown more compelling. In our view, residential mortgages represent an opportunity that we believe has years to run. We see two attractive investment avenues for insurers.

Buying in Bulk: Banks are sitting on thick books of loans originated at yesterday’s low rates. This inhibits their ability to make new loans at today’s higher rates and dulls their desire to hang on to the existing ones. Managers with strong underwriting capabilities can acquire pools of performing loans at a discount and repackage them into portfolios that meet specific insurer requirements. This might mean excluding mortgages with loan-to-value ratios above, and FICO scores below, certain thresholds.

Forward-Flow Arrangements: An asset manager can agree to purchase a predetermined amount of newly originated mortgages from a bank or a private lender for a certain time. In exchange for this forward-flow commitment, investors get a steady pipeline of loans at today’s high rates.

What Mortgages Offer—Including Yield and Capital Efficiency

The advantages, in our view, are many: diversified exposure, predictable cash flow and coupons that range from below 3% to 8% or more, depending on loan type and credit quality. Insurers can also use residential mortgages as collateral for securing low-cost loans from the Federal Home Loan Banks (FHLB) system on favorable terms.

Durations that can help to offset insurance liabilities and low regulatory-capital charges also make these assets a highly capital-efficient investment. While it’s possible that rates will decline in 2024 if inflation ebbs and the Fed begins easing policy, we don’t expect rates to return to their pandemic-era lows.

We anticipate newly issued mortgage loans to continue generating attractive income while diversifying commercial real estate and corporate credit holdings. Meanwhile, discounted loans issued before the Fed began tightening policy last year should perform well if rates fall, helping to offset underperformance of loans purchased closer to par. Active portfolio management can help manage duration in changing market conditions.

Overcoming Operational Challenges

A strategy is only as good as its implementation. For insurers, finding a partner to execute and manage residential mortgage investments and the accompanying reporting requirements is critical. Here are some attributes to look for:

Operational Efficiency: Putting whole loan strategies into practice and tackling the legal reporting they entail have been a challenge for insurers, who would typically need to buy hundreds or even thousands of residential mortgage loans. Tracking that effectively can be daunting. A manager can make the process straightforward and seamless. Insurers should look for managers with experience in setting up the legal structures to house these assets, and cutting-edge cloud-based performance reporting and data-management services.

Sourcing and Loan Expertise: Deep and diversified sourcing networks should stretch beyond banks and boutique lenders. The list of potential sources is long and can include dealers, other asset managers and family offices that want to monetize their portfolios. Also important: robust modeling capabilities across loan types, including prime, jumbo, subprime and non-qualified-mortgage loans for borrowers who don’t meet traditional lending requirements.

Impeccable Underwriting: Private strategies that rely on private sourcing require top-notch underwriting capabilities. Buying whole mortgages in pools can involve hundreds of individual loans. Managers must have both the capability to underwrite each loan and a reliable network of servicers to collect and distribute the cash flows.

Command of Regulatory and FHLB Requirements: Insurers have choices when it comes to structuring whole loan investments. That makes it important to work with a manager who understands the various regulatory and FHLB requirements and can walk insurers through the pros and cons of each option.

Now that rates are likely to stay higher for longer, we expect more insurance companies to target the residential loan market. In our view, strategies with sourcing expertise, a strong investment structure and seamless regulatory reporting capabilities have the most potential to succeed.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Jess Dvorak

Jess Dvorak is Managing Director for AB CarVal, leading the US Residential Loan Portfolios and RMBS strategy. He joined AB CarVal in 2008 and has led execution of the residential strategy since 2010. Mr. Dvorak previously worked at GMAC ResCap, Opus NW, Boulay, Heutmaker, Zibell & Co, and D.R. Horton. Mr. Dvorak holds a B.A. in accounting from the University of St. Thomas. Mr. Dvorak is a Certified Public Accountant (inactive).

Dmytro Mukhin, PhD, FSA, CFA

Dmytro Mukhin is a North America Senior Insurance Strategist in the Global Business Development Group. In this role, he partners with insurance companies and AB's investment and insurance accounting teams to evaluate strategic asset allocations, peer comparisons, risk/stress scenario tests and capital efficiency to help insurance clients think about optimal portfolio structure and implementation. Prior to joining AB in 2022, Mukhin was a member of the Global Insurance Solutions Strategy & Analytics group at J.P. Morgan Asset Management (JPMAM) for seven years. Before JPMAM, he was head of Annuity ALM at Voya Financial. Mukhin's career track also includes two other asset management companies, both in Boston: Wellington Management, where he was a vice president and fixed-income quantitative analyst, and Standish Mellon Asset Management, where he focused on investment strategy and risk analysis for insurers and other liability-conscious clients. Prior to that, Mukhin was a senior actuarial associate at MetLife. He started his professional career at Conseco Services. Mukhin holds a PhD in mathematical economics from Purdue University. He is a Fellow of the Society of Actuaries and a CFA charterholder. Location: New York

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Finding a Home in Residential Mortgages

A Durable Opportunity…with Two Avenues of Access

What Mortgages Offer—Including Yield and Capital Efficiency

Overcoming Operational Challenges

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