Hello, and thank you for joining me. My name is Fernando Zoota and I am your host for the podcast and blog, Non-QM Insider, the show where we talk about regulations, guidelines and anything having to do with non-qualified mortgages. The topic of discussion is, when will things get back to normal in non-QM. Let’s get into it. Before we proceed, I liked to issue a disclaimer. Things are moving fast. Beliefs and understandings from a week ago are vastly different from today. A week from now and things will look different from how they appear today.
I guess what I’m saying is no one really knows how things will play out.
The content of this article is based on what I know currently, and I reserve the right to change my opinion as things progress. Let’s begin with some background for context. Be patient, it’s going somewhere, I promise.
In 1973 the Black-Scholes quantitative financial models (BSM) was developed. The model is widely used in global financial markets by traders and investors to calculate the price of options. The formula has demonstrated an ability to very closely predict the value for a call or put option. The introduction of quantitative financial models increased accuracy which in turn lowered risk. With lowered risk came tighter margins. As margins tightened, hedge funds and investors were forced to move away from active hedge fund managers, adopt the practice of high–frequency trading, a method of trading that uses Machine Learning to transact several orders in milliseconds and employ the use leverage. The most common use of leverage is to borrow on margin to increase the magnitude or “bet” on their investment. Borrowing on margin means taking an interest-bearing loan secured by assets in your brokerage account.
However, leverage works both ways, it magnifies the gains, but also the losses.
Enter the coronavirus. According to the Center for Disease Control, the coronavirus disease is an infectious disease caused by a new virus. The disease causes respiratory illness (like the flu) with symptoms such as a cough, fever, and in more severe cases, difficulty breathing. The World Health Organization has classified COVID-19 as a global pandemic. Economically, the stock market has lost all gains made since 2016 and there’s record unemployment. Machine learning relies on the input of algorithms created by humans. Without directive as to how to handle a global pandemic, machine learning has been unable to accurately predict the market. Essentially, the high-frequency trades mentioned earlier were bad. They caused severe losses.
The repercussions are that hedge funds and other investors have been required to liquidate all or most of their assets to pay margin calls.
As many of you already know, the result of most non-QM loans is securitization, which is the pooling of residential mortgages and selling their related cash flows to third party investors as securities (bonds). Hedge funds and other investors act as the secondary market for non-QM loans. They purchase consummated loans from lenders, organize pools and sell them as securities (bonds). Circling back to the question everyone wants to know. When are things going to get back to normal? The answer is, I don’t know. I’ve been told from 2 weeks to 6 months. I’ve also been told non-QM is not coming back at all. I’m more optimistic than that. What I have been able to determine, through my research, is the secondary market for non-QM is broke or, at a minimum, severely hampered due to bad trades and exacerbated by trading on margin. Additionally, they don’t seem to have a solution outside of a federal stimulus package. Jeanna Smialek mentions in her March 23rd New York Times article, The Fed Goes All-In With Unlimited Bond-Buying Plan, “As mortgage markets showed signs of crumbling, companies struggled to sell debt.” To bolster confidence in bond markets liquidity, “The Fed pledged to buy as much government-backed debt as needed to bolster the markets for housing and Treasury bonds.” Most importantly for us, in the non-QM sector, the feds also announced, for the first time in history, it would purchase the riskiest investment-grade debt. While non-QM was not specifically mentioned, I am hopeful. Another potential solution is for non-QM lenders to switch focus and start offering conventional and government-sponsored loans. It’s a lot easier said than done, but not unrealistic. It’s certainly better than shuttering the doors and it’s an opportunity to take advantage of a booming market.