Non-QM lender First Guaranty Mortgage Corp. (FGMC) filed for Chapter 11 bankruptcy protection at the end of June — leaving four warehouse lenders on the hook for more than $415 million.

Sprout Mortgage imploded in early July, leaving its employees out in the cold. The lender so suddenly shuttered its doors it failed to file advanced notice of the layoffs, as required under federal law. It has since been sued by its former employees.

Just weeks later, a leaked text message from Flagstar Bank provided an inside look at how dire the current climate is for many non-QM lenders. The bank calls out 16 non-QM lenders in the text message, indicating it is ramping up scrutiny of its loan reviews, prior to advancing warehouse funding.

The examples, all within about a month, illustrate a non-QM lending world in disarray, turned upside down in recent months as originators battle an unassailable force over which they have no control: fast-rising interest rates. It’s an ongoing battle, which already has been lost by at least two lenders, FGMC and Sprout. 

And others in the sector, warehouse lenders included, must now navigate the fallout, heed the warning signs and take action to avoid a similar fate. One executive said “it would be naïve” to think Sprout and FGMC will be the only casualties, given the current environment. In time, he said, they may well end up being “more of a trend than outliers.”

The Flagstar text message leaked to the media in mid-July confirmed, going forward, funding advances for non-QM mortgages will require advance approval by the lender’s warehouse lending arm. The bank also indicates it may adjust “haircuts” — the percentage of the loan the originator must fund itself to ensure it has skin in the game. 

Thomas Yoon, president and CEO of Excelerate Capital, a full-service non-QM lender, said the move essentially means Flagstar now will “monitor every loan because they don’t want [to fund loans] that will be hard to sell in the open market, and then they’re stuck with that loan.” 

“So, they are going to babysit now,” Yoon said, adding that from a business standpoint, it will slow down the loan originators’ processes. “Someone at Flagstar has to physically look at the deal and make sure it aligns with what they want before they’re able to fund, and that’s going to cause delays.”

Flagstar spokesperson Susan Cherry-Bergesen verified the authenticity of the text message when contacted by HousingWire and confirmed its content: The bank is adjusting its loan-review process. The leaked message included a list of 16 non-QM lenders that would be affected by the changes, according to published reports.

“We were at a meeting with one of our warehouse providers [recently] and … they asked a smart question: “Is Acra Lending on that list?” recalled Keith Lind, CEO of Acra Lending, a leading non-QM lender. “Of course we’re not. 

“…If lenders didn’t take rates up fast enough, or they didn’t liquidate their positions fast enough, there’s going to be warehouse facilities where the loans [made to lenders] are worth less than the equity [skin in the game] that the originator posted. That’s probably a little more common than people think.”

Lind said many lenders are now trying to digest a plethora of lower-rate loans, essentially “orphaned by the market.” During the height of the refi boom and earlier this year, scores of loans were originated at interest rates much lower than current market rates, which have risen dramatically in recent months. 

As a result, there exists a mismatch between those legacy lower-rate mortgages and the new higher-rate loans. That’s the case even though the lower-rate loans are widely considered to be well-underwritten, quality loans. As of mid-July, according to Freddie Mac’s purchase mortgage-market survey, the 30-year fixed mortgage stood at 5.54%, compared with 3.22% as of the first week of January 2022 and 2.88% in July 2021.

The market’s interest rate woes contributed to non-QM lender FGMC’s downfall. FGMC and its affiliate, Maverick II Holdings LLC, filed for Chapter 11 bankruptcy protection June 30, leaving four of the country’s major warehouse lenders with claims totaling $418 million, according to court filings.

Those warehouse lenders are Customers Bank, Flagstar Bank, JVB Financial Group and Texas Capital Bank. 

Another non-QM lender also was swept up in the “orphaned” loan market. Sprout Mortgage on July 6 closed its doors suddenly, leaving hundreds of employees without jobs and paychecks. Real estate agents and their clients also received no advance warning and multiple deals fell through as a result, sources told HousingWire. The lender also did not file a WARN Act notice — required of any employer of more than 100 that has a mass layoff at one location involving more than 50 employees.

“The New York State Department of Labor has not received a WARN notice from Sprout Mortgage,” states an email from the department sent in response to a HousingWire inquiry. “We do not comment (confirm nor deny) on potential or pending investigations.”

The failure to provide proper notice of the layoffs prompted a class-action lawsuit by former Sprout employees. The litigation — lodged in early July in U.S. District Court for the Eastern District of New York — seeks to recover wages due the workers.

The current interest-rate spread pressure-cooker tends to be even more acute in the non-QM sector, compared with the prime-mortgage market, according to John Toohig, managing director of whole loan trading at Raymond James in Memphis.

“[There’s] a lot of underwater coupons due to rapidly rising rates,” Toohig said. “The problem with non-QM is that most banks won’t be the liquidity source for those loans in whole-loan form [purchasing] vs. the aggregators putting them into RMBS [private label securitization deals] — which doesn’t work right now [either].

“So, I wouldn’t be surprised that there is some pain coming at the warehouse-line level [revolving lines of credit used to fund mortgage originations] as loans start to age. The good news for prime jumbo [is] banks want to own those loans and balance-sheet them. The same cannot necessarily be said for non-QM.” 

Non-QM mortgages include loans that cannot command a government, or “agency,” stamp through Fannie Mae or Freddie Mac. The pool of non-QM borrowers includes real estate investors, property flippers, foreign nationals, business owners, gig workers and the self-employed, as well as a smaller group of homebuyers facing credit challenges, such as past bankruptcies. 

Because non-QM, or non-prime, mortgages are deemed riskier than prime loans, in a normal market they generally command an interest rate about 150 basis points above conforming rates, according to Excelerate’s Yoon.

Excelerate and Acra each raised rates rapidly starting early in the first quarter of this year to stay ahead of the fast-rising interest rate curve, according to Yoon and Lind. The rapid surge in rates in the market is being fueled, in part, by the Federal Reserve’s ongoing benchmark rate bumps, intended to battle inflation. The consequence of failing to anticipate the velocity of rate increases could result in a lender getting stuck with millions of dollars in underwater loans — mortgages that are well-underwritten but valued under par, the lending executives said. 

In other words, these lower-rate — now “scratch and dent” — loans are at a competitive disadvantage in terms of pricing in securitization and loan-trading liquidity channels because they are worth less than the newer crop of higher-rate mortgages. Lind put it this way: “These aren’t bad loans, just bad prices.”

“I don’t think [Sprout and FGMC] are the only two lenders that are in a bind,” Lind said. “I’m sure there’s other originators that are in difficult situations, given this movement in rates and probably their inability to get liquidity or to sell loans fast enough.”

Yoon said the Sprout and FGMC failures are likely going “to be more of a trend than outliers.”

“A lot of lenders took on, or funded, these really low-coupon loans,” Yoon continued. “And they probably had them sitting in their gestation pipelines thinking that the things will get better, and they could sell them off. That day never came.

“What I’ve been told through warehouse lenders and Wall Street aggregators is that there’s several billion dollars’ worth of these [low-coupon] loans out there, still sitting on balance sheets. At some point, they [lenders] will have to pay the piper, right? It’s naive to assume we’re not going to see more casualties.”

***

Q&A

HousingWire contacted half a dozen non-QM lenders seeking interviews for this story, including Angel Oak Cos., Deephaven Mortgage, CarVal Investors, Verus Mortgage Capital, Acra Lending and Excelerate Capital. All the lenders, as well as the now-failed Sprout Mortgage, participated in a prior story on the same subject — the state of the non-QM market, which was published in April. 

This time around, only Acra and Excelerate agreed to participate. Representatives of the other lenders declined to comment or make executives available for an interview, with most saying the executives didn’t have time. The top executives at Acra and Excelerate, Lind and Yoon, respectively, each declined to comment on specific competitors in the non-QM market, but they did share their views on current market conditions and the challenges faced today by non-QM lenders in general.

Lind and Yoon stressed they are not predicting with certainty other non-QM lenders will fail, nor do they hope that will be the case. Both, however, predict due to the runup in rates, there will likely be painful losses incurred by some non-QM lenders, which will have to be dealt with somehow.

All non-QM lenders now face the same economic challenge — coping with the fallout from interest rates rising at a faster clip than the market has seen in decades. Following are comments from Acra’s Lind and Excelerate’s Yoon on a range of issues affecting the non-QM lending space.

Interest Rates

We saw the market [earlier in the year] and knew it would only get worse, at least in the short-run, and we put our rates above market at that time sharply. …We’re positioned really well to navigate the current market. That doesn’t mean it’ll be easy, but you know, we’re positioned better than most, so we feel fortunate about that. … When we raised our rates that significantly in the first quarter, it essentially blew up our pipeline in the short-run, but we felt like we needed to do that. …Going into October, November, December [of last year] and into January [2022], everyone was thinking, including us, that we’re going to have a banner 2022. Then the market changed on us overnight. There was only a handful of us that that made the move [to raise rates sharply], and they are positioned well going forward. — Thomas Yoon of Excelerate Capital

We’ve moved rates 18 times in 2022 [to date] — mostly up, with maybe one or two down. Listen, everyone’s got a different execution or [liquidity] outlet. I can just tell you that we’re breaking even or making a little bit of money in the first few quarters [of this year], and our rates are higher than others. I don’t know how some of these other people [lenders] have been able to do it. But if they have, then kudos to them. …You’ve probably heard this before: Don’t fight the Fed [the Federal Reserve]. The Fed is bigger than everyone. Well, guess what? So is the housing market, and you don’t fight the housing market. Everyone’s like, “Oh, I’m going to keep rates low because I need market share.” I think it’s always better to be prudent and pay attention to rates. It’s not a race [or sprint]. This is a marathon to be successful in this business. That’s the way we look at it. — Keith Lind of Acra Lending

Warehouse Lenders

The biggest problem in non-QM right now is the fear of liquidity, right? It’s whether they’re able to sell off their closed loans. If they don’t, then it becomes a burden and a debt. The biggest, I think, challenge that these non-QM platforms face — outside of what’s happening in the market — is will they maintain a stable relationship with their warehouse lines. …I expect lower limits in warehouse funding capabilities and more haircuts, so that they [warehouse lenders] feel that they’re protected. Oftentimes, warehouse divisions are a real profit-maker for banks, but we’re going through a cycle change, and originations have dropped 40-plus percent nationally. It means that everyone’s taken a hit. …Most warehouse lenders are banks and, of course, they’re feeling it too. — Yoon of Excelerate Capital

Regional banks [who are warehouse lenders] have a lot more exposure now and could be holding loans that are underwater. I’ve heard some of them are comfortable with the risk, and they’ll just wind down these positions over time. It’s still a good return for the bank. Others are looking for exit strategies. … Some of these regional warehouse lenders may ultimately do a full turbo feature where they collect all interest and principal, and the originator gets nothing. It’s going to be harder for the little guy [smaller originators] to come back because warehouse providers, as well as people that are lending money [generally], are going to demand more capital. — Lind of Acra Lending

Raising Capital

If you’re a [non-QM] executive and have a $300 million negative on the balance sheet [due to underwater loans], any company that’s going to provide capital is going to question whether [the leadership of the lender] knows how to run a mortgage-banking platform in this marketplace. …It’s not like they will be using that capital to build technology or to hire more great talent or [launch] a new system. To be clear, it’s to make themselves whole, right? That’s a tough, tough sell in today’s market. — Yoon of Excelerate Capital

You don’t throw good money after bad, right? — Lind of Acra Lending

Market Share

We took flack for raising our rates and recalibrating ourselves. A lot of our competition, for example, kept their rates really low and kept them low for all of the first quarter. They took on a massive risk, and their logic was that the market will turn for the better … and they’ll be able to sell these [loans] off at a profit, instead of just breakeven. They looked at it as an opportunity to gain market share. Everyone that did that, you know, they were wrong. — Yoon of Excelerate Capital

The originators that have made it through the first two quarters in [good] financial shape absolutely I would expect all of us to gain market share. There are going to be [originators] that go out of business, as we’ve seen, and they’re probably not the last, and then others are probably going to struggle. — Lind of Acra Lending

Survival Strategies

Our liquidity channels are still really viable. We have strong relationships with our aggregators and outlets. We’re very fortunate, but we also recognize how volatile [this market] is. We have to be nimble. So, we have a plan A, but we also have plan B and C ready, just in case. …The market is moving so quickly, so we’re shooting higher [on rates] than we normally would to make sure that the collateral bought is worth something when they securitize it — [a process that can take months]. The dramatic move [in rates] that we saw in the first quarter and second quarter, I don’t think it’s going to be that exaggerated [going forward], but we’re constantly chasing the bogey here, so to speak. — Yoon of Excelerate Capital

There are three aspects that we focus on. First of all, we focus on rates. And I told you, we’ve moved rates 18 times since January 3. We were at a 4.5% coupon, and now we’re low 8% [range] in terms of where our portfolio is. …Two is liquidity. If you don’t have strong liquidity, and you’re not getting off loan sales fast enough and at the [right] prices, that’s going to be difficult. So, rates, liquidity and then lastly operational expenses. Are you managing your expenses? We took our headcount from 450 down to 350. We did that two months ago. And we’re still looking at that, to make sure that that we are managing expenses and salaries. We’ve not only reduced headcount, but we’ve made adjustments to salaries. — Lind of Acra Lending

Downturn Duration

We’re going to go into a recession — if we’re not already in it right now. I hope that it’s a mild recession. We’re prepping as if this is going to be a 12- to 24-month downcycle for us as an industry. If it [ends] earlier, we look at that as very fortunate. But we anticipate that this year and the bulk of next year is going to be trying times for us. We’re taking a very conservative approach. — Yoon of Excelerate Capital

I’m going to take the view that until we have a better understanding of where we are with inflation and taming it, that this market is going to be choppy. And when the overall market has a more comfortable understanding of where inflation is, and that it’s under control, I would think that things will fall back into order. …There’s still a lot of tailwinds in the housing market, however. We’re short [some] 5 million homes [in the housing market], and I think from an investor perspective, depending on the price and the homes picked, there’s good cash flow every month. I think that’s why you’re seeing more and more people, as far as mom-and-pops [small landlords, who are non-QM borrowers] getting into the housing market as opposed to the equity market moving forward. I like the tailwinds in housing, for sure. — Lind of Acra Lending