For example, bank regulators in July released a plan to increase capital requirements for residential mortgages, the Basel III Endgame rules. Redwood executives are positioning the company to acquire mortgage loans in the market, mainly jumbos, with the expectation that banks will have a reduced appetite.
Abate doesn’t think “banks are going to necessarily exit the mortgage market,” but they will “be heavily disincentivized from growing mortgage portfolios.” Ultimately, “the real shift is going to be all those jumbos that were going to banks will come back out, hopefully to non-banks like us.”
Another opportunity is in the home equity space. Redwood launched in September its in-house home equity investment (HEI) origination platform called Aspire. Through Aspire, Redwood plans to directly originate HEIs by leveraging the company’s nationwide correspondent network of loan officers and establishing direct-to-consumer origination channels, the company said.
“The interesting thing about HEIs is instead of a homeowner taking out equity in the form of cash and paying a mortgage on it, there is no monthly payment within HEI,” Abate said. “The way the investor gets paid is that you share in the upside of the home.”
Abate explained the impacts of the Basel III Endgame rules on the market, the rationale behind the home equity investment product, and more about Redwood strategies in an interview with HousingWire from a company’s office in New York last week.
This interview has been condensed and edited for clarity.
Flávia Nunes: How has Redwood strategically positioned itself in the residential mortgage space amid all of these potential regulatory changes?
Christopher Abate: Redwood is almost a 30-year-old company. The company was originally built to serve banks and others with the thought that there was no private sector [to invest in mortgage assets], only Fannie Mae and Freddie Mac. We would partner with banks to buy their loans and securitize them so the banks could recycle their capital. We don’t originate residential mortgages. We don’t service them. We’re very similar to the GSEs. We modeled the business to serve that role in the private sector. The mortgage market has changed over the decades. We’ve seen a few cycles. We’ve got the Great Financial Crisis, the Covid-19 pandemic, and now we’ve had a lot of interest rate volatility. Along the way, there have been many regulatory changes that have impacted the market; the CFPB has been created, and there’s the Dodd-Frank Act. Then there are the Basel rules, the regulatory capital rules for banks. And that’s what’s really in play today.
We’ve positioned the company, from a strategic perspective, with the thought that banks will be heavily disincentivized from growing mortgage portfolios as an earning asset class. The banks are not going to necessarily exit the mortgage market because the mortgage asset is the biggest that a client takes out, and you want to be there for all the cross-selling in all the other consumer products. Banks will always serve their best clients. But viewing the mortgage portfolio as an investment class, that’s where the posture will shift because the capital required to hold against it [residential mortgages] is going to go up. And just based on the rapidly rising rate of deposits, just given where interest rates are at, the net interest income that they earn is getting squeezed. Banks move slowly. This will be an evolutionary shift, not an overnight shift.
Nunes: As you noted, bank regulators released a plan to increase capital requirements for mortgages through the Basel III Endgame rules. Can we expect changes to what was proposed?
Abate: Yes, it will change. In particular, some of the sliding scale capital charges are based on things like LTV [loan-to-value]; there’s a fair likelihood that that changes because of the way it disproportionately impacts first-time homebuyers and underserved communities. But the rule is not going away. Bank regulators are paid to keep things safe. And the idea that regulators are going to allow banks to continue to do what a First Republic or Silicon Valley Bank did, I don’t see that in the cards.
We saw significant changes after the Great Financial Crisis, which was more of a credit crisis. We saw banks getting out of risky credit mortgages like option ARMs and some subprime lending happening back then. There will be changes. Banks will not wait for the rule to be finalized to start implementing it. There will be some evolution to the rule itself. But the thrust of the rule is that it’s going to be more expensive for banks to hold mortgages.
Nunes: If banks won’t wait for the Basel III Endgame to be finalized, how are they anticipating the rules?
Abate: A year ago, banks were very happy to hold mortgages, deposit rates were sticky, and the cost of deposits was still very low. Now, all of them are looking for a capital partner, at least an option to have liquidity. The tone has changed dramatically amongst bank executives. Some banks move more slowly than others.
I like to remind people that independent mortgage banks live and die by liquidity. They care about the basis point. Banks don’t operate that close to the ground. Things take longer to develop, but the relationships are also typically stickier. Once you forge a strong partnership with a bank partner, the likelihood of them shopping for that liquidity is much less than an independent mortgage bank that is trying to optimize every dollar.
Nunes: In your recent 2Q 2023 earnings report, you mentioned acquiring three bulk pools of loans from depositories, primarily with seasoned underlying loans at attractive discounts. How is the secondary market now for these trades in terms of volumes and prices?
Abate: I certainly expect RMBS volumes to go up significantly over time. It’s not something that happens overnight. We’ve been active. We just completed a deal in August. I would expect us to continue using securitization.
Right now, we’re in this hybrid phase where loans that are getting securitized are partially seasoned loans, and some of the loans have gone down in value–the lower coupon mortgages. The banks have been slowly selling some of those, and Wall Street dealers have quite a bit in inventory. We’re still seeing a lot of that aged collateral coming out through securitization. Issuers like Redwood have been combining current coupon mortgages. We saw this last year in the private sector securitization market, where we had all of this aged inventory. It was hard to get investors to focus on the collateral because there was so much sitting in inventory that they could price it wherever they wanted to. The pricing now is probably the best it’s been in a year, maybe two years. So, the market is finally starting to cross back into more current coupon on-the-run production, which is what we’re focused on.
We’ve completed well over 100 residential securitizations, close to 140 If we factor CoreVest. There’s been years we’ve done 12-15 securitizations. There’s been years where we’ve done none or one. So, we very much want to get volume going again to the extent we could be in the market with certainly a deal a quarter, but if not two or three, that would feel the base to me.
Nunes: In terms of products, what the current landscape brings in terms of opportunities?
Abate: Right now, the biggest opportunity, ironically, is in the regular prime jumbo market because that was the product banks were most focused on. And they weren’t wrong to focus on it from a credit standpoint because when the banks got through the Great Financial Crisis, all the big regulatory shifts were to get them out of taking risky mortgages on the balance sheet. Then, they started taking less risky mortgages, which are jumbos. The real shift is going to be all those jumbos that were going to banks will come back out, hopefully to non-banks like us.
Nunes: Redwood also launched a home equity platform. What is the strategy here?
Abate: When you look at prime rates in the high single digits and add a credit spread to that, even for the most well-qualified borrowers, you are looking at a 10% to 12% interest rate on a second mortgage. For a well-qualified borrower, 750 FICO or above, and a low-LTV first mortgage, you might be comfortable paying 10% to 12%. But that’s the best-case scenario. For everybody else, unlocking that equity is even more expensive. We’re seeing that for the traditional second mortgage products, there’s way more investor demand than consumer demand.
We’ve rolled out the traditional products and a newer product called home equity investment [HEI] options. The interesting thing about HEIs is instead of a homeowner taking out equity in the form of cash and paying a mortgage on it, there is no monthly payment within HEI. The way the investor gets paid is that you share in the upside of the home, so the home price appreciation. There are a lot of use cases for HEI over traditional products. If you think about somebody with a lot of student debt or lower FICO, they’re going to qualify for a very expensive second mortgage. So, this is a good option. It doesn’t add to their monthly payment obligation. You can do what you want with the cash, just like with a home equity line of credit, but not having the payment. It’s a bridge until the second mortgage is cheaper.
Nunes: To invest in this product, investors must believe home prices will keep rising, right?
Abate: There are a couple of things investors care about. You have to believe in a HPA [home price appreciation] story. But one way we mitigate that is we strike the price of the home at a discount to its current appraised value. So that, even if the home is sold next week, the investor will make money. If you believe that interest rates are nearing the top, as far as the Fed’s rate hike cycle, HPA should start to realign. If rates are going down, HPAs are going up. Investors are starting to get comfortable with this huge move in rates, hopefully, this fall is gonna pause.
Then, ultimately, the investors want to understand if we give you $100,000 with this HEI, when do they get their money back? Because it’s a 30-year product. And that’s where we’ve designed the product, which is unique to Redwood, that creates strong incentives for the homeowner to refi.
Nunes: How did you get the property at a discount?
Abate: The product is for people in their homes that are not moving out. There isn’t an actual transaction on the property. It’s somebody that wants to stay in their home. And if it’s a $1 million home, and we offer you $150,000 HEI, we might strike that HEI at $900,000. Let’s say it’s a $1 million home, and for purposes of coming up with the investor return, we’re going to call it a home at $850,000. Even if they sold the home at a $50,000 loss, the investor would still generate a return, and that’s what gets investor capital into the asset class. But what the homeowner gets is all of the proceeds, the cash and no monthly payments
The investors are institutional investors, well-known institutions, firms, pension funds, and life companies; they’re all just to varying degrees focused on HEI now. And the big reason is that nobody’s been able to tap this massive home equity opportunity. We are going to give it a try.
Nunes: Residential mortgages are just one facet of the business. What are your plans for commercial real estate, which has had a challenging year?
Abate: What we do here in New York is our business-purpose lending platform. We realized a number of years ago that investors are becoming a much bigger participant in the real estate markets. Serving them and providing bridge loans to investors who want to flip homes or provide turned-out financing for investors who want to rent homes, that’s an entire other residential business that we run under the flag of CoreVest. In residential, we’ve more or less stuck to our knitting of non-agency. We’ve had opportunities to enter the agency space in the past and participated in certain instances, but mostly, what we do is non-agency.
Nunes: You mentioned banks, but what are the business opportunities with IMBs?
Abate: We’ve had a great long-term relationship with the IMBs. The IMBs have a big opportunity to pick up some [market] share. Since the Great Financial Crisis, most of our business has been with the IMBs. We have a network of between 150 to 200 [partners], predominantly non-banks that we will buy mortgages from. We expect that to rebalance in the next few years. But the IMBs are also a big opportunity to take clients from the banks.
Nunes: And what are the plans for servicing mortgage rights?
Abate: Servicing will continue to move out of the banks. That’s another big opportunity that we’ll focus on. We don’t plan to operate as a servicer, but we might own servicing rights. What we’ve done typically is when we own servicing rights, we will subservice. We want to hire somebody with a call center. And we’ll pay them a monthly fee. But when you balance out the revenue potential with the servicing asset, with the cost of service, there are still good opportunities. There’s a lot of competition for servicing. For some mortgage REITs, that’s their primary asset class, just not for us.
Nunes: Can you shed some light on your partnership with Oaktree and Riverbend?
Abate: Both of those are related to the business-purpose lender space. Oaktree is a great example of us expanding our capital partnerships into the private credit sector. Redwood is a publicly traded company, and historically, when we needed to raise money, we would do a common stock offering or a public market deal. When rates started going up, things got pretty ugly for the mortgage REIT space and the public markets. We and all other mortgage REITs started trading at discounts. Raising money in that environment hasn’t been overly attractive. So, building partnerships with private credit firms like Oaktree to focus on specific asset classes is a big part of what we want to do. One aspect that’s attractive to us is we can earn asset management fees.
The Oaktree model is something that we want to replicate on the residential side as the jumbo opportunity picks up. We’ve been in discussions with other private credit investors and institutional investors who see the same opportunity as in jumbo and non-QM.
Nunes: With a reported cash and cash equivalents of $357 million as of June 2023, can we anticipate any M&A activities, especially considering the challenges faced by many lenders in the industry?
Abate: M&A activity has picked up in the space and based on our track record, we are a logical call. Part of our strategy is: to be active in M&A, you have to be active. It’s not efficient to call on at eight, seven different firms. You start with the ones that have shown interest in actually transacting. We have seen some opportunities, and nothing I can share in this interview, but it’s safe to say we’ve been active in M&As and we’ll continue to focus on that as part of our growth strategy.
We haven’t been open to it [acquiring a lender]. For many years, we’ve wanted to keep the business sort of regulator-light. The best way to do that is not to directly face consumers with products. We’re comfortable originating to investors, that’s what CoreWest does. But investors are sophisticated business-run ventures and not homeowners who may or may not be sophisticated in the financial markets. We have tended to not originate, but I think where we’re at as a company is from a strategic standpoint, we’d be much more open to it through M&A.
Nunes: What do you expect for the macro landscape in the coming year?
Abate: There’s such a vast shortage of supply of homes in many parts of the country, which is supporting home prices. The Fed consciously inflated home prices, particularly during the COVID years. These high asset values prevented normal credit losses you might see through a cycle. The combination of QE-fueled asset prices with an economy that hasn’t dropped off too much has created a strong housing market.
But credit in residential housing should perform immensely better than many facets of the commercial real estate market. There’s so much vacancy in these central business districts. These buildings are valued based on cash flows– not like a residential home, which is an appraisal. If it’s 50% full, it’s worth half as much. From a credit standpoint, certain facets of the commercial real estate sector will have a rough road ahead.
I’m probably supposed to say this, but I feel better about my sector. The technical supporting housing will continue to be strong. The big challenge with residential today is just transaction activity. If you own a home with a 3% mortgage, you don’t want to sell it. If your home suits your needs, the prospect of doubling your monthly payment to move is very unappealing. The real challenge in residential has been a lot of capacity to make loans, but there’s not much demand. If rates do stabilize, that will change quickly. When the market thought in January that rates were stabilizing, we saw a pickup in loan activity, and then they started going up again; we’ll see what happens this fall.
Nunes: Do you see a crisis on the commercial side of the market? If so, how could it impact the residential side?
Abate: It’s hard to say. The only real obvious driver for a crisis is what could be a permanent impairment of occupancy in these commercial office buildings. The way that can affect our markets is there’s a trickle-down effect. If the buildings aren’t full, the restaurants aren’t full, the delis aren’t full, the subways are not full, and the hotels aren’t full because people aren’t traveling to see people in the office. That could have an effect on the economy in general, which would impact housing indirectly. As far as the economy goes, the airports seem more full than ever, and hotels seem to be doing fine. Overall, [the problem] is probably mostly office. But if it keeps getting worse, it certainly could have downstream effects.